Description
Rushing this out due to upgrades today. Please see PDF for properly formatted, unabridged, write-up: http://goo.gl/3iIW6i
Mohawk Industries (NYSE:MHK)
Market Cap: $10.0 BN
Daily Value Traded: $105 MM
Conclusion: Mohawk offers a potential 28% return over the next 12 months.
Thesis: A slowly recovering housing market, significant synergies from its recent acquisitions, and a favorable business model with secular tailwinds, will propel sustained growth over the next few years.
Opportunity #1: The Marazzi acquisition provides a valuable distribution channel into Russia, which is comparable in size to the US flooring market with much greater fragmentation. Marazzi’s network of retail stores provide a cross-selling opportunity for Mohawk and a strong foothold in this valuable market.
Opportunity #2: Historically, flooring sales have rebounded sharply after periods of negative growth. This has not yet occurred, largely due to a lag in discretionary spending on remodeling and weak economic conditions. A sharp increase, coupled with Mohawk’s leaner cost structure, should create significant margin expansion opportunities.
Opportunity #3: Secular trends in the flooring market include a mix-shift to hard surfaces like ceramic tile, hardwood, or vinyl; additionally, those consumers that choose carpet for more intimate areas are opting for new extra-soft fibers. This shifts sales towards higher margin products with greater differentiation that provides pricing power and margin expansion.
Opportunity #4: After Mohawk delevers from its present position, the company will likely seek to make more accretive acquisitions to enter more geographies, add new products to its distribution channels, or shore up market share. This is not included in our models but provides another source of upside.
MORE DETAILS
About Mohawk
Mohawk is the world’s largest flooring manufacturer. It produces flooring for Residential (new construction and remodeling) and Commercial applications, primarily in North America and Europe. Its segments include Carpet, Ceramic Tile, and Hardwood/Laminate. It is the only manufacturer with vertical integration in all its segments, from production through distribution. It also has the leading market share in nearly each segment.
History
The oldest predecessor to Mohawk was founded in 1878. The current corporate form was created in an LBO in 1988, and was IPOed in 1992. At the time, Mohawk had only a 2% market share in Carpet & Rugs. The company grew market share via acquisition-- between 1993 and 2001, Mohawk completed over 11 significant acquisitions of carpet companies for at least $1.2 BN in cash and stock.
Mohawk then began expanding into other product lines. In 2002, it entered the Tile segment with its acquisition of Dal-Tile for $1.5 BN (8.5x EV/EBITDA). In 2005, it entered the Laminates space by purchasing Unilin for $2.5 BN (9.0x EV/EBITDA)—this also was the company’s first significant international expansion, namely to Europe.
The company was hit hard by the recession; between 2007 and 2009, Revenues fell by 33%, EBITDA fell by 72%, and the stock price fell by 83%.
In 2012, the company started benefitting from the perceived economic recovery and expected recovery in housing, and the stock rose 51%. In 2013, Mohawk entered a new stage of its lifecycle, through its transformative acquisitions of Pergo, Marazzi, and Spano.
Industry OverviewThe flooring industry has many favorable characteristics:
Concentrated Players:
Mohawk 3,808 22.6%
Shaw 3,553 21.1%
Armstrong 916 5.4%
Tarkett 911 5.4%
Mannington 625 3.7%
Beaulieu 638 3.8%
Interface 421 2.5%
Engineered Floors 285 1.7%
The Dixie Group 257 1.5%
Imports & Other 5,426 32.2%
Market share in the US Flooring industry is heavily concentrated among the top two participants: Mohawk Industries, and Shaw Industries, which was bought in 2000 by Berkshire Hathaway for a 53% premium. The oligopolistic industry structure helps maintain pricing rationality and avoids price wars; industry contacts said Shaw tends to set price increases and Mohawk follows. (It also helps when your chief competitor is owned by one of the most economical men around.) When Warren Buffett bought Shaw it was Berkshire’s largest non-insurance operation at the time.
Diverse Channels:
1998 Share 2012 Share
Specialty Retail 65% 51%
Home Centers 13% 31%
Contractors 18% 16%
Other 4% 2%
The flooring industry has uniquely been able to support a healthy Specialty Retail channel. This is largely because flooring is a high-touch, unique, and important purchase. A Home Depot representative anecdotally claimed the average flooring buyer will require 10 visits to the store. This is caused by a number of factors: (1) very important decision that fundamentally changes the look and feel of a home; (2) expensive purchase that is done infrequently (7-10 years) therefore worth the time; (3) the choice among many different SKUs due to the wide selection of materials, colors, textures, thickness, etc. requires guidance; (4) installation requires consultation, measurement, discussion of needs, and ordering product due to the inability to stock large amounts of product.
