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.