ARMSTRONG WORLD INDUSTRIES INC - Annual Report: 2018 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2018

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 every Interactive Data File required to be submitted 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 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, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act                                                                      ☐

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 ($63.20 per share) on the New York Stock Exchange (trading symbol AWI) of June 30, 2018 was approximately $3.3 billion.  As of February 19, 2019, the number of shares outstanding of the registrant's Common Stock was 48,502,391.

Documents Incorporated by Reference

Certain sections of Armstrong World Industries, Inc.’s definitive Proxy Statement for use in connection with its 2019 annual meeting of shareholders, to be filed no later than April 30, 2019 (120 days after the last day of our 2018 fiscal year), are incorporated by reference into Part III of this Form 10-K Report where indicated.

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 leading global producer of ceiling systems for use primarily in the construction and renovation of commercial and residential buildings. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) throughout the Americas.

In August 2018, we acquired the business and assets of Steel Ceilings, Inc. (“Steel Ceilings”), based in Johnstown, Ohio. Steel Ceilings is a manufacturer of aluminum and stainless metal ceilings that include architectural, radiant and security solutions with one manufacturing facility. Steel Ceilings’ operations, and its assets and liabilities as of December 31, 2018, are included as a component of our Architectural Specialties segment.  

In May 2018, we acquired the business and assets of Plasterform, Inc. (“Plasterform”), based in Mississauga, Ontario, Canada.  Plasterform is a manufacturer of architectural cast ceilings, walls, facades, columns and moldings with one manufacturing facility.  Plasterform’s operations, and its assets and liabilities as of December 31, 2018, are included as a component of our Architectural Specialties segment.  

In November 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. (“Worthington”) in which AWI holds a 50% interest. The consideration paid by Knauf in connection with the sale was $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.  

On July 18, 2018, we entered into an amendment to the Purchase Agreement, pursuant to which Knauf agreed to irrevocably and unconditionally pay AWI (i) $250 million on August 1, 2018, and (ii) $80 million on September 15, 2018, if, prior to such date, (A) any competition condition has not been satisfied or (B) the closing has not yet occurred. The amendment also provided for the reduction (from a maximum of $35 million to a maximum of $20 million) of potential adjustments to the purchase price consideration for the transaction based on the impact of remedies required to satisfy competition conditions. We received both the $250 million payment and the $80 million payment from Knauf in the third quarter of 2018.  Following receipt of these payments, we remitted $70 million to WAVE in partial consideration of the purchase price payable in respect of the business and operations of WAVE under the transaction.  WAVE subsequently paid each of AWI and Worthington a dividend of $35 million.  We also recorded a $22.4 million payable to WAVE, which is reflected within Accounts Payable and Accrued Expenses. The total consideration payable by AWI to WAVE will be determined following closing in connection with the calculation of the adjustments contemplated by the Purchase Agreement.  

The transaction was notified for merger control clearance in the European Union (“EU”), Bosnia and Herzegovina, Macedonia, Montenegro, Russia and Serbia, and was cleared unconditionally in Montenegro (February 2018), Serbia (February 2018), Russia (March 2018), Macedonia (July 2018) and Bosnia and Herzegovina (August 2018).   On December 7, 2018, the European Commission granted conditional clearance of the transaction, subject to certain commitments intended to address concerns regarding the overlap between the activities of AWI and Knauf, including the divestment by Knauf to a third party of certain mineral fiber and grid businesses and operations in Austria, Estonia, Germany, Ireland, Italy, Latvia, Lithuania, Portugal, Spain, Turkey and the UK.  This includes our sales operations in each of the relevant countries, as well as our production facilities, and those of WAVE, located in Team Valley, UK.  The terms of the sale of the divestment business by Knauf and the identity of the purchaser are subject to the approval of the European Commission.

We continue to work closely with Knauf towards closing and expect the transaction to close by the end of the first half of 2019.  The EMEA and Pacific Rim 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, 2018, are included as a component of our Architectural Specialties segment.  

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In April 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 5 to the Consolidated Financial Statements for additional information related to our acquisition and discontinued operations.

We are focused on driving sustainable shareholder value by consistently delivering profitable sales and earnings growth, while maintaining a balanced approach to capital allocation.  Through our expanding architectural specialties offerings, bolstered by our acquisitions of Tectum, Plasterform and Steel Ceilings, our innovative core ceilings portfolio, including our Total Acoustics solutions and Sustain family of products, and digitally-enabled systems and tools, we are expanding our capabilities to sell into more spaces and sell more into every space. 

Markets

We are well positioned in the industry segments and markets in which we operate, often holding a leadership or significant market share position. Our 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. 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, performance attributes (such as acoustics and sustainability), availability, affordability and ease of installation also affect our revenue.