Shift to Hard Products:
Carpet has steadily been losing market share to the hard surfaces. Carpet still has over 50% share in the US, while in other parts of the world market share is closer to 30-40%. It’s likely it will continue losing share, which could be beneficial to margins for diversified producers assuming they can capture this shift. Producers tend to get better margin on hard products. Notably, the growth of ultra-soft carpets can stem the tide of share declines slightly, and would improve margins as well.
Pricing Power:
Historically, pricing increases have come through in the 2-4% range, with some years where the industry lost price. Through interviews with industry participants, it appears Shaw sets prices and Mohawk and others quickly follow. (It’s worth noting that in August 2000, Shaw and Mohawk settled a class-action lawsuit alleging price fixing, for $27.5 MM and $13.5 MM, respectively, while denying the allegations.) Participants were optimistic the companies should be able to raise prices going forward, as they could not during the recession. MHK plans to increase carpet prices by 4-6%, ceramic tile by 2-4%, and has passed on multiple hardwood pricing increases recently. The companies have also been taking back bargaining power from the buying groups by offering their own associations with benefits including exclusive colors, lower prices, unique designs, and benefits from SPIF (Sales Promotion Incentive Fund).
Required Purchase:
Everyone needs to purchase flooring, and although most flooring is durable, it requires eventual replacement due to wear and tear. Additionally, technical advances, fashion changes, and a desire to upgrade ones living conditions may expedite the replacement cycle. The decision to upgrade flooring is usually driven by factors including consumer confidence, spending for durable goods, interest rates and availability of credit, turnover in housing, the condition of the residential and commercial construction industries and the overall strength of the economy. Unfortunately, although Flooring is non-discretionary in the long-term, it is discretionary in the short-term and can be delayed during difficult times; it is also heavily dependent on the strength of the housing market.
Housing Cycle Leverage:
This has not been a “favorable characteristic” of the flooring industry between 2007-2009—as you can see above, the industry sales dip in 1991 corresponded with the dip in housing permits, as did the peak and subsequent precipitous decline after 2006. However, this bodes well for the future. Without going into macroeconomic projecting, I will assume the forecasts of people smarter than me are accurate and we should have a sustained housing recovery due to a multitude of factors (new household formation, historic underbuilding relative to population growth, etc.) Recent data points have been encouraging, with Homebuilder Confidence increasing to an 8-year high, YTD home starts up 24% y/y, etc.
Barriers to Entry:
Distribution: Only MHK and Shaw own national distribution systems. Specialty retailers generally do not maintain inventory. They leverage the manufacturers’ ability to serve them quickly and effectively.
Scale: This is a manufacturing business with traditional economies of scale and the need to drive utilization of equipment. Scale and vertical integration gives MHK the lowest costs in the industry and the most room to compete on price. Only Mohawk manufactures its own products in all segments.
Innovation: Significant innovation occurs in the flooring space, and requires continuous investments in R&D and plant upgrades (e.g. new soft fabric, luxury vinyl tile, etc.).
Shelf Space: Channel checks at specialty flooring retailers uncovered crowded displays with an overwhelming number of choices. Because a new entrant cannot compete on price, it is nearly impossible to create a compelling need for a new product to take up valuable real estate.
Reliability: Finally, the purchase of carpet is a very involved process given the inconvenience, cost, and complexity. Customers, and retailers, tend to go with the established players to mitigate any manufacturing defects or delivery problems.
Segment Descriptions
Mohawk has three operating segments: Carpet (historically called Mohawk), Ceramic (historically called Dal-Tile), and Laminate & Wood (historically called Unilin).
[SEE ATTACHED DOCUMENT FOR MORE ON EACH SEGMENT]
Historical Performance
Carpet
2006 2007 2008 2009 2010 2011 2012
Revenue: Carpet 4,742 4,206 3,628 2,857 2,845 2,928 2,912
growth y/y 0.5% -11.3% -13.7% -21.3% -0.4% 2.9% -0.5%
OI: Carpet 387.4 254.9 82.9 12.6 133.2 135.8 165.6
OI margin 8.2% 6.1% 2.3% 0.4% 4.7% 4.6% 5.7%
The company attributes the recent margin expansion, despite tepid top-line growth, to (1) a right-sizing the cost structure, (2) abating material cost pressure, and (3) a mix-shift to higher margin products.
