Description

Mohawk hasn't been written up in depth since 2013, therefore we tried to bring the reader up to speed on most of the pertinent facts and trends. Prior write-ups (and comments) do a good job of laying out how the business has evolved.

Mohawk Industries is a “catch-up” investment idea that we believe has the chance to generate 50-75%+ in a fairly short time frame (< 18 months), as investors and the sell-side appreciate the multiple tailwinds helping the residential flooring market over the next few quarters. We’ve taken the recent weakness to accumulate a position, as we think the stock has overreacted to a class action lawsuit regarding revenue recognition problems. While there was likely some channel stuffing and shenanigans occurring, in the grand scheme of things, that constitutes only a fraction of the overall business. If there is a payout, we believe it is likely ~$100mn, based on conversations with legal experts-- something very manageable, given Mohawk’s liquidity and strong investment grade credit profile.

We think Mohawk offers a compelling value in a frothy market trading just above trough multiples (7.15x NTM EV/EBITDA) going back over a decade, while the U.S. residential housing market (MHK’s largest exposure) is booming. In late 2019 (pre-Covid), Mohawk was trading ~$150 per share with a much more uncertain macro backdrop; fast forward to today, it is quite clear the residential housing market is flourishing as a result of the massive stimulus package and extremely low rates. Given the unique lag effect with regards to flooring, we think the sell-side is drastically underestimating how quickly Mohawk will recover from the pandemic. Putting all this together, one can invest in the global low-cost flooring manufacturer with massive scale advantages trading well below pre-Covid levels, in what is likely the best residential housing market since the early 2000s. 

While Mohawk is a cyclical business it is more resilient than most cyclical businesses, Mohawk has been free cash flow positive for 25 consecutive years, including the depths of the housing crisis. With leverage around its historical lows (1.6x), the downside appears to be limited with the business trading around trough valuation levels on normalized operating trends. As we will expand on later, we think the housing market is in a much healthier condition from a supply/demand perspective than pre-GFC. While other stocks with exposure to the housing market are absolutely booming, Mohawk has lagged due to disruptions in production and a temporary demand shift away from bigger ticket discretionary items, like flooring. Flooring is one of the last items installed in a newly built home; it takes roughly 12-18 months to see the underlying growth. There is also another unique lag effect taking place in the professional (Pro) installation market (~23% of the U.S. market), where this Pro channel was all but shuttered due to Covid, as consumers wanted to avoid workers in their homes and businesses. Specialty retailers are already noticing an inflection in consumer attitudes towards the Pro installation market, with many specialty retailers experiencing a large backlog of pending jobs. Thus, once this inflection is picked up on by investors, we think the multiple re-rates (~11-13x EV/EBITDA; w/ LT visibility on top-line growth) as the operating leverage of the business becomes more apparent.

Finally, management has been extremely conservative with guidance, in light of the class action lawsuit and SEC inquiry into channel stuffing. With that being said, many of the headwinds (dollar strength, cost input inflation, lack of tariffs) the company has experienced over the past few years, are abating and are turning into future positive catalysts over the next couple quarters.

Upcoming Catalysts:

1. Underappreciated advantage with new tariffs (08/20) on Chinese Luxury Vinyl Tile (LVT) & vinyl flooring.

2. Currency tailwind- What was once a significant headwind for the business in ‘18 and ‘19 has become a significant tailwind, as the largest international translated revenue base is in Europe. USD vs. Euro is down ~ -10% since March.

3. Recent carpet price increases (4-8%; based on carpet type), indicative of strong underlying demand.

4. Lagging demand in the professional installation market due to COVID-19, which masks the recovery and growth in flooring. While the DIY channel has recovered and grown substantially in this environment, the “pro” market is still recovering and lags the overall DIY channel by at least 1-2 quarters.

5. Channel inventories are extremely low and have destocked significantly from complete/partial halts in manufacturing during Q2 ‘20.

6. End markets are extremely strong, as witnessed by sales trends at home centers (LOW, HD), and public specialty flooring retailers (LL, FND).

7. New residential housing and repair and remodel (R&R) market are much stronger than anticipated, vastly outweighing weakness in commercial (office).

8. Management’s decision to keep operational flexibility open during the recovery looks prescient, given the ramp in housing demand.