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. 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.  

Customers

We use our reputation, capabilities, service, innovation 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., with wholesalers who re-sell our products to dealers who service builders, contractors and consumers, and also with architects and designers who specify products.

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 primarily to direct customers and retailers.  

Net sales to three commercial distributors totaling $459.3 million, included within our Mineral Fiber and Architectural Specialties segments, individually exceeded 10% of our consolidated net sales in 2018.  

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

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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: wood pulp, 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 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 13% of our total consolidated revenue in 2018.

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®, DESIGNFlex™, 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.

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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 at least 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, 2018, we had approximately 4,000 full time and part time employees. As on December 31, 2017, we had approximately 3,900 full-time and part-time employees. Excluding our EMEA and Pacific Rim businesses, we had approximately 2,200 employees as of December 31, 2018 and December 31, 2017.  

As of December 31, 2018, approximately 81% of our approximately 1,000 production employees in the U.S. were represented by labor unions.  Collective bargaining agreements covering approximately 65 employees at one U.S. plant will expire during 2019.  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.

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 three domestically owned locations allegedly resulting from past industrial activity. We are one of several potentially responsible parties in these matters 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.

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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. During the first quarter of 2018, the Court denied, in part, and granted, in part, our motion to dismiss, dismissing two of the claims brought by Roxul USA, Inc. We recently filed a motion seeking summary judgment on all of Rockfon’s remaining claims and have moved to exclude the testimony of Rockfon’s expert witness.  Rockfon moved for partial summary judgment in its favor on a single claim of alleged liability only (not damages).  We subsequently opposed that motion on numerous grounds.  The date for determination of motions is not currently scheduled.  A trial date is reserved, if necessary, for early in the second quarter of 2019.  We continue to incur defense costs for 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 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 $12.4 million and $13.5 million as of December 31, 2018 and December 31, 2017, 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.

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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 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.

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

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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.

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, 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 (“FTCs”), and state net operating losses (“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.

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 have considered the effect of the disposition on competition within their relevant jurisdiction.

On December 7, 2018, the European Commission granted conditional clearance, subject to certain commitments, of our proposed disposition of our EMEA and Pacific Rim businesses.  The commitments are intended to address concerns regarding the overlap between the activities of AWI and Knauf and include the divestment by Knauf to a third party of certain mineral fiber and grid businesses and operations of the Company in Austria, Estonia, Germany, Ireland, Italy, Latvia, Lithuania, Portugal, Spain, Turkey and the UK.  This includes our sales operations in each of the relevant countries, as well as our production facilities, and those of WAVE, located in Team Valley, UK.  The terms of the sale of the divestment business by Knauf and the identity of the purchaser are subject to the approval of the European Commission.

There can be no assurance that regulators will not impose additional 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 additional 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 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.

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.

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.

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:

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

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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.

Adverse results caused by 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.

We are currently a party to litigation filed against us in the United States District Court for the District of Delaware by Roxul USA, Inc. (d/b/a Rockfon) 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.  

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.

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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.

A disruption in our information technology systems 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 of information technology. We strive 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.

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. The transaction is subject to regulatory approvals, including the terms of the conditional clearance granted by the European Commission, and other customary conditions, and is currently expected to close by the end of the first half of 2019.

A significant portion of our products move in international trade. See Notes 3 and 5 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 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.

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.

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Our U.S. pension plans were overfunded by $0.7 million as of December 31, 2018.  Our unfunded U.S. postretirement plan liabilities were $65.4 million as of December 31, 2018.  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.

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.

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.

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.

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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, 2018, we had 18 manufacturing plants in eight countries, including nine plants located throughout the U.S., which included our St. Helens, Oregon mineral fiber manufacturing facility, which closed in the second quarter of 2018.  During the second quarter of 2018, as part of our acquisition of Plasterform, we acquired one additional plant located in Canada. During the third quarter of 2018, as part of our acquisition of Steel Ceilings, we acquired one additional plant located in Ohio. We have one idle mineral fiber plant in China, reported as a component of our Unallocated Corporate segment as it is not included in the pending sale to Knauf.  Upon closure of the sale of our EMEA and Pacific Rim businesses to Knauf, we will have 12 plants, including nine plants in the U.S, two plants in Canada and the idle plant in China which management decided to close in the third quarter of 2017.

WAVE operates nine 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 to Knauf, WAVE will operate five plants in the U.S.

Two of our plants are leased and the remaining ten are owned.  

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 19, 2019, there were approximately 240 holders of record of AWI’s common stock.