Ceramic
2006 2007 2008 2009 2010 2011 2012
Revenue: Ceramic 1,942 1,938 1,815 1,427 1,367 1,454 1,616
growth y/y 11.9% -0.2% -6.3% -21.4% -4.2% 6.4% 11.1%
OI: Ceramic 270.9 258.7 213.9 101.9 98.6 104.6 127.1
OI margin 14.0% 13.4% 11.8% 7.1% 7.2% 7.2% 7.9%
Despite growing sales, margins have not yet rebounded. This is mostly due to negative mix issues as customers traded down to lower margin products, and a desire to maintain plant capacity for the upturn. Management expects margins to revert to 13-14% over the “next couple of years.”
Laminate
2006 2007 2008 2009 2010 2011 2012
Revenue: Lam/Wood 1,237 1,488 1,465 1,128 1,188 1,345 1,350
growth y/y 20.3% -1.5% -23.0% 5.3% 13.2% 0.4%
OI: Lam/Wood 214.1 272.3 171.8 121.6 115.9 127.1 127.3
OI margin 17.3% 18.3% 11.7% 10.8% 9.8% 9.5% 9.4%
Laminate margins have also been slow to recover despite some rebound in sales. Management attributes this to the majority of sales being in Europe, and the shift to lower margin products at lower price points to win share. Over time, they believe Laminate/Wood can get back over 14-15% as well.
Cost Structure
Estimated cost structure for the different segments:
(As a % of Sales) Carpet Ceramic Wood/Laminate
Sales 100% 100% 100%
Cost of Goods Sold 75% 70% 69%
Materials 50% 23% 46%
Labor 8% 23% 7%
Overhead 17% 23% 16%
Gross Margin 25% 30% 31%
For Carpet and Wood/Laminate, the majority of the cost structure is in Materials, while Ceramic tiles require a significant amount of labor. This is because the manufacture of carpet and wood/lam is mostly automated while ceramic tile still requires some manual intervention. The automation protects the former two segments from foreign competition (as lower labor rates are less meaningful), while Ceramic Tile has some protection due to its greater weight and need to produce locally.
In the Carpet segment, incremental margins appear to be around 20-25%. In Ceramic, it’s closer to 25%, while the Hardwood/Laminate section segment has averaged 25-30% incremental margins.
Management
CEO – Jeff Lorberbaum – 58 y/o – Jeff worked at Aladdin Mills since 1976. Following Mohawk’s merger with Aladdin in 1994, he was named President and COO of Mohawk. He became CEO in 2001 and Chairman in 2004. Jeff and his family own 15.6% of Mohawk’s shares outstanding, making him the firm’s largest shareholder.
CFO – Frank Boykin – 57 y/o – Frank has worked at Mohawk since 1992, having been previously at KPMG. He became CFO in 2005. Frank is very available to investors and has spoken with me a few times during this analysis.
COO – Chris Wellborn – 57 y/o – Chris was previously the CFO of Dal-Tile from 1997 until it was acquired by Mohawk in 2002. Interesting, Chris is the second-highest compensated employee at MHK, and is based out of Dallas (Dal-Tile HQ) leading the Marazzi integration. This reflects the company’s emphasis on Marazzi and the ceramic segment overall.
Opportunities
The opportunities for MHK over the next few years will come from (A) growth and synergies from its major 2013 acquisitions; (B) secular trends leading to margin expansion; and (C) a nascent housing recovery leading to an increase in sales and expansion of margins.
A) Acquisitions
Each of Mohawk’s three acquisitions was opportunistic and done under its own rationale:
Pergo – Laminate producer that was purchased by Mohawk in January 2013 for $150 MM, or approximately 6x EV/EBITDA. The company had approximately $310 MM in 2012 sales and $25 MM in EBITDA. Although Pergo was in bankruptcy due to weakness in Europe, the brand name actually has better recognition among retailers due to its introduction of laminate flooring. They’re able to place Pergo’s products into Mohawk’s distribution channel for top-line synergies, and use Pergo’s base for expansion int the Nordic countries. By shutting Pergo’s Sweden plant and folding Pergo’s manufacturing and distribution into its own, Mohawk thinks they can get Pergo to 7-8% operating margin.
Spano – Chip-board manufacturer that was purchased by Mohawk in October 2012 for $168 MM, or approximately 5.6x EV/EBITDA. The company had approximately $190 MM in 2012 sales and $30 MM in EBITDA. Spano provides Mohawk with additional clout in the chip-board market, and the company will be able to leverage European manufacturing synergies with its Belgium plant. Given both companies have plants in Belgium, the company should be able to realize immediate manufacturing synergies and benefits from cross-distribution. This is expected to become a 7-8% operating margin business as well.
