Edited Transcript of AFI earnings conference call or presentation 7-May-20 2:00pm GMT

LANCASTER May 8, 2020 (Thomson StreetEvents) — Edited Transcript of Armstrong Flooring Inc earnings conference call or presentation Thursday, May 7, 2020 at 2:00:00pm GMT

* Douglas B. Bingham

Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer

* Michel S. Vermette

Armstrong Flooring, Inc. – President, CEO & Director

* Justin A. Speer

Nomura Securities Co. Ltd., Research Division – Research Analyst

* Paul T. Betz

Good day, and welcome to the Armstrong Flooring, Inc. First Quarter 2020 Earnings Call. Today’s conference is being recorded. And at this time, I’d like to turn [the conference] over to Mr. Doug Bingham, Senior Vice President and Chief Financial Officer. Please go ahead, sir.

Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [2]

Thank you for joining us today for Armstrong Flooring’s First Quarter 2020 Earnings conference Call. I am joined by our President and CEO, Michel Vermette. We trust you have seen our press release this morning on the Investors section of our website at armstrongflooring.com.

During this call, we will be making forward-looking statements that involve risks and uncertainties. Actual outcomes may differ materially from those expected or implied. For a more detailed discussion of the risks and uncertainties that may affect Armstrong flooring, please review our SEC filings. Forward-looking statements speak only as of the date they are made. And we undertake no obligation to update any forward-looking statement beyond what is required by applicable securities law. In addition, our discussion of operating performance will include non-GAAP financial measures within the meaning of SEC Regulation G. A reconciliation of these measures to the most directly comparable GAAP measures is included in the press release.

Additionally, due to the global outbreak of COVID-19, we have taken a 45-day extension to file our 10-Q in line with the recent order from the SEC to provide us with more time to finalize our accounting for a longer asset impairment testing, including intangible and other assets. The impact to our GAAP financial results, if any, will be reflected in finalized results in the 10-Q.

I’ll now turn the call over to Michel.

Michel S. Vermette, Armstrong Flooring, Inc. – President, CEO & Director [3]

Thank you, Doug, and good morning to everyone on the line. The world has changed significantly since we introduced our strategic road map in early March. The first quarter marked the beginning of the initial progress with our long-term plan. At the same time, during the quarter, we also experienced the early stages of an unprecedented environment for the global economy as many governments, communities and companies implement strict controls to minimize the spread of the COVID-19 virus.

Over the past couple of months, we have shifted our focus to prioritizing safety, financial flexibility and operational efficiencies to address this pandemic. Our strategic road map is still the backbone of where we want to take this company. But clearly, there are evolving market developments that will require us to balance our near-term and long-term decisions in a way that allows us to be successful through and beyond this crisis.

At the heart of all our decisions, we are focused on the well-being of our employees and the communities around the world in which we operate. We are fortunately being able to do so while maintaining operational continuity to serve our customers, most of whom operate in essential industries.

Looking at our first quarter, we had a strong start to the year. Producing results in line with our expectations for sales and adjusted EBITDA. Global net sales down 2% year-over-year was attributable to a more than 40% drop in China sales given the earlier outbreak of the virus in that region, which I’ll discuss in a moment.

In our largest region, North America, net sales increased 2%. In January and February, in particular, North America sales were up 10% and exceeded our expectations, attributable to stronger volume. We believe this was driven by a combination of previously initiated efforts to expand, simplify and strengthen the business, together with a favorable comparison in the previous year quarter. In North America, we saw good momentum continue in the first half of March. The market environment really shifted in the second half of March, as many independent retailers’ locations began to close and some large commercial projects were delayed.

The first quarter in the rear-view mirror at this point, but we believe the North America operating momentum before the impact of COVID-19 is an early indicator that demonstrates the value of our efforts to serve customers the way they want as well as the path that we hope to resume once the world recovers.

In China, the $5 million sales decline was slightly less severe than we had cautioned during our last call. This market represents a comparatively small portion of our sales but had an outsized influence on our first quarter results, given the magnitude of the decline. We have 1 plant in China, which was closed during most of February, and has substantially ramped up back up since that time.

Our experience in China with their earlier exposure to the pandemic gave us valuable perspective on adapting our North American operation. This in part played into our decision to voluntary suspend operation in all our U.S. production facilities for 2 weeks in April. We were able to coordinate the shutdown of our U.S. production in a way that enable us to keep our U.S. warehouses open, and filled critical orders from customers with ongoing projects, particularly in the health care, education and home building end markets.

