|Shares Out. (in M):||69||P/E||31.4x||0.0x|
|Market Cap (in $M):||7,100||P/FCF||22.0x||0.0x|
|Net Debt (in $M):||1,100||EBIT||350||0|
We’ve been long Mohawk on several occasions over the past decade. Our original interest in the business came about after Berkshire bought Shaw back in 2000. We believed at the time that both companies would act in a very rational way given the duopoly nature of the business. We became even more interested in Mohawk after they acquired Dal-Tile in 2002. Dal was a transformative acquisition that allowed Mohawk to diversify their exposure from carpet while adding a highly profitable tile business. In 2005, the company bought Unilin establishing a large presence in Europe and gaining control of Unilin’s laminate business which again diversified Mohawk’s product offering. Though we haven’t been long MHK during this whole period, we have followed it closely, met with management on many occasions, and studied the business from many angles.
Now, we think it is time to short Mohawk (MHK). The stock is trading at $103, higher by 2.5x over the past eighteen months as investors warm to an improving residential construction environment (see cnm3d’s arguments on which we largely agree). Since December, the stock has rallied another 20 dollars (25%) after the company announced an acquisition of Italian tile maker Marazzi for $1.5 billion U.S. dollars. Despite the incredible run in the past few months, we are not shorting this stock simply on valuation. Rather, we think the quality of the business is much lower than widely believed. Thus, we think the shares trade at a significant premium to intrinsic value which should fall over time.
Let’s begin by talking about carpet, which historically has represented more than 50% of total revenues. Mohawk did $3.6B in carpet revenues in 2002 (in the midst of a mild recession and before the housing boom). Carpet generated a 10.8% EBIT margin in 2002. Remarkably, with the housing bubble, MHK grew the carpet business to $4.7B in 2006 but EBIT margins fell to 8.2%. This occurred despite the general idea that both MHK and Shaw would price/compete rationally and both could experience increasing returns on capital.
Back in those days, MHK management thought it was only a matter of time before EBIT margins crept back up to the 2002 levels (we believed it too). Energy prices, which make up about 65% of carpet COGS, were a significant headwind. There were shifting consumer preferences toward tile/hardwood, but that wouldn’t prevent MHK from gaining efficiencies and price (along with Shaw). That never panned out, primarily due to the financial crisis, but also due to a business that simply is not as structurally sound as it first appears. In 2012, we think MHK had about $2.9B in carpet revenues and operated with an EBIT margin in the high 4’s (less than half the peak margin in 2002). In the past 4 quarters, carpet has generated $137M of EBIT employing assets of approximately $1.8 billion.
Given the reliance on carpet, a poor management bench, and a desire to compete across all flooring options, MHK has acquired flooring businesses with better prospects (and better management, which we’d say they succeeded in when they bought Dal-Tile and picked up Chris Wellborn).
The acquisition of Dal-Tile in 2002 brought a $1.2 billion dollar tile business and structurally higher EBIT margins (primarily due to shifting consumer tastes and brand). It also opened Mohawk up to have blowout financial results as the housing bubble began to take shape. We always joke that everyone in Orange County that made $500,000 per year selling subprime loans were huge consumers of Dal-Tile products given that back in the good old days a $25K tile investment in the foyer increased the asking price of the house by $75K. Those days are over. Dal-Tile EBIT margins peaked at 15% in 2005 and have steadily declined since. Even with the Marazzi acquisition, we do not believe that Mohawk’s tile business will return to the margins they enjoyed during the housing bubble. Further complicating the Dal-Tile/Marazzi business is that tile doesn’t really wear out like carpet. Rather, the motivation to change tile is almost always decorative which lowers the replacement rate considerably.
Finally, there is Unilin, an acquisition done by Mohawk in 2005 to gain a foothold in laminate flooring products and also a presence in Europe. Unilin also had the added attraction of having developed a technology called UNICLIC which is a patented installation system for laminate floors (you could easily install Unilin products yourself which made them very popular in Europe). Unilin also generated royalty income from other laminate manufacturers that wanted to use the Clic technology in their products (which makes the total cost of buying flooring cheaper for those DIYers out there).
While Unilin never directly gave out precise figures for royalty payments (which of course have 100% margins), we think royalty payments were reasonably large during the housing bubble as Mohawk aggressively fought Chinese copycats in the courts (yes, the flooring conventions are hilarious as you watch lovely Chinese women walk around the convention floor taking pictures of various design elements for use back home by MHK competitors). During the 2006-2007 bubble years, Unilin EBIT margins were in the 17%-18% range. They’ve since fallen off dramatically.
The bottom line is that we believe that after studying Mohawk for over a decade, we’ve concluded that it is a very average business, with very mediocre growth prospects (though they will grow as housing starts pick up in the U.S.), and mediocre returns on capital. We think that after Marazzi, the company has “normal” earnings power of between $5.50 - $6.00 per share (maximum earnings of $6.57 in 2006 and earned $1.53 in 2009). Marazzi adds to those historical figures, but we think margins are permanently lower than the go-go years of the U.S. housing bubble. We also believe that returns on shareholder equity are around 10%, so the business should trade near book value of around $60. At $103, they look significantly overvalued and investors will catch on as Mohawk struggles to reach historical margins as U.S. housing comes back.