Marazzi – This has the potential to be a transformative acquisition. Mohawk announced the deal in December 2012 and closed at the start of April 2013. The purchase price was $1.5 BN and comprised of a $307 MM cash payment and $314 MM in stock, plus $900 MM in assumed indebtedness. In 2012, Marazzi had approximately $1.2 BN in sales, $200 MM in EBITDA (16.5% margin), and $115.5 MM in Operating Income (9.5% margin).
Per the conference calls, and a general discussion with Mohawk’s business development, the benefits from the Marazzi acquisition can be broken down into three silos:
1) Russia – This is the main benefit. Ceramic Tile in Russia has been growing like gangbusters, with year-over-year growth rates above 15% and expected to stay that way for the near future. This business was performing perfectly well on its own, but was capital starved, and needed new capital to expand and grow. This is especially important given the fragmented nature of the market in Russia; the Marazzi has an opportunity to build dominant market share similar to the US, and the Russian Ceramic Tile market is as large as the US currently.
Besides the healthy industry-wide growth of tile in Russia, Marazzi also possessed a unique advantage in their distribution system. Due to the lack of infrastructure in Russia, the company needed to develop its own distribution and retail selling system. Marazzi runs 21 regional distribution centers which provide service to all channels, including over 300 retail stores in 161 cities across Russia and neighboring countries. 70 of these stores are owned by Marazzi, and the balance are exclusive franchises that carry only Marazzi product. This is a huge opportunity to push Mohawk’s other products that fit the marketplace and significantly improve margins.
2) US – Marazzi also had a great business in the US as the #2 provider with very close market share. Combined, Mohawk now has 47% market share, while its nearest competitor is at 6.1% share, providing a dominant lead and significant scale advantages. In the US, the companies had complementary go-to-market strategies—for example, Marazzi had a larger presence in the Home Improvement stores, while Mohawk was stronger in independent retailers. These relationships should form complementary and aid in cross-selling products, creating top-line synergies.
3) Europe – The European business is struggling, with exposure to Italy, Spain, and France. Mohawk is focused on right-sizing the business, shutting down production lines, cutting back on headcount, and combining the Italy/Spain/France management teams. This will position the segment for growth If Europe is able to turn around. Management stressed that one aspect they are excited about is acquiring the European manufacturing and R&D teams. Marazzi has been an industry leader, having developed the first “one-pass” kiln that allowed tile to pass through in a single continuous conveyor, rather than placed in a traditional oven. They’re also been on the forefront of using high definition inkjets to print patterns or images on the tile before it is glazed, creating the look of expensive stone or even hardwood at a lower price with much higher resiliency.
B) Secular Trends
As noted earlier, the flooring market is actually very dynamic. Carpet has gone from a 74% market share in 1987 to a 52% market share in 2012. Share has shifted to “hard surfaces” including hardwood, ceramic, resilient, and laminate. Fortunately, Mohawk has been able to capture much of this share shift with higher priced, higher margin products. Historically, there has been significantly more room to differentiate product offerings with hard surfaces, including engineering relating to installation (adhesive vs quick-lock), soundproofing (engineered hardwood), resiliency (ArmorMax coatings), etc. This share shift is likely to continue, as Carpet is typically only 30-40% of the market in other countries. As this happens, Mohawk’s other business lines should benefit, and accrue higher margins. However, even within the Carpet segment, there has been a shift towards ultra-soft proprietary fibers that command higher price points and better margins.
C) Housing Recovery
Note: I won’t spend a great deal of time here regurgitating housing statistics. I believe there is a strong body of evidence that points to an ongoing housing recovery (housing starts, permits, household formation, builders confidence, architecture billings, Case-Shiller, over/underbuild by population trends, etc.)
All of Mohawk’s segments should benefit materially from an ongoing housing recovery, especially once it spills into the residential remodeling market. Housing data has been positive; projections call for a 25% increase in new home starts, homebuilders are at 8-year record confidence levels, and major appliance and home improvement retailers (HD, LOW) are posting strong results.
Historically, we have seen a large rebound in flooring sales after cyclical declines. Industry-wide data provides examples back to 1988:
1990-1991 average (4.5%)
1992-1994 average +9.6%
1995-1997 average +3.6%
1998-2000 average +8.0%
2001-2002 average +1.4%
2003-2005 average +7.4%
2007-2009 average (13.4%)
2010-2012 average +3.8%
The market is still expecting a strong rebound with high single digit growth rates as it seeks to recoup the 35% drawdown it experienced between 2006 and 2009. It’s worth noting that of the U.S. Residential business, nearly 80% of the segment is for Repair/Remodel, rather than new installation.