9. Restructuring of both carpet and ceramics (mostly centered on ceramics) in 2019 will improve margins once volumes are normalized. Changes with LVT lines within the U.S. is helping to add incremental profitability versus ‘19, in which LVT was a cost center due to manufacturing inefficiencies. 

10. Mohawk recently won a blockage order (09/16/20) from competing LVT products imported from abroad that stole MHK’s patented locking mechanisms in both glueless rigid and multi-layer flooring. Of the approximate 48 violators, 35 have settled with Mohawk; the remaining were found to be in default by the U.S. ITC.

Business Overview

Mohawk is the world’s largest flooring manufacturer and has completed 45 acquisitions since 1992. Mohawk is a vertically integrated manufacturer with a scaled logistics system, 1,600 sales reps, 340+ distribution points, and 750+ trucks within the United States. Mohawk’s competitive advantages are through its scale, distribution network, patented flooring technology, and its well known brand leadership in North America, Brazil, Europe, and Russia. In the U.S., Mohawk and Shaw Industries (owned by Berkshire) dominate, with Mohawk at approximately 22% market share and Shaw ~20%; the next largest player has less than 6% market share within the U.S.

Mohawk has three reporting segments including Global Ceramic, Flooring North America, and Flooring Rest of the World (ROW). The approximate end markets for Mohawk break down with commercial at ~25% and residential at ~75% of the sales mix.

1. Global Ceramic consists of: ceramic tile, porcelain tile, natural stone tile, quartz, and porcelain slab countertops; main distribution is in NA, Europe, Brazil & Russia.

2. Flooring North America consists of broadloom carpet, carpet tile, rugs, carpet cushion, laminate, and vinyl products-- including luxury vinyl tile (LVT) and sheet vinyl, and wood flooring-- all distributed through MHK's network of regional distribution centers and satellite warehouses using company-operated trucks, common carriers, or rail. These products are sold through independent floor covering retailers, independent distributors, home centers, mass merchandisers, department stores, shop at home, online retailers, buying groups, commercial contractors, and commercial end users.

3. Flooring ROW designs, manufactures, and sources/licenses vinyl products-- including LVT, sheet vinyl, wood flooring, roofing panels, insulation boards, medium-density fiberboards, and chipboards. These products are primarily distributed throughout Europe, Russia, Australia, and New Zealand

Source: Mohawk Investor Presentation August 2020

While Mohawk has been considered by many as a high quality operator in a consolidated flooring industry, recent secular trends have tarnished much of that image over the past few years-- specifically the growth in Luxury Vinyl Tile (LVT), which has been taking market share from other flooring categories, especially within the U.S. where this trend has been the most pronounced. Currently, LVT represents approximately 17% of the U.S. flooring market, with the Chinese importing about 62% of the U.S. LVT market. During LVT’s rapid ascent in the U.S., it has pulled market share from other higher margin products for Mohawk. While Mohawk has seen this playbook before with secular challenges in carpet, Mohawk has been behind in adjusting to the rapid emergence of LVT. As Mohawk has pivoted and tried to produce more LVT at scale, it has run into production issues; and these issues amounted to LVT production being a cost center in the U.S. for the past couple years.  As the technical know-how has been transferred over from Mohawk’s successful European LVT facilities to the North American LVT sites, profitability has been slowly improving, and management has noted that 2020 should be an inflection point with regards to improving LVT margins.

Residential Housing Poised For Long-term Growth 

Source: Bloomberg, U.S. Existing Home Inventories 1999-2020

The chart above shows the U.S. existing home inventory over the past 21 years. On the y-axis, the range rose from roughly 1.5mn to 4.0mn during the height of the housing bubble. It’s important to note in 1999 the U.S. had roughly a population of 279mn; today the U.S. is at ~330mn-- so just over 50mn in net adds over 21 years, while the country has existing home inventories well below those trough levels in 1999.

Source: Bloomberg, S&P CoreLogic Case-Schiller 20-City Price Composite

The S&P/Case-Shiller Composite of 20 Home Price Index is a value-weighted average of the 20 largest metro areas within the U.S. With median home prices around $225k-- almost double the value in ‘08-09-- it is clear that Americans have built up a lot of equity since the lows of the GFC.

