Dixie Group DXYN
November 02, 2003 - 12:40pm EST by
2003 2004
Price: 7.20 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 87 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Dixie Group (ticker symbol DXYN)

At Price of $7.20. Basic shares out of 11.78M shares. 1.3M options appear to all be in the money now with avg strike of $6. Get FD shares of roughly 12.1M, $87M market cap. (if I did the treasury method incorrectly, please feel free to post your own calculation)
Total debt of $208M, (deferred income taxes of $24.5M, and other liabilities of $17M as well)

Thesis: old line family company sells commodity carpet assets to Berkshire (who combines them with Shaw), uses cash to pay down debt/share repurchase/dividend, and focuses on remaining high end higher margin businesses. Lack of proforma numbers requires some reasoning, but it looks like shareholders will 1) benefit from cash proceeds event and 2) be left with a decent business at a very cheap price. Additional kicker could be new product line which is just being rolled out

On September 4th The Dixie Group announced an agreement to sell roughly half of its business to Berkshire Hathaway for $180M in cash proceeds. I traveled down to GA shortly thereafter to meet with CFO and have spoken to the CEO as well. (note: headquarters are in TN, but executive offices are in Calhoun, GA) I believe this a very intelligent transaction that was well thought out and is an honest attempt at creating value for shareholders.

While the company is not giving out specifics, they say the after tax and after fee (for early debt pay down) proceeds should be “in the ballpark” of $150M. DXYN current FD market cap is roughly $87M. DXYN operates in both the lower end commodity carpet business (wholesale ASP of $4-6 per square yd) and the high end residential and commercial carpet business (wholesale ASP $25-35 per square yard). They are selling the low end commodity business to Berkshire who will merge it with BRK sub Shaw. DXYN has struggled in this business as they lack the size needed to compete with Shaw and Mohawk and other bigger players. The New DXYN will be focused on the more attractive high end business where they own the two top brands, and the company will have a much stronger balance sheet.

The main questions are 1) will the transaction happen, 2) what will management do with the cash proceeds, and 3) what is the earning power of the remaining business. HSR for the transaction expires on about 11/13. Company does not think there will be an issue. In the carpet and floorcovering industry, this sale is immaterial. It is a very small deal. However, one area of potential concern is that DXYN has close to 100% share of the manufactured home carpet business. Management claims this should not be a problem as there are very low barriers to entry into that business and Mohawk is expected to enter the business. Also, they doubt the gov will define the market in such a narrow fashion. Carpet industy, only $7B industry, looking at $250M of carpet business in this sale. Certainly BRK has some worthy lawyers working on the case. Note that HSR was supposed to expire around 10/12, but FTC is so backed up that they had not begun work on this transaction early in October. With this understanding, DXYN voluntarily started the process over again, with HSR to expire on about 11/13. What is important is that this was not caused by a second request for info by the FTC. I spoke to CFO this week and they have had a lot of contact with the FTC since refilling. They are still confident that it will be approved. Sounds like they have given the data necessary and now FTC is calling competitors and checking the data. This past week the company moved it’s earnings call from 10/30 back to Nov 12 in the hope that they will have heard something from the FTC by then. Once approved, the transaction should close very quickly and BRK is good for the money. Company has said cash should come in very quickly in this asset sale.

Next, the company has not said anything about the proceeds except they will pay down some high cost debt and that all other options are on the table. My guess is they use half of proceeds to pay down debt, then one time dividend or stock buyback with the rest. CEO has family members who have not been rewar\ded over the years (despite recent run up), and would likely support a one time big dividend. Everything is on the table according to the CEO. Sounded like buyback is possibility as well, depending on price of stock.

Risk of transaction not closing is minimal in my opinion. Risk that managmenet gets cash and uses it to make a stupid acquisition. Doubt this as well. CEO has said they do not need to make acquisitions.

Exciting part. You can play with the numbers in a lot of different ways. Assume $150M in proceeds and CFO told me company targets 40-50% debt to cap (thought CEO told me initially they might go below this suggesting more debt paydown). Debt of $208M, Book equity of $112M as of june 30th. Assume debt after WC cycle is more like $180M. Look at any number of possibilities, see that this company could pay down $100M of debt, and still pay a 50-60% dividend on the stock, and likely be well under target debt level with new book equity. Or they could just pay down almost all their debt.

Will pay down high cost debt first. Sounded like they have already done some work as far as looking at what debt can be paid down. Then can restructure remaining debt (you would think they would get a much better rate)

Remaning business – the New DXYN
So what’s left? Two very strong carpet businesses. Fabrica (serves residential market) $33/sq yd avg price (wholesale), and Masland ($23 ASP) which is 50/50 commercial/residential. Both are in the very high end of business. ASP for industry is about $6/sq yd.. DXYN owns roughly 33% market share in high end. These brands are the top in the business. Much is sold through designers, quality is as nice as can get. Karastan (Mohawk) is a big competitor, but they have moved down in price.