United States Carpet Ceramic Laminate/Wood
Residential New Construction 10% 20% 10%
Residential Repair/Remodel 55% 35% 90%
Commercial 35% 45% 0%
The underlying drivers of Repair/Remodeling work do overlap with overall housing drivers (unemployment, interest rates, etc) but because they are consumer discretionary, they are also dependent on consumer confidence, home prices, etc., which may take longer to rebound. However, Harvard’s Leading Indicator of Remodeling Activity, included below, points to an inflection point in Q2/Q3 of this year.
Model
To project forward financial results, I built a financial model up from the individual product segments, and the 2013 acquisitions, based on our estimates of top-line growth, management’s commentary on cost structure and incremental margins, and our assumptions about the business.
Consensus 2013 2014 2015
Sales $ 7,340 $ 8,171 $ 8,977
EBITDA 966 1,183 1,330
EPS $6.46 $8.09 $9.41
OCF-CapEx 309 512 628
Maint. uFCF 698 857 971
Price $ 137.73 Consensus 2014 2015
Shares Out 72.6 EV/EBITDA 10.4x 9.2x
Market Cap 10,002 P/E 17.0x 14.6x
- Cash (63.6) FCF Yield 5.1% 6.3%
+ Debt 2,346.4 Maint. uFCF Yield 7.0% 7.9%
Ent. Value 12,295.3
Risks
+ High expectations: Our projections for the company’s operating performance do not differ materially from consensus until 2015; this does not provide us with a significant margin of safety operationally. Although our assumptions were modest, it is a risk that unexpected operational difficulties or issues integrating the companies could cause a slip-up in operating performance and cause the company to miss expectations.
+ Bob Shaw & Engineered Floors: Interviews with market participants indicate that Bob Shaw is a credible threat to competition in the Polyester residential carpet segment. Although this is a small piece of Mohawk’s revenues, and even smaller of its earnings, it is a growth area, and Engineered Floors is making significant progress penetrating the market. Industry gossip suggests Mr. Shaw is building his company out of spite because he did not feel he received an equitable retirement package when he chose to leave Shaw and Berkshire Hathaway.
+ Lack of housing recovery: If the macroeconomic environment makes a dramatic shift downward, and both new housing and homeowners’ appetite for renovation falls through, this would have a dramatic effect on MHK given its high operational and financial leverage.
+ ROIC post-2005: Mohawk comfortably earned its cost-of-capital with ROICs averaging 14.5% between 1990 and 2004. Unfortunately, the $2.5 BN acquisition of Unilin in 2005 was badly timed, and ROICs have since collapsed down to 3.4% by 2009. The trend is positive, and I am modeling 7.5% in 2013, 9.7% in 2014, and 11.4% in 2015, but this historical misstep is noteworthy.
+ Upside risk- better than expected housing recovery: Industry sales of Carpet, Ceramic, and Hardwood still need to grow by 54%, 34%, and 43% before they match previous highs. A sharp recovery in housing, or the repair/remodel business, could lead to double-digit revenue growth and substantial margin expansion beyond our model.
Conclusion
Mohawk is a great business with unparalleled market share, tangible barriers to entry, and a highly incentivized and aligned management team. The company has secular tailwinds due to the shift to hard-surfaces and new highly advanced products. It is also on the cusp of a potentially massive cyclical upswing caused by a recovery in the housing market and remodeling spending.
Tempering this enthusiasm are the already high expectations built into the stock. That being said, I do not believe the valuation metrics below reflect a company of this quality at this point in the housing cycle.
+ P/E: Historical multiples put the company in the 17x P/E range during growing market conditions. On 2015 numbers, this would imply a $160 stock by Y/E 2014, or a return of 16%.
+ EV/EBITDA: At 12x 2015 EBITDA, assuming $600 MM in debt paydown, MHK would trade at $195, or a return of 42%.
+ FCF Yield: At a 5% FCF yield, MHK would trade at $173, or a return of 26%.
The average of these targets is $176, or a 28% return from here. Upside could come from greater-than-expected success in Russia, better company integration with more cross-selling opportunities, or a faster housing recovery.
More broadly, MHK has shown its appetite for doing large international acquisitions to enter new geographies or augment its product offerings. The company’s priority for cash will be to pay down the 2.8x net leverage, and it should do so easily with ample FCF. At that time, it will likely pursue similar accretive acquisitions as it builds a global powerhouse.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
Earnings and guidance. Progress in Russia. Housing recovery. Secular trend to hard surfaces. Delevering. Additional acquisitions.