Background
The Dixie Group (DXYN) manufactures high-end carpet for residential and commercial markets (2006 sales were 66% residential and 34% commercial). Over the last 15 years, the carpet industry has undergone dramatic consolidation, with the top four players now controlling roughly 80% of the market. The top two players, Shaw and Mohawk, control roughly 2/3 of the market. This consolidation has played to DXYN’s strengths in three ways.
First, their size has focused Shaw and Mohawk on high-volume production. While these two firms have high-end product lines, they lack the focus on style and innovation required to succeed in this segment of the market. DXYN’s strength, by contrast, is in these creative elements, which are critical to serving the desires of high end consumers.
Second, consolidation has improved DXYN’s position with retailers. Because of their size, Shaw and Mohawk generally sell to all of the nation’s +20K carpet retailers. Universal availability, however, is negative for retailers because it begets price competition and lower margins. DXYN limits its distribution to 3-5 retailers in each geography, which is very attractive to retailers since it allows them to offer differentiated merchandise.
Lastly, consolidation has improved DXYN’s position with its fiber supplier, Invista (maker of Stainmaster). Invista makes premium fibers and being coupled with DXYN helps them to receive a premium price. This is because DXYN’s products are premium products, DXYN has limited distribution, and DXYN is not backward integrated. Shaw and Mohawk, by contrast are vertically integrated and prefer to use the fiber produced by their internal fiber operations.
Residential Carpet
While DXYN is a small player in the overall carpet industry, it dominates the high end of the market, with 35% marketshare of all residential carpet priced at or above $22/sq. yd. (mill price). In this segment, DXYN competes with 8 to 10 other companies, none of which approach it in size. DXYN files 8K’s of its investor presentations which show a very helpful chart of the industry positioning of its three brands. This chart shows that the industry average price of carpet is $7/sq. yd. (mill price). DXYN’s brands are priced as follows:
Fabrica: $28-$49/sq yd.
Masland: $18-$30/sq. yd
Dixie Home: $8-$21/sq. yd
The chart also shows that Dixie Home’s addressable market is considerably larger than Masland’s or Fabrica’s. (This is significant because Dixie Home’s 2006 sales were only 78% of Masland’s residential sales.)
All three of DXYN’s brands participate in the retail market. Only about 10% of DXYN’s revenues comes from new construction, with most of its business generated from remodeling and replacement. Fabrica and Masland are super-premium brands that are usually sold through interior designers or specialty retailers. Since 2003, Fabrica’s sales have increased slightly, and Masland’s sales have averaged 7% annual revenue growth. Both of these brands have benefited from demographic trends and very robust repair / remodeling expenditures among affluent households.
From 1993 to 2006, maintenance and improvement expenditures on homes valued over $250,000 increased at a 16.0% CAGR to $103.0BB. During that period, maintenance and improvement expenditures for all homes grew at a 6.1% CAGR to $167.2BB. This trend can also be see by segmenting households by income. From 1993 to 2006, spending on home maintenance and repairs by households with incomes over $75,000 grew at a 14.1% CAGR to $101.8BB. This compares to the 6.1% CAGR for maintenance and improvement expenditures for all homes. (This data is from the U.S. Census Bureau.)
Dixie Home is a premium brand that was launched in 2003 and has accounted for 3/4 of DXYN’s growth in the residential market since its launch. Dixie Home addresses consumers that desire a well styled, high quality product, but do not use a designer. It is worth noting that while Dixie Home’s 2006 sales were lower than Masland’s, Dixie Home’s addressable market is significantly larger than Masland’s. Consequently, this division probably has considerable growth potential ahead of it.
Commercial Carpet
Roughly 31% of DXYN’s sales are into the commercial market, and Dixie addresses this market through its Masland Contract business. Masland Contract competes in the “specified commercial” marketplace, which means it targets high end customers that often use a “specifier” (the commercial equivalent of an interior designer). The overall commercial market has been depressed along with commercial construction since 2001, though only about 10% of Masland Contract’s sales are for new construction. Masland Commercial has realized 11% annual revenue growth since 2003, and I estimate that most of this has come through Masland’s “Energy” product line. DXYN conceived the Energy line in the early 2000’s when the price differential between branded and unbranded fibers became extremely wide. The Energy line took advantage of this by combining good styling with unbranded fiber, allowing DXYN to address a new set of customers.
DXYN’s growth in the specified market has historically been limited because it previously didn’t offer carpet tile. Carpet tile represents roughly 1/3 of the overall specified market and ½ of the office specified market. More importantly, there are many jobs that require both tile and broadloom to bid. In practice, the tile and broadloom requirements are often sourced to different vendors, but these are opportunities that DXYN hasn’t even be able to compete in because it couldn’t offer carpet tile. In 2Q06, DXYN began to produce carpet tile, and breakeven for this operation expected in mid-2007. According to management’s 2006 Letter to Shareholders, Mansland’s modular product has been exceptionally well received. Tile alone will increase Masland Contract’s addressable market by at least 50%. Being able to offer tile will also expand Masland’s addressable market in broadloom by allowing DXYN to pursue orders it had previously been excluded from.