Dividends are payable 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, we announced that our 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 (as amended the “Program”).  On October 30, 2017, we announced that our Board of Directors had approved an additional $250.0 million authorization to repurchase shares under the Program.  The Program was also extended to October 31, 2020.  On July 31, 2018, we announced that our Board of Directors had approved an additional $300.0 million authorization to repurchase shares, increasing the total authorized amount under the Program to $700.0 million.

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. 

On August 2, 2018, we entered into an accelerated share repurchase agreement with Deutsche Bank AG under the Program. The ASR included a pre-payment of $150.0 million to Deutsche Bank, at which time we received 1,766,004 shares. The ASR terminated on October 8, 2018, with approximately 389,825 shares returned on that day to complete the ASR.

During 2018, including the ASR, we repurchased 4.7 million shares under the Program for a total cost of $306.5 million, or an average price of $64.74 per share.  Since inception of the Program, we have repurchased 7.7 million shares under the Program for a total cost of $430.6 million, or an average price of $56.01 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 leading global producer of ceiling systems for use primarily in the construction and renovation of commercial, institutional and residential buildings. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) throughout the Americas.

In August 2018, we acquired the business and assets of Steel Ceilings, Inc. (“Steel Ceilings”), based in Johnstown, Ohio. Steel Ceilings is a manufacturer of aluminum and stainless metal ceilings that include architectural, radiant and security solutions with one manufacturing facility. Steel Ceilings’ operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment.  

In May 2018, we acquired the business and assets of Plasterform, Inc. (“Plasterform”), based in Mississauga, Ontario, Canada.  Plasterform is a manufacturer of architectural cast ceilings, walls, facades, columns and moldings with one manufacturing facility.  Plasterform’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment.  

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. (“Worthington”) in which AWI holds a 50% interest. The consideration 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.  

On July 18, 2018, we entered into an amendment to the Purchase Agreement, pursuant to which Knauf agreed to irrevocably and unconditionally pay AWI (i) $250 million on August 1, 2018, and (ii) $80 million on September 15, 2018, if, prior to such date, (A) any competition condition has not been satisfied or (B) the closing has not yet occurred. The amendment also provided for the reduction (from a maximum of $35 million to a maximum of $20 million) of potential adjustments to the purchase price consideration for the transaction based on the impact of remedies required to satisfy competition conditions. We received both the $250 million payment and the $80 million payment from Knauf in the third quarter of 2018.  Following receipt of these payments, we remitted $70 million to WAVE in partial consideration of the purchase price payable in respect of the business and operations of WAVE under the transaction.  WAVE subsequently paid each of AWI and Worthington a dividend of $35 million.  We also recorded a $22.4 million payable to WAVE, which is reflected within Accounts Payable and Accrued Expenses.  The total consideration payable by AWI to WAVE will be determined following closing in connection with the calculation of the adjustments contemplated by the Purchase Agreement.  

The transaction was notified for merger control clearance in the European Union (“EU”), Bosnia and Herzegovina, Macedonia, Montenegro, Russia and Serbia, and was cleared unconditionally in Montenegro (February 2018), Serbia (February 2018), Russia (March 2018), Macedonia (July 2018) and Bosnia and Herzegovina (August 2018).   On December 7, 2018, the European Commission granted conditional clearance of the transaction, subject to certain commitments intended to address concerns regarding the overlap between the activities of AWI and Knauf, including the divestment by Knauf to a third party of certain mineral fiber and grid businesses and operations in Austria, Estonia, Germany, Ireland, Italy, Latvia, Lithuania, Portugal, Spain, Turkey and the UK.  This includes our sales operations in each of the relevant countries, as well as our production facilities, and those of WAVE, located in Team Valley, UK.  The terms of the sale of the divestment business by Knauf and the identity of the purchaser are subject to the approval of the European Commission.

We continue to work closely with Knauf towards closing and expect the transaction to close by the end of the first half of 2019. The EMEA and Pacific Rim 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

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

operations from the date of acquisition, and its assets and liabilities as of December 31, 2018, 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 5 to the Consolidated Financial Statements for additional information related to our acquisitions and discontinued operations.

As of December 31, 2018, we had 18 manufacturing plants in eight countries, including nine plants located throughout the U.S., which included our St. Helens, Oregon mineral fiber manufacturing facility, which closed in the second quarter of 2018.  During the second quarter of 2018, as part of our acquisition of Plasterform, we acquired one plant located in Canada. During the third quarter of 2018, as part of our acquisition of Steel Ceilings, we acquired one plant located in Ohio. We have one idle mineral fiber plant in China, reported as a component of our Unallocated Corporate segment as it is not included in the pending sale to Knauf.  Upon closure of the sale of our EMEA and Pacific Rim businesses to Knauf, we will have 12 plants, including nine plants in the U.S, two plants in Canada and the idle plant in China.