The New DXYN businesses have held up better than the rest of the industry. Over the last 3 years, Fabrica has grown its sales and Masland has been flat, while rest of industry has fallen. Their products are sold to wealthy customers who have continued to make purchases.

Fabrica and Masland have been growing at a faster rate than the economy over the last 10 years. No customer is more than 3% of total business, before divestiture Home Depot was 10-15% of DXYN’s business.

Masland in the commercial end as well, nice business, not just standard office carpet, they have a nice business with restaurants, where they do the installatikon as well, Darden and Applebees, does all of their carpets , Jack and the Box as well, Target, and deal with Ritz Carlton, Sheraton,.

Breaking down numbers: about $135-140M of high end residential carpet business. 30% goes to decorators, rest to go to high end retail and specialty, strong long term relationships with them. Then have $75M of high end commercial carpet, specified, do some store planning for bloomingdales, restaurante business, all of Darden group, Applebees, commercial, make custom designs to fit their needs.
So $210M of business, and $30M of carpet yarn business. Yarn business, so small, really just sell it to yourself, 80% of what make, use in own operatioins, $30M of sales

Capital needs – capacity is not an issue, no need for expansionary capex for a long time according to CEO. CAPEX a lot less than DA now, proforma the gap will narrow, but they still will not spend their depreciation accordiong to CEO. CAPEX of $7M versus DA of $21M in 2002.

Consensus seems to be that the new DXYN should have op margins of 10% or more. Looked at Mohawk a few years back before they bought Dal-Tile, and they were earning 9-10% op margins, and they are in the low end commodity business. However, New DXYN will not have scale that Mohawk has. Talking to CFO, he endorsed the reasoning, said there was no reason why the new DXYN cannot get to the Mohawk margins I was referencing.

We will get our first look at new DXYN in this next release, as they will separate continuing operations.

Looking at the results for the first 6 months of this year it appears the company has been struggling. According to the company these issues have mainly been in the businesses that are going to be sold. Also hurt by start up costs for new business. That being said, it’s hard to believe that the cont ops had HSD op margins in the first 6 months, but we’ll see. (that would mean the to be divested businesses were really hurting) It is very possible that the commodity business is even worse than I expect and it has been dragging down the new DXYN. So the new DXYN couild have operating income of $20M+ on an equity purchase price of $87M (and remember you will be getting a much better balance sheet and likely a one time event from cash proceeds to equity holders). (again, I’m not that naïve to think they will be earning this in year one, I think it will take time as a new focused company) And it will likely be a growing company. In fact, growth could be very nice. Big risk, is that when we get proforma numbers in two weeks, they are a much longer way away from HSD op margins than I am assuming.

Dixie Home – could be the real kicker
Final note that could provide nice upside to this story
New product line just being rolled out
Dixie Home line of carpet, sells for $10-20/sq yard, 2-2.5X the industry average. Quality is not quite as good as Masland and Fabrica, but still a premium carpet they can sell through mass market. Filling a niche. Differentiated product, sold through retail channels, but being very selective, only going to sell to 4K of the 25K retail outlets in the market. Only give it to the ones who can do well, Home Depot, lot of ind retailers. Rolled it out in Jan of this year, just getting first orders, started sending out samples in May/June, 80% of samples sent out as of early Sept. 3100 have received them of the 4K, starting to see business. Generally has to be shipped to customer, retailer does not hold inv. Very good response so far, far exceeded expectations. David Polley is star of this story, legend in industry, in charge of Dixie Home, knows all the retailers, from Mohawk. 68 years old, spent his life in the industry.
In the $10-20 range, (manufacturer price), big market so just get 5% of that and would be big. According to CEO, CEO and Polley just in TX for meetings, no one is saying no. Will be making Dixie Home out of Masland facility now that No GA is being sold. That will bring some efficiencies, nice synergies, according to CEO. 3 year contract with Dave Polley, likely will stay longer.

Demand driven by consumer confidence, not really by new home starts
It is a deferrable good, driven by replacement market
Oil is a big ingredient, but they have been able to pass along price increases to customers in high end business. CFO says they actually enjoy oil prices going up, as eventually oil price goes back down, but they keep their prices up.
Industry sales are down 3% year to date, Mohawk thinks 2H will be stronger.

Little History
Was a textile company, then in 1993 CEO saw the future in textiles was so bleak, they became a carpet company. Look what happened to other textile companies. Not many have avoided bankruptcy. So two ways to look at management. 1) Haven’t created much value in last few years, or 2) shareholders should be happy this management team avoided the coming disaster in textiles.

One analyst said he heard BRK wanted to buy the entire company. Not hard to believe.
Talking to them, does not sound like they would sell rest of company.
Average vol per day is about 80,000.
The stock has already soared so you need to make your peace with that fact and look at the valuation as it is today.
There is a dual class structure in place, whereby Frierson family has total control.
Seems to be little concern in docs. Unfunded pension is immaterial. $2-3M. Frozen in ’93.
No other material cont liabilities, litigation or environmental


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