All of our global production facilities are currently operational, and we are managing our lines in stamping levels on a real-time basis to match demand.

In terms of U.S. market demand, nearly all states and local governments have classified construction as an essential business. However, the inconsistent patchwork of state and local government orders have created an uneven demand environment. The extent and duration of which remains to be determined. This, in turn, has resulted in varying impacts to our business across geographies, channels and customers into April. As examples, we are seeing double-digit growth in home centers, which is partly offsetting lower activity in independent retail locations, many of which are closed. In commercial, as I mentioned, most education and health care projects are moving forward. At the same time, many commercial projects such as those in the retail and hospitality sectors have been postponed. These factors, together with the broad-based social distancing and shelter-in-place guidelines, have resulted in a softer demand environment.

While it’s too soon to predict the timing or the magnitude of the recovery, last quarter, we introduced our strategic road map to transform and modernize our operations to become a leaner, faster-growing and more profitable company. This is a multiyear plan, with 3 critical objectives to expand, simplify and strengthen our business. That I believe will not only help us manage through the uncertainty, but also position us to emerge as a stronger company when we get back to more normal operating conditions.

To effectuate the plan, we established a new customer-centric operating model, which, among other benefits, aims to reach all addressable markets, reduce complexity, roll out product faster, and make faster business decisions. Significant portion of planned investments to entice growth have been put on hold for now, but we have, for some initiatives that had already started prior to COVID pandemic, which will continue. I’ll provide some brief updates on recent accomplishments that help demonstrate structural improvements in the business.

In terms of expansion, our strategy is to penetrate deeper where we operate, and significantly expand our presence in underserved markets. We have shifted to direct sales with commercial national accounts, national flooring association retailers and several large national customers. The response has been positive from retailers and contractors alike. At home centers, we have seen growth accelerate since the beginning of the year, and we’ll look to continue serving them with branded and private label products to help grow our share.

In addition, in the first quarter, we entered with a partnership with a national mass merchant retailer to introduce flooring at their stores. Our launch with the national flooring retailer association kicked off last week, and we’re happy with the initial response. Our distributors are taking advantage of improved service level, and this enables them to keep their inventories stable. We have made significant progress simplifying our product line, dropping least productive SKUs, netting us more than 25% reduction in SKU count since the third quarter of 2019. This reduction has enabled us to improve on time and in full-service metrics and increase our inventory on our fast-moving and new product launches by 5% since Q3 2019. As another good example of the benefits of SKU simplification, our Lancaster sheet operation achieved a 7-point efficiency gain during the back half of Q1, when the residential SKU reductions were fully implemented. Having the right product portfolio will improve quality, service, margin and growth.

As we reduce our least productive SKUs, we launched 3 new collections using our new fast track product development process. During this process, we received multiple rounds of inputs from customers to ensure we hit the mark on all aspects from design to performance and price. We also incorporate feedback from our internal teams to reduce complexity, maximize quality and service. All 3 introductions are made in the U.S.A. and were developed, beginning to end, within half the time of our historical product launches. And remember, these types of success stories will allow us to be more competitive, serve our customers and better and drive growth.

There are many more examples of early-stage wins that are completed or in the works that I can share. But the takeaway is that through our new operating model and our strategic road map, we are better positioned today versus a year ago to face the uncertain times ahead.

As Doug will expand upon further, we’re taking proactive actions to enhance our financial flexibility and liquidity in response to the COVID-19 pandemic, building upon a solid start to the year, we’ll continue to evaluate safety protocol, cost containment and cash preservation measures that balance the interest of all stakeholders.

I will now turn the call to Doug to provide additional updates on our financial performance and liquidity.

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [4]

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Thank you, Michel. I’ll begin with a brief review of our financial performance. As Michel mentioned, our first quarter 2020 adjusted EBITDA was in line with our expectations. As we communicated on our last call, the $1.6 million decrease compared to the prior year quarter was primarily due to lower net sales in China.

Looking at adjusted EBITDA in the first quarter of 2020 compared to the prior year quarter, the top line impacts from lower volume reduced EBITDA by approximately $1 million. Price/mix headwinds of $4 million were largely reflective of lower price in response to the abatement of tariffs.

We also had $3 million of headwinds in SG&A, resulting from 2019 benefits that did not recur in 2020 as well as some planned growth investments to support our strategic road map.