WAVE operates nine 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 

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, 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 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 sell 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. 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’ 2018 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.  

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

In addition, we noted several factors and trends within our markets that directly affected our business performance during 2018. 

In our Mineral Fiber segment, we experienced increased volume activity due to growth in the distributor customer group. In our Architectural Specialties segment, we experienced strong growth primarily due to increased market penetration and due to the impact of recent acquisitions.

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. Within our Mineral Fiber segment, 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 total consolidated net sales for 2018 by approximately $43 million compared to 2017.  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 sales to volume.  

In the first, second and third quarters of 2018, we implemented price increases on Mineral Fiber ceiling tile and certain grid and Architectural Specialties products. In the fourth quarter of 2018, we announced a price increase on Mineral Fiber grid products to be effective in the first quarter of 2019. We may implement additional pricing actions based on numerous factors, most notably upon future movements in raw material prices and sourced product costs.

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 2018, the costs for raw materials, sourced products and energy negatively impacted operating income by approximately $7.0 million, compared to 2017.

Employees

As of December 31, 2018 we had approximately 4,000 full time and part time employees. As of December 31, 2017, we had approximately 3,900 full-time and part-time employees. Excluding our EMEA and Pacific Rim businesses, we had approximately 2,200 employees as of December 31, 2018 and December 31, 2017.

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.

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

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, 2018 and 2017, we assumed discount rates of 4.30% and 3.63%, respectively, for the U.S. defined benefit pension plans.  As of December 31, 2018 and 2017, we assumed a discount rates of 4.32% and 3.60%, 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 2019 operating income.

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, 2018, the historical annualized return was approximately 7.9% compared to an average expected return of 6.8%. The actual loss on plan assets incurred for 2018 was 4.4% net of fees. 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 2018 U.S. pension cost was 6.50%.  We have assumed a return on plan assets for 2019 of 5.75%.  The 2019 expected return on assets was calculated in a manner consistent with 2018.  A one-quarter percentage point increase or decrease in this assumption would increase or decrease 2019 operating income by approximately $3.5 million.

Contributions to the unfunded plan were $3.9 million in 2018 and were made on a monthly basis to fund benefit payments.  We estimate the 2019 contributions will be approximately $4.3 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, 2018, 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 2019 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 an increase in net actuarial losses related to our U.S. pension benefit plans of $57.1 million in 2018 primarily due to a worse than expected return on assets, partially offset by changes in actuarial assumptions (most significantly a 67 basis point increase in the discount rate).  The $57.1 million actuarial loss 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.

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

Income Taxes – Our effective tax rate is primarily determined based on our pre-tax income, statutory income tax rates in the jurisdictions in which we operate, and 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 losses (“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 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, 2018, we have recorded valuation allowances totaling $79.6 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, 2018 includes net deferred income tax assets of $101.9 million.  Included in this amount are deferred federal income tax assets for FTC carryforwards of $19.1 million, and state NOL deferred income tax assets of $58.7 million. We have established valuation allowances in the amount of $79.6 million consisting of $19.1 million for federal deferred tax assets related to FTC carryovers, $13.2 million for the outside basis difference between book and tax basis of our EMEA and Pacific Rim businesses, and $47.3 million for state deferred tax assets, primarily operating loss carryovers. The state deferred income tax asset and related state valuation allowance were each grossed up by $26.5 million in 2018, with no overall net change to the net deferred state income tax asset, to reflect gross Pennsylvania net operating loss deferred tax asset and valuation allowance amounts, pursuant to a change in that state’s net operating loss regulations. 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 $537.5 million for state income tax purposes during the respective realization periods (ranging from 2019 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.

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

Impairments of Long-Lived Tangible, Intangible Assets and Goodwill – 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.  In connection with the performance of an impairment test for indefinite-lived intangible assets and goodwill, we compare the carrying amount of the asset group (when testing indefinite-lived intangible assets) and reporting units (when testing goodwill) to the estimated undiscounted future cash flows expected to be generated by the assets.  If the undiscounted cash flows of the asset group/reporting unit are less than the carrying value, an estimate of an asset group’s/reporting unit’s fair value is based on discounted future cash flows expected to be generated by the asset group/reporting unit, 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/reporting unit, we record an impairment charge equal to the difference between the fair value and carrying value of the asset group/reporting unit.

