|Shares Out. (in M):||74||P/E||0||0|
|Market Cap (in $M):||13,850||P/FCF||0||0|
|Net Debt (in $M):||2,475||EBIT||0||0|
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We used last week’s 2Q earnings sell-off in Mohawk (MHK) to initiate a long position in the stock.
Over the past two decades Mohawk has pursued an aggressive acquisition strategy that transformed the company from a U.S. based carpet manufacturer to the world’s largest flooring manufacturer and second largest producer of carpet and rugs. Mohawk is a leader across all flooring products including carpet, rugs, ceramic tile, laminate, wood, stone, luxury vinyl tile (LVT) and vinyl flooring. Mohawk serves the residential and commercial markets through a wide variety of channels under well-known brands that include American Olean , Daltile , Durkan , IVC, Karastan, Marazzi, Mohawk, Pergo, Quick-Step and Unilin. Mohawk is vertically integrated, and has a large distribution network that cannot be matched by smaller competitors. The company reports under three segments: Global Ceramic, Flooring North America and Flooring Rest of World.
Historically we thought Mohawk was a slightly overrated “story” stock that checked off a lot of boxes for compounder / GARP investors. MHK is run by Jeffrey Lorberbaum, an owner / operator whose family owns a 15% stake in the company. MHK is the largest player in fragmented global markets with only one competitor of similar size - and that company is owned by Berkshire. While not a duopoly, the companies have been able to gain share through superior distribution networks and acquisitions. At a high level there is a lot to like, but management has mistimed prior M+A transactions and competition in the industry is fierce.
Like many housing / building products companies, shares had been under pressure since late last year on rising interest rate concerns and general housing malaise. Many of Mohawks input costs are tied to oil prices which have hurt margins, and the strong dollar has hurt translations from its European business. Lastly, a strong economy and shortage of truck drivers has pushed freight costs up dramatically year over year which isn’t great when you’re moving around heavy flooring and ceramics.
Many of these issues and more came to a head in the second quarter earnings release last week, as the company whiffed on 2Q results and guided down for the remainder of the year.
Quoting the CEO/Chairman from the press release:
"Our results fell short of our expectations, and we are taking actions to improve the performance of our U.S. businesses. With the overall economy, our results were negatively impacted by input inflation, higher transportation costs, a stronger dollar and a tight labor market. We were also affected by changing product mix, timing of price increases, lower production units, start-up of new projects and the delayed Godfrey Hirst closing. To address these, we are raising prices, expanding in growing channels and participating in new products and geographies. In the U.S. market, we are increasing our LVT production and sourcing, as LVT continues gaining market share.”
Sadly that sounds a lot like my 2Q investor correspondence. Basically everything possible within - and outside of - the company’s control contributed to the miss, and unsurprisingly shares plunged nearly 20%. To their credit, management held court on a long conference call and addressed the margin challenges for the remainder of the year.
You can’t put a dress on the 2Q results or 3Q margin guidance, but with the stock trading at $185 and expectations reset, we think shares are an attractive value investment for investors with a longer-term outlook. Earnings estimates have come down, some of the issues have already been taken care of (closing of Godfrey Hirst deal), some of the issues should be taken care of by 1Q19 (pricing catching up to input costs, reduction in start-up costs) and some issues might linger (LVT capacity and pricing), but 2019 should look better than 2018. With lowered expectations and investors discarding shares due to poor results and a lack of catalysts over the next six months, investors can buy a quality business run by a strong management team at 12x next year’s earnings. The company is coming out of a significant multi-year investment phase, and free cash flow should ramp significantly in the coming years as growth projects come online and utilization improves.
At a high level, Mohawk reports under 3 divisions: Flooring North America was 42% of sales in 2017, Global Ceramics was 36% and Flooring Rest of World was 22%. The United States is still the bulk of revenues at 63%, but acquisitions in recent years have led to leading positions in Europe – 25% of sales – and Russia – 3% sales. The business skews to repair and remodel, with commercial, and residential new construction markets both significant drivers.
Mohawk has completed 40+ acquisitions in the past 25 years including the recently closed Godfrey Hirst deal, and is now a serious global player in all flooring categories. Historically, post-acquisition Mohawk retains senior management and spends significant CapEx wringing out efficiencies, while plugging new products into their leading distribution system.
The Global Ceramic unit produces and markets ceramic tile, stone floors and countertops. Mohawk is the market leader in North America with unmatched distribution and production capabilities and has strong positions in Europe, Mexico and Russia. The company has extended its reach / focus to new residential construction (builders) and Home Depot and Lowe’s and is completing a large quartz countertop plant in Tennessee.
The Flooring North America business carries a wide variety of products including carpet, LVT, wood and laminate. Mohawk has a leading market share in all channels, and is in the midst of a significant LVT plant expansion to meet the growing demand for LVT products.
Flooring Rest of World has a stronger position at the mid and high-ends of the market. This is partially due to acquisitions, and the European LVT business has been a strong performer. Mohawk has been acquiring companies and investing abroad for years. With leverage down to 1.3x and well below where they have operated in the past, it would not be a surprise to see additional activity here in the near future.