Internal Difficulties
From 2H03 through 4Q05, DXYN experienced rapid revenue growth, accelerating from 5% in 3Q03 to 28% in 4Q04. This was driven largely by the success of Masland’s Energy line and Dixie Home.
In 2005, however, DXYN suffered from three factors. First, rapid order growth pushed DXYN past its manufacturing and distribution capabilities. Second, raw material costs increased faster than DXYN’s ability to pass them along. A final and less significant factor, was a very active hurricane season which resulted in temporary production outages at some facilities in 3Q05. I have detailed the DXYN’s 2005 operational challenges below.
In April, 2005, the combined orders for Masland and Dixie Home rocketed 51% Yr./Yr., precipitating greater operational complexity, fewer shipments from inventory, longer lead times, and late shipments. As lead times extended, orders went elsewhere. Management responded by adding staff, lengthening operating schedules, and accelerating the company’s move into a new facility in Eton, GA in order to reduce the congestion at their Saraland, AL facility. While these actions remedied DXYN’s service problems, they added expenses due to higher overtime, additional staffing and training expenses, and the costs associated with moving inventory to the new Eton, GA facility. Concurrent to this move, management also began to install new tufting machines at their Eton, GA facility. This created unabsorbed start-up costs. During the course of these moves, management met DXYN’s production needs through outsourcing, but this resulted in a lot of off-quality inventory, also adding costs. During this time, they also began to install their carpet tile equipment, adding additional start-up costs.
On the West Coast, they consolidated their operations, allowing them to shed a leased facility and positioning them to better support their East Coast operations.
The overall effect of these actions were higher costs, delayed new product introductions, and decelerating sales growth.
Catalyst
2005’s investments hurt profitability, but the company’s operations are now much simpler and better positioned to support future growth. Some of the additional costs associated with DXYN’s operational challenges began to roll off in 2Q06, but these were replaced by start-up costs associated with new tufting equipment and the new carpet tile operation. Consequently, DXYN’s operating margins are still far below historic levels.
Excluding start-up costs, DXYN’s operating margins would have started returning to normal levels in the last nine months of 2006. Because these were included in COGS and SG&A, however, reported numbers have shown limited improvement. In 2007, however, these operations should ramp past breakeven, resulting in margin improvements. 2007’s gross margins should also benefit from DXYN’s price increases catching up to its input costs. Longer-term, I expect DXYN’s margins to improve as the company grows into its new facilities. After the last two years’ investments, most of DXYN’s operations could handle a 40% increase in volume before requiring additional capacity.
Investment Opportunity
Poor results over the last two years have led to a sell-off in DXYN’s stock, and it is currently bouncing along in the $11.50 to $13.50 range. I suspect some investors are concerned about DXYN’s exposure to the housing market, but I believe DXYN’s very affluent customer base and low exposure to new construction (10% of sales) will insulate it from the general housing industry.
I expect DXYN to generate EPS of $0.90 and $1.27 in 2007 and 2008 respectively. At $13.50, this yields EPS multiples of 15.0 and 10.6x, respectively. On an EV / EBITDA basis, DXYN is trading at 7.0 to 5.8x 2007 and 2008 figures, respectively.
DXYN has concrete growth opportunities at Dixie Home and Masland Contract (roughly 51% of 2006 sales, combined). Fabrica and Masland Residential (45% of sales) have an emerging opportunity in wool products, which they will introduce in 2007. In the past, wool carpet was much more expensive than nylon carpet, but rising petroleum prices have narrowed this differential. Given DXYN’s strength in design, I expect them to do very well in wool carpet. (Many designers prefer wool.)
Over the next five years, I am expecting mid-to-high single digit annual revenue growth and 25-33% annual EPS growth as DXYN’s margins recover from depressed levels and the company grows into its new facilities. Assuming DXYN will trade at 12-14x EPS in 2011, this EPS growth translates into annualized stock price performance of 18-30% through 2011.
Other Comments
It is worth noting that DXYN’s CEO controls the company through a dual share class structure. His son manages the company’s Masland Residential division (27% of sales).
DXYN’s 2005 investments hurt profitability, but the company’s operations are now much simpler and better positioned to support future growth. Some of the additional costs associated with DXYN’s operational challenges began to roll off in 2Q06, but these were replaced by start-up costs associated with new tufting equipment and the new carpet tile operation. Consequently, DXYN’s operating margins are still far below historic levels.
Excluding start-up costs, DXYN’s operating margins would have started returning to normal levels in the last nine months of 2006. Because these were included in COGS and SG&A, however, reported numbers have shown limited improvement. In 2007, however, these operations should ramp past breakeven, resulting in margin improvements. 2007’s gross margins should also benefit from DXYN’s price increases catching up to its input costs. Longer-term, I expect DXYN’s margins to improve as the company grows into its new facilities. After the last two years’ investments, most of DXYN’s operations could handle a 40% increase in volume before requiring additional capacity.