At positive partial offsets, input costs contributed about $5 million primarily due to the previously mentioned lower tariffs. In addition, workforce reductions that we made at our plants last year, along with other manufacturing efficiencies, drove a $1 million benefit to manufacturing.

Looking at our cash flow. During the first quarter of 2020, we invested $7.5 million in CapEx, which remained below our run rate depreciation. Operating cash flow was a usage of $17.1 million, which represented a typical seasonal outflow based on the usual timing of working capital spend. This included a net working capital build in the quarter with an increase of $4.8 million in accounts receivable and an increase of $8.1 million in inventories. Partly offset by a $1.2 million inflow of cash coming from accounts payable and accrued expenses.

The first quarter typically represents our low point for cash flow before we build cash throughout the year. While we don’t expect the remainder of the year to follow normal cash flow patterns, we are implementing numerous measures to preserve cash. At March 31, 2020, we had total liquidity of approximately $52 million, including cash of $32 million, plus availability under our credit facilities. Our long-term debt of $72.2 million did not mature until 2023. We believe our capital position should allow us to effectively operate during the current health and economic crisis. In anticipation of continued market challenges, we have already initiated cost actions to enhance our liquidity and cash. This includes focusing on higher-value marketing and promotional spend, furloughing a portion of salaried employees, suspending the employer match on certain benefit plans, reducing corporate expenditures, freezing hiring, limiting capital expenditures and reducing labor costs at facilities to match the current demand environment.

Prior to the pandemic, we started the process of assessing the monetization of noncore assets such as our South Gate facility land portfolio in California. That assessment has continued unabated and the market value that we estimate for that sole property in California, gives us comfort in the strength of our total noncore asset monetization potential.

In regard to our ABL facility, we have a covenant tied to a minimum LTM adjusted EBITDA dollar level. In light of the current economic uncertainty from COVID-19 and based on our internal EBITDA projections, we believe it is likely that we will be below that minimum adjusted EBITDA level in the second quarter of 2020. We are in active discussions with our lenders, and we expect to get a waiver or more likely an amendment to adjust the covenant terms that are more appropriate under the current circumstances.

Last quarter, we introduced several long-term financial targets that did not anticipate a worldwide outbreak of COVID-19. The pandemic has impacted our planned investments and financial expectations for 2020. For context, April net sales were down approximately 20% year-over-year, which was less severe than our initial expectations. That said, for the second quarter of 2020, we expect sales to remain weak.

The full impact of COVID-19 to our 2020 performance will depend on the magnitude and duration of this pandemic. In light of the rapidly evolving market landscape, most of the planned SG&A investments to help drive long-term profitable growth has been deferred. In addition, we expect the near-term macroeconomic uncertainty and the resulting weak demand environment to more than offset formerly anticipated benefits to sales and gross margin from strategic initiatives in 2020. We will continue to test additional actions to strengthen our financial position and we have contingency plans in place should end markets remain under pressure for an extended period or weaken further. Looking beyond this year, we remain committed to getting the business back to positive cash flow in 2020.

I will now turn the call to Michel for closing remarks.

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Michel S. Vermette, Armstrong Flooring, Inc. – President, CEO & Director [5]

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Thank you, Doug. I would like to thank the Armstrong Flooring team for their commitment during this time. We’re managing through the near-term challenges while being mindful that demand for our critical products will recover. With our well-defined road map and new operating model, we are prepared to successfully operate through this period of uncertainty. Our focus on expanding our reach, simplifying our processes and strengthening our competitive position will help us execute better regardless of the demand environment. I have full confidence in the team to continue to safely serve customers in this rapidly evolving market, while continuing to make incremental progress on our long-term value creation initiatives.

Thank you, again, for joining us today. Operator, please open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We’ll take our first question from Mike Wood with Nomura Instinet.

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Michael Robert Wood, Nomura Securities Co. Ltd., Research Division – Research Analyst [2]

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First question, I just wanted to follow-up on the comment in your prepared remarks about the likely amendment to the covenant. Can you provide any more color in terms of how far along you are in the discussions there?

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [3]

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Yes. We’re in regular contact with the banks. We alluded to them to this situation as we work through our forecast models. They’ve been very supportive of the process. We’re anticipating that we’ll be able to get this wrapped up without any trouble before it becomes an issue at the end of the quarter.