Source: Bloomberg, U.S. New One Family Houses Sold Annual Total SAAR

The above implicit US index is computed by taking the number of houses sold in the US and dividing it by the seasonally adjusted number of houses sold in the US. Over the past 6 months, this index has seen one of the largest jumps ever in new home sales.

Source: Bloomberg, Fannie Mae 30-year Fixed Rate Mortgage

Source: Bloomberg Home Sales Contracts

Home Sales Contracts, a leading indicator, reached an all-time high over the prior two decades in the most recent data, suggesting continued demand for homes and housing-related durable goods. The demand pull forward from urban flight, millennial home formation, Covid nesting trends, and the Fed aggressively cutting rates, has resulted in demand overwhelming supply in certain channels i.e. homes, lumber, used cars etc.-- so much so that Jefferies believes that the restocking cycle will be the biggest on record.

These inventory challenges have also been manifesting in the flooring market; Mohawk’s Q2 ‘20 conference call gives some color:

Q: “Yes, I mean what kind of capacity, are you going to be running at. You cut a lot in the second quarter to get inventory down. What's it going to look like in the third, compared to second?” -- Keith Hughes 

A: “This third quarter, we're running the business at a much higher rate than we were. We're actually trying to increase the inventories, but they decreased too much, but we're having difficulties getting them up given the labor issues, vacations in Europe and other things. So they're going to run at much higher rates.” -- Mohawk COO, Christopher Wellborn

As we begin to understand more about the virus, domestic manufacturing will adapt to the new reality and we believe management will eventually find a way to return to higher utilization rates than pre-Covid levels. We believe that domestic manufacturing will become more important in the coming months and years as shipping costs have recently skyrocketed and the dollar’s recent weakness become impediments for imported goods.

Significant Challenges to Imported Flooring

Imported products into both the U.S. and Europe have become significantly challenged by a number of recently developing factors including exponential shipping costs, new tariffs, and recent dollar weakness.

Source: Bloomberg, Drewry- Hong Kong to LA Shipping Rates, 40 ft. box

Since the March low, the cost of shipping a 40 ft. container from Hong Kong to L.A. has gone up almost 3x in just 6 months-- from ~ $1,300 to ~ $4,100, which is by far the largest percentage increase in shipping rates in such a short timeframe. Not only has this put pressure on imports into the United States, but products shipped into Europe are also experiencing elevated rates.

One of largest imported flooring segments into the U.S. is Luxury Vinyl Tile (LVT), which makes up roughly 17% of the U.S. market and is the highest growth category. Of that 17%, roughly 75% is imported product, and approximately 62% of all U.S. LVT is from Chinese imports. Shipping cost increases combined with aggressive tariffs are upending the supply chain for home centers and specialty retailers, as they scramble to find adequate domestic (and Intl) supplies to replace Chinese LVT. Considering the lead time issues sourcing from other countries, we think a substantial portion of the LVT will rely heavily on domestic manufacturing and distribution.

"What we think is going to happen is, the reverse of what happened last year, and the industry will have to increase prices to cover the tariffs which would increase the value of our manufacturing as we go through," -- Mohawk CEO, Jeff Lorberbaum. (08/07/20)

Recent tariffs on LVT are making other products such as ceramic, carpet, and hardwood much more price-competitive. In anticipation of this tariff, the imports of Chinese LVT have caused a temporary spike in U.S inventory levels; this is transformational long-term, with respect to Mohawk’s competitive positioning versus the Chinese. In some cases, Mohawk is able to replace LVT sales with ceramic-based products which are now closer to price parity.

Recent Section 301 LVT/Vinyl Tariff description (effective 08/07/20):

1. (3) Floor coverings of polyvinyl chloride, presented in the form of tiles or planks designed to snap together during installation (described in statistical reporting number 3918.10.1000) 

2. (4) Vinyl floor tiles of polymers of vinyl chloride, designed to click together during installation, each measuring 4.7 mm or more but not over 8 mm in thickness, 18 cm or more but not over 23 cm in width and 120 cm or more but not over 182 cm in length (described in statistical reporting number 3918.10.1000)

3. (5) Vinyl floor tiles of polymers of vinyl chloride, designed to click together during installation, measuring 7 mm in thickness, 18 cm or more but not over 19 cm in width and 120 cm or more but not over 125 cm in length (described in statistical reporting number 3918.10.1000).”