The flooring market is showing relatively healthy growth in the 3-4% range. Mohawk is more tied to the repair and remodel market, and thus would benefit from any pick-up in housing turnover. In the most recent quarter, Mohawk had topline issues due to an inability to source LVT while it ramps up production at a new plant in the US. The strong dollar also hurt the translation of revenues earned in Europe in the quarter.
Margin issues in the quarter, and for the remainder of the year, are what sent the stock spiraling to 52 week lows. Many of Mohawk’s input costs are tied to oil and even though they recently put through a third carpet price increase in the past year, pricing is still not keeping up with inflation. Freight costs have been a significant issue for many companies this quarter and Mohawk was no exception; Mohawk owns a significant trucking fleet but oil prices hurt margins here as well. Mohawk has a history of passing on pricing with a lag, but this is easier to do at higher price points. If inflationary pressures stay where they are, Mohawk has the potential to get to price-cost equivalence in the first quarter of next year. Mohawk also had higher than usual start-up costs as new plants are increasing utilization.
Overall, the business faced a significant number of headwinds in the second quarter, many of which will persist over the remainder of the year. Although it may seem like an eternity to some investors, if we fast forward to early 2019, Mohawk product pricing should begin to catch-up to inflation, start-up costs will decline and capital projects where capital has already been spent will contribute to revenues. Additionally, the company will have a full year of Godfrey Hirst earnings, and LVT production in the US and Europe should be much improved.
Outside of cyclical housing pressures, concerns over global LVT supply increases and in turn pricing, as well as LVT cannibalization of higher margin products will persist. Luxury Vinyl Tile has been all the flooring rage and is 10% of the U.S. flooring industry from nothing a decade ago. LVT and WPC (wood plastic/polymer composite) can be made to look like stone and wood at cheaper prices, and with improved technology these products are durable and waterproof and look similar more expensive tile and wood products. Installation is easier than traditional wood flooring products which is important given regional skilled labor shortages. It remains to be seen how far penetration rates can go before plateauing, but recent growth has been strong in the +20% range for the past few years. LVT / WPC does well in places like basements where humidity and water issues can cause trouble for traditional wood flooring.
Mohawk acquired a leading LVT position in Europe through the purchase of Belgium-based IVC Group in 2015. IVC was founded in 1997 by Filip Balcaen, who took 10% of the sales price in Mohawk shares, and received a board seat. Filip has been aggressively buying shares in the open market both before and after the recent earnings miss. His most recent purchase was more than $9 million worth of shares at $183 after the miss. Given Filip’s expertise in the industry, founding and growing a leading LVT flooring company before selling out to Mohawk, we think his purchases deserve more attention than a token insider buy at the director level.
As a result of the IVC acquisition Mohawk carved out a strong LVT position in Europe. Mohawk is using the expertise learned abroad to ramp production of LVT in the U.S. The US plants are behind their European counterparts and in the second quarter a lack of LVT production combined with trouble sourcing supply from abroad hurt the topline. When fully ramped, Mohawk will have capacity for $1 billion in LVT sales and will source the remainder of its needs. MHK will be able to add additional lines at its plants and bring additional production online in 12-18 months.
In the U.S., Shaw’s created a strong market position when it acquired USFloors, the fastest growing LVT company in the US, in late 2016. Shaw’s also invested $100 million in a new Georgia facility at the same time. In the U.S. and globally, Armstrong, Interface, Beaulieu America, Balta, Tarkett and others are investing in new LVT facilities. Big industry shifts in the flooring industry happen every decade, and Mohawk will need to keep investing and innovating in new and improved LVT products to maintain pricing.
While excess global LVT capacity in the coming years is a concern, we’re comforted by the insider purchases, MHK managements comments about the ability to add more LVT capacity in 12-18 months (implies they are not too worried about capacity), the strong balance sheets at MHK and BRK that enable them to further consolidate the market and MHK’s historic ability to innovate and gain share (in this case rigid LVT). Tariffs on low-end Chinese LVT would also be a positive for MHK but it is tough to predict where these trade wars will net out.
The catalyst is an attractive entry price following the second quarter earnings sell-off. We think many of the issues are transitory and investors are can buy a quality housing name run by owner operators at an attractive price. Raymond James’ piece entitled “Wake me up when 2018 ends” pretty much sums it up. As we turn the page on a forgettable year for Mohawk shareholders, 2019 should show improved results and a higher stock price. Given a growing top-line, slowing margin pressures, significantly lower CapEx, a full year of the Godfrey Hirst acquisition and incremental returns from the significant amount of money spent on CapEx and acquisitions in the past few years, MHK should earn at least $15 a share next year and the recent sell-off will have provided an excellent entry point in the stock.
Cyclical – recession, rising interest rates impact housing market
Rising oil prices
Further freight inflation / negative impacts from new electronic logging device regulation in the U.S.
Integration issues with newly acquired businesses, particularly those overseas
LVT start-up delays and / or over supply in the market
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