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Michael Robert Wood, Nomura Securities Co. Ltd., Research Division – Research Analyst [4]

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Okay, great. And then in terms of commercial and residential trends, are you able to break out that April commentary to down 20% to parse those 2 end markets out? And in particular, can you give us any color in terms of the residential trends that you’re seeing in April for customers that are actually open for your retail partners?

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Michel S. Vermette, Armstrong Flooring, Inc. – President, CEO & Director [5]

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Yes, Mike. This is Michel. So commercial was definitely better than residential through the month of April, definitely helped out by some of the health care orders. As you know, we have a nice health care business. We were able to help out our communities with some urgent orders. So that was helpful, for sure. And I would say a lot of maybe the education seasons start a little early. So we have a nice presence in that. So that was positive. So the commercial business was definitely more robust than residential, not what it has been, but definitely stronger than residential. Residential, as you can — I’m sure you’ve heard from others, is a little bit spotty all over the country, depending where you are, depending on the situation, the retailers, DIY is definitely good overall. They’re taking to manage the situation. But the residential business, I think mid-April was at the kind of the low point, it has gotten a little better recently, and we’ll see how things open up over time, right? But we will see how that evolves in the coming weeks as everybody is trying to wrap what the new normal looks like.

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Michael Robert Wood, Nomura Securities Co. Ltd., Research Division – Research Analyst [6]

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Okay. Last question before I pass it along. The January and February North American trends that you pointed out, on the surface, it appears to be reflective of share gains. Curious if you just can comment on that. And in terms of what products or markets, retail versus distribution were those share gains concentrated in?

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [7]

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Yes. I don’t think we want to go down the path of discussions on share. I mean, I will remind you that we did have a relatively easy comp in the first part of last year that helped. That said, we’re still pleased with the results that we achieved and felt like we made some good progress in getting out and driving some meaningful sales improvements.

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Michel S. Vermette, Armstrong Flooring, Inc. – President, CEO & Director [8]

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And I think the one thing, our service was better overall. So definitely, that helps as we service our business better and this we expect to continue as we work on our operational improvement across the business that will help all segments in all channels over time, both commercial and residential. So we’re working very hard on making sure that the — our operations are much more robust as we continue improving the business.

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Operator [9]

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We’ll move to our next question from Justin Speer with Zelman & Associates.

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Justin A. Speer, Zelman & Associates LLC – MD of Research [10]

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I wanted to start, just in terms of the percentage of your business that flows to that specialty retail channel. Just curious, if you look into April, how much of your business is just being affected by customers just being shuttered?

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Michel S. Vermette, Armstrong Flooring, Inc. – President, CEO & Director [11]

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Well, that’s a very hard number to assess, to be honest with you. We talk to customers all the time to go through some customers are anywhere between 40% and 50% active from what they were, depending on the country, some are totally shut down as you — like here in Pennsylvania. There was basically independent retail locations, until this week, were not active at all. So it goes from inactive to still operating depending where you are and how you consume in different parts of the country. And as you know, some are doing by appointment only.

So it’s a smorgasbord, probably the best way I can put it up there, and we’re trying to figure that out as well as everybody else. The one thing I would say, you could tell there’s a little more activity overall. But how will that pan out and how quick, that’s everybody’s guess.

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Justin A. Speer, Zelman & Associates LLC – MD of Research [12]

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And I guess, in terms of your home improvement side business, how much of that flows through? I guess, what percentage of your business is home center tied versus specialty retail distribution?

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [13]

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Yes. So our mix has been around 75% through distribution and then 25% through more direct channels, including the home centers. And the home centers, in general, have done better. They are still open, and I think folks have taken advantage of DIY opportunities during these stay-at-home periods.

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Justin A. Speer, Zelman & Associates LLC – MD of Research [14]

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Okay. And just in terms of your cost structure, I know there’s a lot of moving parts here, but how should we think — I don’t know how you want to address this, but how should we think about SG&A, for example, how much of that is going to be fixed? And how much is variable, based on all the moving parts that are ongoing in your transformation?

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Michel S. Vermette, Armstrong Flooring, Inc. – President, CEO & Director [15]

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Ultimately, everything is variable, right, to go through. So I think we’re reassessing, I think something short term, we made some decisions on marketing. We made some tough decision in furlough in assessing the business. I think the big thing is I think there’s a combination of short-term decisions to help ourselves in understanding where the market is to go through. We’re happy how April turned out. We had some more conservative outlook to go through not knowing what that would be. So we took more stringent SG&A actions in April and I would say, in the quarter overall through — with a more pessimistic outlook. And the big thing is what will a new normal look like, right? So that’s the longer demand environment. So I think we took actions based on what we thought the quarter would look like. And I think as we see the longer-term view based on each channels, we’ll adjust accordingly.