4. In May 2020, the tariff exclusions were expanded to include, “edges that are interlocking or simply cut at a 90-degree angle.”

5. As a result of this omission from the exemption list, all vinyl flooring made in China is saddled with a 25% tariff, effective immediately.

“Flooring companies not excluded from tariffs under USTR order, says Wedbush analyst Seth Basham says that while many products imported from China will be excluded from tariffs through December 31, 2020, flooring was not among them, which will lead to increased costs of certain luxury vinyl tile and possibly laminate flooring imported from China that was previously excluded from 25% tariffs. The analyst notes that Floor & Decor (FND) and Lumber Liquidators (LL) booked material refunds from the tariff exclusions in late 2019 and have been purchasing these products from China at the non-tariffed price since then, and with the tariffs exclusions expiring, the companies will now pay 25% more for the products. The analyst expects the companies to raise prices to combat the higher prices, and sees the potential for a mid-single digit impact to earnings growth for F&D in Q4 and a low-double digit impact for Lumber Liquidators.”

Mohawk has had some recent success in pushing for tariffs and leveling the playing field with Chinese imported LVT. While this doesn’t solve all the problems with LVT, it should slow the growth of LVT within the U.S. and provide more time for Mohawk to adjust to rapidly changing flooring dynamics.

“Mohawk, which produces LVT in the United States, pushed for the tariffs last year, which began at 10% and were later raised to 25% before the temporary suspension of all tariffs for nine months last November. But other floor covering companies, including Shaw Industries, have argued against the tariffs because they fear it will hurt sales in one of the few growing sectors on the flooring industry if prices rise for consumers somewhere between 15 - 20% for such vinyl flooring”

Furthermore, on September 16th of this year, the U.S. International Trade Commission ruled in favor of Mohawk, blocking imports of rival vinyl flooring. Mohawk had successfully argued that there was a “widespread pattern of infringement” from Chinese companies using its patented Clic or L2C systems for installation. The patents of concern are related to locking mechanisms in the flooring panels that make installation easier, limit irregularities, increase stability, and improve water resistance. Mohawk has settled with approximately 75% of the four dozen or so Chinese offenders.

Source: U.S. ITC, Goldman Sachs

Since the beginning of 2017, Chinese imports of ceramic tiles into the U.S. have increased by over 600%, peaking at around 6.4mn sq. meters in 2018. Goldman estimates that roughly 600 bps of decline in segment margins have been experienced by Mohawk in the ceramic channel due to the influx of Chinese ceramic imports. In recent conversations with the company, Chinese ceramic imports are essentially non-existent now in the U.S. due to the culmination of approximately 300%+ tariffs on Chinese ceramic imports. The last round of tariff increases on ceramic tile were in the fall of 2019, resulting in outsized imports prior to the tariff implementation. The cumulative effect of these tariffs has altered the cost structure meaningfully with respect to the value of imported ceramic tiles, thereby shifting more demand to domestic manufacturing channels. Historically, ceramic has always been more insulated from imports than other lighter products, as weight is a big variable in shipping costs.

“Additionally, to line our own inventory levels we meaningfully reduced production in our North American ceramic plants, which increased our costs. We have started to see some trends that should benefit our business in 2020. Compared to the prior year fourth quarter, total US ceramic imports declined 17% with Chinese ceramic imports falling 90%. Lower interest rates in improving new and existing home sales should also benefit the market this year.”-- Christopher Wellborn, MHK COO Q4 2019

Over the past few years, Mohawk has suffered significantly from strength in the dollar. To give an example: During Q1 ‘20 with marginal strength (~ +3%) in the dollar on the back of the Covid panic, MHK experienced a -$322mn currency translation loss. Since the dollar strength plateaued in late March, the dollar has weakened substantially (-10% since March peak). This is especially important to Mohawk, with its largest international segment residing in Europe (~25% of total sales). Not only does the weaker dollar help with currency translation, but it helps with imports into the U.S.- a weaker dollar means it’s more costly to purchase imported flooring products.