The principal assumption utilized in our impairment tests for definite-lived intangible assets and goodwill 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.  The principal assumptions utilized in our impairment tests for goodwill include after-tax cash flows growth rates and discount rate.  Revenue growth rates, after-tax cash flows growth rates 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 capital 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 asset group.

In 2018, indefinite-lived intangibles were tested for impairment based on our identified asset groups.

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 2018, 2017 or 2016 related to intangible assets.

We did not test tangible assets within our continuing operations for impairment in 2018, 2017 or 2016 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 11 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.

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

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 5 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.

2018 COMPARED TO 2017

CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS

(dollar amounts in millions)

Consolidated net sales increased due to favorable AUV of $43 million and higher volumes of $39 million.

Cost of goods sold was 65.8% of net sales in 2018, compared to 64.7% in 2017.  The increase in cost of goods sold as a percentage of sales in comparison to 2017 was impacted by an increase in input costs and $14 million of higher accelerated depreciation and closure costs in 2018 related to management’s decision to permanently close the St. Helens, Oregon plant, partially offset by savings from the closure of the plant realized in the second half of 2018.  Also impacting the increase in cost of goods sold as a percent of net sales was $10 million of environmental insurance settlements, net of charges, recorded in 2017 partially offset by $6 million of accelerated depreciation of machinery and equipment recorded in 2017 based on management’s decision to permanently close a previously idled plant in China.

SG&A expenses in 2018 were $159.0 million, or 16.3% of net sales, compared to $138.6 million, or 15.5% of net sales, in 2017.  The increase in SG&A expenses was primarily due to higher selling expenses due to an increase in net sales, an increase in legal fees and higher stock-based compensation expense.  Also contributing to the increase in SG&A expenses was a $3 million reduction in environmental insurance settlements, net of expenses, in 2018 as compared to 2017.  

Equity earnings from our WAVE joint venture were $74.9 million in 2018, compared to $67.0 million in 2017.  The increase in WAVE earnings was primarily driven by an increase in net sales as a result of positive AUV, partially offset by higher input costs, particularly steel and freight.  See Note 10 to the Consolidated Financial Statements for further information.  

Interest expense was $39.2 million in 2018, compared to $35.4 million in 2017. The increase in interest expense in 2018 was due to increased floating interest rates. Also contributing in the increase of interest expense over 2017 was the expiration of a $250 interest rate swap on March 31, 2018.

Other non-operating income was $32.5 million in 2018 and $13.7 million in 2017.  The increase in other non-operating income was primarily related to higher pension and postretirement net periodic benefit credits, excluding service costs.  In accordance with our adoption of Accounting Standards Update (“ASU”) 2017-07, all non-service cost components of net periodic pension and postretirement benefit costs were recorded as a component of non-operating income in both 2018 and 2017.  Also contributing to the increase in other non-operating income, net was a $20 million partial settlement loss recorded in 2017 for our RIP. See Note 16 to the Consolidated Financial Statements for further information.

Income tax expense was $53.1 million and $1.5 million in 2018 and 2017, respectively.  The effective tax rate for 2018 was 21.9% as compared to a rate of 0.7% for 2017.  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%.  We applied the guidance in Staff Accounting Bulletin (“SAB”) 118 when

24

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

accounting for the enactment-date effects of the 2017 Tax Act in 2017 and throughout 2018.  As a result, in the fourth quarter of 2017 we recorded a net $82.5 million income tax benefit. At December 31, 2018 we have now completed our accounting for the enactment-date income tax effects of the 2017 Tax Act. We increased our December 31, 2017 estimated tax benefit of $82.5 million to $83.7 million in 2018, primarily related to the mandatory repatriation of earnings feature of federal tax reform. Excluding the December 31, 2017 enactment-date impact of the 2017 Tax Act, income tax expense for 2018 decreased in comparison to 2017 due primarily to the reduced 21% federal income tax rate that took effect January 1, 2018.  The 2017 Tax Act subjects a U.S. shareholder to tax on Global Intangible Low Tax Income (“GILTI”) earned by certain foreign subsidiaries. We have elected to account for GILTI as a current period expense when incurred, with the December 31, 2018 GILTI income tax expense being immaterial. Other than the items noted above, the remaining provisions of the 2017 Tax Act did not have a material effect on our financial condition, liquidity or results of operations.

Total other comprehensive income (loss) (“OCI”) was a $59.4 million loss for 2018 compared to $57.9 million of income for 2017.  The change was primarily due to foreign currency translation adjustments and pension and post retirement adjustments. 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 2018 were driven primarily by changes in the exchange rates of the Russian ruble and the British pound. 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. 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.  These losses in OCI in 2018 primarily related to our U.S. pension plans. 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. See Note 24 to the Consolidated Financial Statements for further information.