So I think that’s why we’re still moving forward, the activities we started with NFI and others were completed and some of the bigger investments and some of the launches until the independent retailers and others are open, we’re postponing those, and we’ll adjust on the investments accordingly at the right time.

So we’re still in — some of this is timing to go through. And we’re working through that with — based on each — looking each channel and each outlook, right? So you heard me last quarter talk about different channels like hospitality that we want to be more in. Right now, hospitality has its own challenges. So we’re not going to do much there right now for sure. So others in education and health care, we’re going to accelerate. So it all depends on what those markets look like.

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [16]

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Thanks, Justin. Let me clarify a comment that I made. We’re actually — in 2019, we were 80% through distribution, 20% through direct.

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Justin A. Speer, Zelman & Associates LLC – MD of Research [17]

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And then, I guess, in terms of the decrementals, a number of the manufacturers have relayed kind of anticipated decrementals associated with productivity drag and all the other elements and you washed and maybe some raw material tailwinds, maybe that’s a good guide, but how should we calibrate our models for decrementals around what is the unprecedented downturn at least in the near term, particularly the disproportionate headwind in the second quarter?

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Michel S. Vermette, Armstrong Flooring, Inc. – President, CEO & Director [18]

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Yes. I mean, there are certainly actions that we’re taking to make sure that we align production with demand and respond to this environment. Historically, we’ve said that it’s probably in that kind of 20% to 30% range, both on the — going up as well as going down. As you said, these are unprecedented in a number of ways just for the magnitude that we’re seeing. And so it might be a little higher than that range has been historically as we try to adjust the cost base.

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Operator [19]

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We’ll take our next question from Paul Betz with Stifel.

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Paul T. Betz, Stifel, Nicolaus & Company, Incorporated, Research Division – Associate [20]

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Can you remind me of all the covenants you had? You mentioned the trailing EBITDA, has that amount been disclosed? And are there any other covenants we should keep an eye on?

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [21]

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Yes. We have 3 covenants in the current credit agreement. The first that we talked about was the trailing EBITDA, minimum EBITDA covenant. The second one is a maximum capital expenditure covenant and the third one is a fixed charge coverage ratio, but the way we have that one structured, we have a grace period through the end of 2021 on that one.

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Paul T. Betz, Stifel, Nicolaus & Company, Incorporated, Research Division – Associate [22]

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Okay. And has the restriction-specific amounts been disclosed anywhere, like the trailing EBITDA?

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [23]

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We did not provide (inaudible) Sure. We did not provide the specific deals on the EBITDA at least. Just as context, we put that amendment together kind of late Q4. And so it was anticipating the time and the turnaround impact that we need in this year and next year as we build those targets, but obviously, the world has changed pretty dramatically since December.

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Paul T. Betz, Stifel, Nicolaus & Company, Incorporated, Research Division – Associate [24]

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Got it. And do you have a liquidity number as the — at the end of April?

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [25]

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We don’t have one that we’re disclosing at this point. I’d just leave it, Paul, that we’re comfortable with where we’re at on liquidity. We’ve got the cash. We’ve got the credit that we need, and we’re working through the process.

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Paul T. Betz, Stifel, Nicolaus & Company, Incorporated, Research Division – Associate [26]

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Okay. Actually, if I could squeeze 1 more in. April, the 20% down, how did that fare with like North America and kind of the rest of the world?

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Douglas B. Bingham, Armstrong Flooring, Inc. – Senior VP, CFO & Treasurer [27]

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Roughly speaking, North America was a little bit worse. China, given where they’re at in their process wasn’t an active year.

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Operator [28]

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And it does appear we have no further questions at this time. I’d like to turn the conference back over to Michel Vermette for any additional or closing remarks. Please go ahead.

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Michel S. Vermette, Armstrong Flooring, Inc. – President, CEO & Director [29]

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Thank you, everyone, for joining us today. We appreciate your interest in Armstrong Flooring, and we look forward to updating you on future calls.

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Operator [30]

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Thank you. And ladies and gentlemen, that does conclude today’s call. We do thank you for your participation. You may now disconnect.

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