Source: Bloomberg EURO/USD LTM

MHK Lagging the Housing Recovery

“...we’ve seen an improvement in housing sales, and improvement in housing sales should benefit us. If you look at new home sales, flooring is the last thing that’s put in before the house is complete. So if it takes 12 months to build a house or 18 months, the flooring is the last thing that’s put in it.” -- Jeffrey Lorberbaum Q3 2019

“In the last 18 months or so, you've obviously had a lot of headwinds, whether it's drawn-down production with the downdraft in demand, price cost and startup costs weighing on profitability. When you kind of look out to 2020, do you expect these headwinds to moderate and some of the self-help initiatives kind of kick in and drop through to the bottom line where margins could actually be up year-over-year next year? It would be helpful to kind of tie all that together.” --Phillip Ng - Q3 2019  

“The market in general, as we keep talking about, is under pressure, and we keep aligning the businesses with the markets. As we look forward, you see us investing more in sales and marketing to increase our share, both in existing products as well as to get these new factories up and running. The positive pieces are, the North American restructuring is going to start benefiting the business next year. The LVT lines will be operating more efficiently. These other plants we're talking about will start adding value versus being a drag on the pieces, and the marketplace will have to keep reacting to whatever happens.”-- MHK CEO, Jeffrey Lorberbaum- Q3 2019

Source: Koyfin relative performance 11/12/20-10/09/20

Almost every housing related manufacturer or retailer’s stock is at or above their pre-Covid levels. Perhaps much of the hesitancy from the sell-side and investors is coming from the fact that there is a significant lag effect as housing activity ramps up; there has been very little proof of a full recovery in the numbers, just subtle hints that flooring is recovering. Conversely, one can actually see the inflection in the numbers at the retail level as housing trends have shown remarkable improvement since March and April levels.

When taking into account the nesting trends in place since Covid-19, much of the flooring market has been relegated to the DIY market. However, even the DIY channel has been impacted, as most specialty flooring stores remained closed for months during the initial outbreak phase of Covid-19. These specialty channels have since largely reopened and begun servicing both the DIY channel and the professional (Pro) installation market. 

In this work-from-home environment, customer orders typically involve DIY lower margin products like click together rigid LVT tiles (or interlocking systems) and flexible adhesive backed vinyl planks. As customers begin to feel safer with professional installers entering their homes, the professional installation market shifts back to more complex installation projects such as ceramic, carpet, and hardwood. While the Pro market has been hit the hardest, there is evidence that professional installations are coming back, as home remodeling projects continue to gain steam.

“Digging a little deeper into the sales trends, our DIY sales showed relative strength in the second quarter, while installation and Pro sales were relatively weaker. We attribute the relative weakness to a general reluctance of consumers to have anyone other than family members and close friends in their home. As the quarter progressed, we saw interest in our installation offerings improve, as evidenced by increasing sales of our installation assessments.” -- Lumber Liquidators CEO, Charles Tyson Q2 2020

Competition:

Success in flooring manufacturing primarily comes from scale; other competitive advantages come from proximity to manufacturing, distribution, volume, and supplying the right product with the shortest lead times. Being the largest vertically integrated flooring manufacturer in the world, Mohawk has the advantages of scale and a management team that has allocated capital well over the years. When Mohawk initially IPOed in 1992, it had less than 2% market share, of which was mainly carpet and rugs. The company has since grown mainly through acquisitions (45 since ‘92), and management has diversified the business away from carpet and rugs into a leading position in ceramics, wood, LVT, and vinyl applications. Mohawk has successfully managed to grow the overall business, while its core product has been in a secular decline for over three decades-- with carpet going from ~75% market share to a current share of only 41%. While there is increasing concern about secular problems with LVT taking market share, given Mohawk’s scale and past experience with carpet, the management team should be nimble enough to adjust to the rapidly changing flooring market.

Source:Investor Presentation August 2020

Source: Investor Presentation, Q2 2020

Mohawk, along with Shaw, are the only major U.S. flooring players with a national distribution network, and thus have more room to compete on price and better relationships with specialty retailers, contractors, and home centers. The competitive advantage for localized manufacturing and distribution at scale has operating leverage benefits only the largest players retain. Many sub-scale competitors in the space don’t have enough volume to efficiently fulfill their own distribution network, and therefore, rely on third party distribution. 