REPORTABLE SEGMENT RESULTS

Mineral Fiber

(dollar amounts in millions)

Net sales increased due to favorable AUV of $42 million and higher volumes of $3 million. The favorable AUV was due to improved price and positive mix from the sale of higher end ceiling tile products.    

Operating income decreased due to higher manufacturing and input costs of $26 million and higher SG&A expenses of $19 million, partially offset by the favorable margin impact of higher AUV of $27 million and higher equity earnings from WAVE of $8 million.  

The increase in manufacturing costs was impacted by increases in input costs and $10 million environmental insurance settlements, net of charges, recorded in 2017.  Also impacting the increase in manufacturing costs was a $14 million increase in depreciation and closure costs attributable to our St. Helens manufacturing plant, partially offset by savings from the closure of the plant.  The increase in SG&A expenses was primarily due to a $6 million increase in legal fees, a $6 million increase in selling expenses, a $3 million increase in stock-based compensation expense and a $3 million reduction in environmental insurance settlements, net of charges.  

Architectural Specialties

(dollar amounts in millions)

Net sales increased due to higher volumes from increased market penetration and new construction activity as well as the 2018 acquisitions of Plasterform and Steel Ceilings.

25

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

Operating income increased due to the positive impact of higher volumes, partially offset by an increase in manufacturing costs, due to investments in design capabilities and investments related to recent years’ acquisitions, and higher SG&A expenses due primarily to increased selling expenses as a result of increased net sales.

Unallocated Corporate

Unallocated Corporate expense of $9 million decreased from $17 million in the prior year primarily due to $6 million of accelerated depreciation charges for machinery and equipment recorded in 2017 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 businesses and a $3 decrease in service costs associated with our RIP.  

FINANCIAL CONDITION AND LIQUIDITY

Cash Flow

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

Operating activities for 2018 provided $203.2 million of cash, compared to $170.4 million of cash provided in 2017.  The increase was primarily due to a decrease in accounts receivable primarily related to proceeds received in 2018 for environmental insurance recoveries.

Net cash provided by investing activities was $309.6 million for 2018, compared to a $54.2 million use of cash for 2017.  The increase was primarily due to $330 million of proceeds received from Knauf related to the anticipated sale of our EMEA and Pacific Rim businesses, net of $70 million of payments to WAVE.  Also contributing to the increase in investing cash flows was an increase of dividends from our WAVE joint venture.

Net cash used by financing activities was $329.3 million in 2018, compared to $102.7 million in 2017.  The decrease was primarily due to the higher repurchases of outstanding common stock, payments of dividends and an increase in credit facility payments, partially offset by proceeds from exercised employee stock awards.

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, 2018, total borrowings outstanding under our senior credit facility were $547.5 million under Term Loan A and $243.1 million under Term Loan B.  There were no borrowings outstanding under the revolving credit facility.    

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 2018 or will be required in 2019.

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, 2018, we were in compliance with all covenants of the senior credit facility.

26

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

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):

Under the terms of our April 2016 swap, we receive the greater of 3-month LIBOR or a 0.75% LIBOR Floor and pay a fixed rate over the hedged period.

Under the terms of our November 2016 swap, we receive 3-month LIBOR and pay a fixed rate over the hedged period, in addition to a basis rate swap to convert the floating rate risk under our November 2016 Swap from 3-month LIBOR to 1-month LIBOR.  As a result, we receive 1-month LIBOR and pay a fixed rate over the hedged period.

We entered into two new swap positions effective November 28, 2018.  Under the $200.0 million notional 2018 swap we pay a fixed rate over the hedged amount and receive 1-month LIBOR.  This includes a 0% floor.  Under the $100.0 million notional 2021 swap, we will pay a fixed rate monthly and receive 1-month LIBOR.  This is inclusive of a 0% floor.

These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt.  

As of December 31, 2018, 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, 2018, we had $325.7 million of cash and cash equivalents, $259.9 million in the U.S and $65.8 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 cash held in various foreign jurisdictions; however our Purchase Agreement with Knauf allows AWI to transfer any cash balances held in our EMEA businesses to Knauf up to $10.0 million.  See Note 1 to the Consolidated Financial Statements for additional information.

As of December 31, 2018, we had a $40.0 million Accounts Receivable Securitization Facility with the Bank of Nova Scotia (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, 2018, we had no borrowings under this facility. In February 2019, the facility was amended to resize the purchase limit from $40.0 million to $36.2 million and to extend the maturity to March 2020.

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):

27

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

As of December 31, 2018 and 2017, $6.0 million and $6.6 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.