Source: Investor Presentation August 2020

Source: FCW, Goldman Sachs

Mohawk has been slow anticipating the rapidly changing competitive dynamic in the U.S. flooring market; LVT has gone from non-existent in the early 2010s to roughly 17% of the U.S. market. While Mohawk has made adjustments to the current LVT environment, problems with U.S. LVT manufacturing have tied up significant amounts of capital to expand production (U.S. LVT capacity expansion ‘16; + expansion in Belgium) and get the correct efficiencies to deliver the target margins. In the past three years, costs on improving efficiencies with U.S. LVT were over $100mn, as the team continues work on transferring knowledge from its successful Belgium operation. Prior to COVID-19, LVT efficiencies with regards to yields and line speeds were improving sequentially over multiple quarters, suggesting a margin inflection. The original targets were for normalized U.S. LVT margins, similar to the Belgium facilities by 2H 2020, considering the length of the pandemic that progress is likely delayed. Prior to the pandemic, management had made forecasts that U.S. LVT would soon be cost competitive with Chinese imports. With the recently announced 25% tariff on Chinese LVT, it would appear that Mohawk’s domestic manufacturing has a big cost advantage over Chinese imports, especially when considering recent dollar weakness and rapidly rising shipping costs. Over the course of the next few quarters, as LVT supply is worked off, we think Mohawk will begin taking market share back from Chinese imports.

In the U.S. carpet market, it is essentially an oligopoly among three players: Mohawk and Shaw are, by far, the largest, with Engineered Floors rounding out the top three. While there are a few other smaller fragmented players, these top three control pricing within the U.S. market. A little over two decades ago, both Mohawk and Shaw settled class action lawsuits that alleged there was a price fixing scheme between the two companies. Based on recent conversations with Mohawk, it appears that Engineered Floors is now the one initiating price increases, which Mohawk and Shaw subsequently follow. In early September of this year, it was announced that the carpet mills would increase pricing anywhere from 4-8%, taking effect on either October or November (Shaw) shipments. While there is some cost inflation occurring, the price increase appears to correlate more with the demand side of the equation. To pass through a fairly substantial price increase in the middle of a pandemic, signifies that the underlying demand (even in secularly challenged carpet) is healthy and rapidly improving.

With regards to ceramic, Mohawk is the low cost leader in North America with approximately 59% of the $3.6bn in ceramic sales residing within the U.S. As mentioned, one of the major weaknesses for Mohawk over the past three years has been the rapid emergence of Chinese imported ceramic tiles. As the most recent tariff went into effect during the fall of 2019, the glut of Chinese imported ceramic is finally being worked off; going forward into 2021, we think Mohawk will begin to recapture share and margin, as Chinese imports drop significantly.

The overall fragmented nature of flooring is notable, as both Mohawk and Shaw Industries have commanded market share that support both being the lowest cost operators in the industry. While smaller fragmented players continue to lose money (some slightly better) and market share, both Mohawk and Shaw have been able to reinvest in the business (both organically and inorganically) and continue to improve product efficiencies to add value. 

Public Flooring Competitors, U.S. & Global Flooring

• Armstrong Flooring (ticker: AFI): primarily wood based flooring (resilient and wood), 2.9% adj. EBITDA margins FY ‘19, four out of the last seven years negative FCF.

• Tarkett SA (ticker: TKTT FP): Company offers a wide range of flooring solutions such as vinyl, laminate, wood, carpet rolls and tiles, linoleum, and artificial turf. Better operator than most flooring manufacturers, margins skew higher due to sports surface exposure. 9.1% adj. EBITDA margins in ‘19, 3.2x leverage.

• Interface (ticker: TILE): Modular carpet tiles focused on the office and institutional market, typically mid-teens adj. EBITDA margins, however weakness in the commercial market is pushing margins to mid-single digits, 4.2x leverage.

• Beaulieu Group: Bankrupt (2016), acquired by Engineered Floors (private).

• Dixie Group Inc (Ticker: DXYN): Producer of carpets and rugs, 4.6% adj. EBITDA margins, topline declining for three consecutive years, ~ 9.0x leverage.

• Victoria PLC:  Offers carpet, high end ceramic and porcelain tiles, underlay, LVT, artificial grass, and flooring accessories. 10.6% adj. EBITDA margins in ‘19, 5.6x leverage.

A recent consolidation example is the aforementioned bankruptcy of Beaulieu Group LLC,  which manufactured carpet with approximately 5.6% market share in the U.S. It was acquired in bankruptcy by Engineered Floors in 2016. This has further consolidated the market and given even more pricing power to the top three carpet manufacturers, as recently witnessed by the 5% price increase. Of the smaller public peers in the flooring space, many were barely surviving prior to COVID-19, and with supply disruptions and massive demand fluctuations these fragmented peers have been disproportionately affected. 

Valuation

*Average annual LTM EV/EBITDA since 2010: 11.32x EV/EBITDA

• 2019 maintenance CapEx + growth CapEx =$545.5m

• 2020 planned total CapEx ~$200mn (per call), might ramp up a bit towards year end as utilizations pickup, almost entirely maintenance CapEx.

Consensus estimates don’t have Mohawk getting above 2019 EBITDA levels until 2023, something we think is absurd, especially if you speak with folks in the specialty retail channels. Over the next few years as Mohawk takes back Chinese market share we envision this as a GDP +2-3% topline grower combined with margin expansion and buybacks, a lethal combo.

A couple recent data points that support our view of a quicker recovery than expected:

• (09/28/20)-- Tarkett a European (with U.S. exposure) competitor recently reported (+42% since 09/25/20) 1H results where sales dropped less than expected and margins held up better due to cost cuts. Furthermore, Tarkett guided to adjusted EBITDA margins for 2020 broadly in line with 2019.

• (09/10/20)-- Victoria PLC mentioned demand has recovered from the pandemic in all its main markets as consumers are prioritizing spending on improving and refreshing their homes following the lockdown.

• (08/05/20)-- Armstrong Flooring, Jefferies presentation, “You can see demand is maintaining and the feedback we're getting from retailers, they're pretty bullish out there. You can see retailers, and different home sellers getting into flooring and want to expand their flooring department for the foreseeable future. Because I think a lot of people believe that we will be dealing with this situation for an extended period of time.”

Risks

• Commercial/office weakness (slightly higher margin) detracts from overall strength in residential housing and the R&R market. While commercial had been strong throughout the early part of COVID-19 as projects were scheduled and completed, since then activity on the commercial side has recently weakened, especially in the office market. 

• Mohawk will likely be stuck with a class action lawsuit for failing to properly recognize sales and disclosure issues with inventory. Bloomberg estimates the value at between $50-$185mn, and based on our conversations we’ve think a ruling could be ~$100mn.

• Continued aggressive Chinese imports could continue into the U.S.

• Failing to catch-up on inventory shortages in its manufacturing facilities due to labor issues and/or production related issues.

• Dollar strengthens, making it cheaper to purchase imports and hurts Mohawk with currency translation from its international divisions.

Summary

In the context of a rapidly expanding U.S. residential housing market, it is quite compelling to acquire shares in Mohawk around trough historical multiples not seen since the GFC. The downside appears mitigated, given that Mohawk has been free cash flow positive for twenty-five straight years, even through the depths of the financial/housing crisis. While the flooring industry has been changing rapidly, we think Mohawk is one of the few players positioned to capitalize on the recent tailwinds (dollar weakness, tariffs, higher shipping costs, and a residential housing boom). As Mohawk begins to take back U.S. market share from the Chinese in ceramics and LVT, along with the recent cost improvements, we think Mohawk will start 2021 operationally at one of the leanest periods it has ever seen. Given U.S. residential housing shortages, we see continued demand for new homes and an increasing amount of repair and remodel driving higher factory utilizations, and thus, rapidly expanding margins. Consensus estimates don’t have Mohawk earning at 2019 EBITDA levels until 2023 in the midst of what appears to be a thriving housing market for at least the next few years. We see profitability rebounding much quicker than consensus towards historical levels in 2021, as volume and costs normalize across product categories and geographies.

Catalyst

LVT and Ceramic market share recapture, weakening dollar, U.S. residential housing boom