2017 COMPARED TO 2016

CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS

(dollar amounts in millions)

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

Cost of goods sold was 64.7% of net sales in 2017, compared to 63.3% 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 of cost of goods sold related to environmental insurance settlements recorded in 2017.

SG&A expenses in 2017 were $138.6 million, or 15.5% of net sales, compared to $184.2 million, or 21.9% of net sales, in 2016.  The decrease in SG&A expenses was impacted by 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 $13.7 million in 2017 and $4.2 million in 2016.  The changes in other non-operating income were primarily due to higher pension and postretirement net periodic benefit credits, excluding service costs.  In accordance with our adoption of Accounting Standards Update (“ASU”) 2017-07, all non-service cost components of net periodic pension and postretirement benefit costs were recorded as a component of non-operating income in both 2017 and 2016. Also contributing to the change were the foreign exchange rate gains on the translation of unhedged cross-currency intercompany loans in 2016.  

28

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

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. As a result of the 2017 Tax Act, 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.

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 $17 million decreased from $50 million in the prior year, primarily due to $35 million of charges incurred in connection with our separation of AFI in 2016.  

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

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.

OFF-BALANCE SHEET ARRANGEMENTS

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

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, 2018.  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.

30

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

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 2018 was $11.2 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, 2018, we would have been obligated to purchase approximately $0.8 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.

Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. Our securitization facility is with the Bank of Nova Scotia and matures in March 2020. 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, 2018.  

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, 2018, we had no liabilities recorded for which an indemnity claim had been received.

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Market Risk

Our primary exposure to market risk is from changes in interest rates that could impact our results of operations, cash flows and financial condition.  We use forward swap contracts to hedge these exposures.  The Company utilizes 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.

In July 2017, the Financial Conduct Authority (the authority that regulates LIBOR) announced it intends to replace LIBOR rates with the Secured Overnight Financing Rate ("SOFR") effective in 2021. The Alternative Reference Rates Committee ("ARRC") has proposed that the SOFR rate that represents best practice as the alternative to USD-LIBOR for use in derivatives and other financial contracts that are currently indexed to USD-LIBOR.  ARRC has proposed a paced market transition plan to SOFR from USD-LIBOR and organizations are currently working on industry wide and company specific transition plans as it relates to derivatives and cash markets exposed to USD-LIBOR. The Company has material contracts that are indexed to USD-LIBOR at the present time and will monitor the new SOFR rates in relation to our debt and interest rate hedging instruments.

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, 2018 levels would increase 2019 interest expense by approximately $0.9 million.  As of December 31, 2018, $243.1 million of our debt under Term Loan B 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 $500.0 million of active interest rate swaps outstanding, which fix the interest rates for a portion of our debt. These active interest rate swaps are included in this calculation.  

As of December 31, 2018, we had interest rate swaps outstanding on Term Loan A and on Term Loan B, with notional amounts of $400.0 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, 2018 (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 $3.5 million at December 31, 2018.

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The table below provides information about our long-term debt obligations as of December 31, 2018, 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 $5.8 million of unamortized debt financing costs as of December 31, 2018.  

33

SUPPLEMENTARY DATA

Quarterly Financial Information for the Years Ended December 31, 2018 and 2017 (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, 2018, 2017 and 2016.

Consolidated Balance Sheets as of December 31, 2018 and 2017.

Consolidated Statements of Equity for the Years Ended December 31, 2018, 2017 and 2016.

Consolidated Statements of Cash Flows for the Years Ended December 31, 2018, 2017 and 2016.

Notes to Consolidated Financial Statements.

Schedule II for the Years Ended December 31, 2018, 2017 and 2016.

34

Armstrong World Industries, Inc., and Subsidiaries

Quarterly Financial Information (unaudited)

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

Note: The net sales and gross profit amounts above are reported on a continuing operations basis.  The sum of the quarterly earnings per share data may not equal the total year amounts due to changes in the average shares outstanding and, for diluted data, the exclusion of the anti-dilutive effect in certain quarters.  

35

Armstrong World Industries, Inc., and Subsidiaries

Quarterly Financial Information (unaudited)

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

Fourth Quarter 2018 Compared With Fourth Quarter 2017 – Continuing Operations

Consolidated net sales of $238.9 million in the fourth quarter of 2018 increased 11.4% due to higher volumes of $16 million and favorable AUV of $9 million.

Mineral Fiber net sales increased 7.8% due to favorable AUV of $9 million and higher volumes of $5 million.   Architectural Specialties net sales increased 29.1% due to higher volumes as a result of increased market penetration and new construction activity, as well as the 2018 acquisitions of Plasterform and Steel Ceilings.

For the fourth quarter of 2018, cost of goods sold was 65.6% of net sales, compared to 71.5% in 2017.  The decrease in cost of goods sold as a percentage of sales in comparison to 2017 was impacted by a $6 million reduction in accelerated depreciation and closure costs related to management’s decision to permanently close the St. Helens, Oregon plant in the fourth quarter of 2017, combined with savings from the closure of the plant realized in the fourth quarter of 2018.  Also contributing to the decrease in cost of goods sold was $2 million of accelerated depreciation of machinery and equipment recorded in 2017 based on management’s decision to permanently close a previously idled plant in China.  Partially offsetting these decreases in cost of goods sold was $2 million of environmental insurance settlements, net of charges, recorded in 2017.

SG&A expenses for the fourth quarter of 2018 were $45.3 million, or 19.0% of net sales compared to $32.8 million, or 15.3% of net sales, for the fourth quarter of 2017.  The increase in SG&A expenses was primarily due an $8 million reduction in environmental insurance settlements, net of expenses, in the fourth quarter of 2018 as compared to fourth quarter of 2017.  Also contributing to the increase in SG&A expenses was higher stock-based compensation expense, higher selling expenses, primarily due to an increase in net sales, and an increase in legal fees.  

Equity earnings in the fourth quarter of 2018 were $15.7 million compared to $15.1 million for the fourth quarter of 2017.  The increase in WAVE earnings was primarily driven by an increase in net sales as a result of positive AUV, partially offset by higher input costs, particularly steel.  See Note 10 to the Consolidated Financial Statements for further information.  

Operating income was $52.5 million in the fourth quarter of 2018 compared to $43.4 million in the fourth quarter of 2017.

Interest expense in the fourth quarter of 2018 increased to $10.3 million compared to $8.9 million in the fourth quarter of 2017 due to an increase in floating interest rates.

Fourth quarter income tax expense was $10.8 million on pre-tax earnings from continuing operations of $47.4 million in 2018 compared to income tax benefit of $60.7 million on a pre-tax earnings from continuing operations of $43.4 million in 2017.  The effective tax rate for 2018 was significantly higher than 2017 primarily due to the income tax benefits derived in 2017 from the 2017 Tax Act. 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 on 2017 results, income tax expense for the fourth quarter of 2018 decreased in comparison to 2017 due to the decrease in the federal tax rate on current activity in 2018.

36

Management’s Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended.  Our internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external purposes in accordance with generally accepted accounting principles.

Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).  Based on this evaluation and the criteria in the COSO framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2018.

KPMG LLP, an independent registered public accounting firm, audited our internal control over financial reporting as of December 31, 2018, as stated in their report included herein.

February 25, 2019

37

Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors
Armstrong World Industries, Inc.:

Opinion on Internal Control Over Financial Reporting

We have audited Armstrong World Industries, Inc. and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.  

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated statements of earnings and comprehensive income, equity, and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes and financial statement schedule of valuation and qualifying reserves (collectively, the “consolidated financial statements”), and our report dated February 25, 2019 expressed an unqualified opinion on those consolidated financial statements.

Basis for Opinion

The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

Definition and Limitations of Internal Control Over Financial Reporting

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ KPMG LLP

Philadelphia, Pennsylvania
February 25, 2019

38

Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors
Armstrong World Industries, Inc.:

Opinion on the Consolidated Financial Statements

We have audited the accompanying consolidated balance sheets of Armstrong World Industries, Inc. and subsidiaries (the “Company”) as of December 31, 2018 and 2017, the related consolidated statements of earnings and comprehensive income, equity, and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes and financial statement schedule of valuation and qualifying reserves (collectively, the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 25, 2018 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

Change in Accounting Principle

As discussed in Note 2 to the consolidated financial statements, effective January 1, 2018, the Company adopted Financial Accounting Standards Board (FASB) Topic 606, Revenue from Contracts with Customers, and the related FASB Accounting Standard Updates using the modified retrospective transition method.

Basis for Opinion

These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ KPMG LLP

We have served as the Company’s auditor since 1929.

Philadelphia, Pennsylvania

February 25, 2019

39

Armstrong World Industries, Inc., and Subsidiaries

Consolidated Statements of Earnings and Comprehensive Income

(amounts in millions, except per share data)

See accompanying notes to consolidated financial statements beginning on page 44.

40

Armstrong World Industries, Inc., and Subsidiaries

Consolidated Balance Sheets

(amounts in millions, except share data)

See accompanying notes to consolidated financial statements beginning on page 44.

41

Armstrong World Industries, Inc., and Subsidiaries

Consolidated Statements of Equity

(amounts in millions, except share data)