Description

INVESTMENT SUMMARY

Mohawk is a well-positioned and well-managed company that is the leader in the United States floor covering products industry with approximately 25% market share.  The company’s stock price declined recently due to a confluence of factors including a weakening consumer, the significant housing downturn and rising raw material prices.  While Mohawk’s results will likely languish as the housing downturn deepens, Mohawk’s current stock price has more than priced-in this scenario and is an excellent long-term investment.

 

Mohawk has many attractive characteristics:

·          The company has dominant market share in a duopolistic industry.  Mohawk is the #1 player in the U.S. floor covering industry.

·          Mohawk competes in an industry with steady growth over the long-term: the flooring industry has grown at a 4.5% CAGR from 1992-2006.

·          The company has an excellent competitive position stemming from its strong pricing power due to scale.

·          Mohawk has a superior, owned distribution network and high-quality service relationships with independent retailers.

·          The company has the ability to manage costs through vertical integration and a combination of in-house and sourced production.

·          Mohawk has a broad product portfolio, strong brand and is well-positioned to benefit from the shift from soft to hard flooring.

·          The company enjoys high returns on tangible capital (18-20%), highlighting the company’s top tier franchise characteristics.

·          Mohawk has a strong management team with respect to operations, strategy and capital allocation.

·          Mohawk’s stock currently trades at a price significantly below its intrinsic value.

 

Although Mohawk will likely grow sales organically in the mid-single digits and earnings at rates in the low-teens over the next 5 years, its share price does not reflect such growth and does not account for the quality of the company’s competitive position or management. At 11.1X 2007E P/E, 7.5X 2007E EBITDA, 11.2X 2007E Free Cash Flow and 10.0X 2008E Free Cash Flow, an investment in Mohawk at current prices is a compelling risk/reward and is likely to generate compound annual returns in the high teens to twenties over a 3–5 year time period with minimal risk of capital loss. 

 

 

THE BUSINESS

Mohawk is the leading flooring manufacturer in the U.S. and Europe with approximately 90% of revenues generated in the U.S. Through organic growth and a highly acquisitive strategy, Mohawk has gained 1,000 basis points of market share over the last decade, diversifying its business from solely soft flooring to becoming the largest total flooring company in the U.S. Mohawk aims to cover almost the entire market based on both price point and product type, and the company is also evaluating entering related business lines (e.g. ceiling tiles). Approximately 19% of flooring sales are due to new residential construction, 55% residential remodeling and 26% commercial, and Mohawk’s revenue breakdown is similar to the industry. The company operates in three segments: Mohawk (principally carpets and rugs, ~60% of revenues), Dal-Tile (principally stone and ceramic tile, ~25% of revenues) and Unilin (principally laminate, ~15% of revenues and 2/3 of business in Europe).

 

The Mohawk segment designs, manufactures, sources, distributes and markets its floor covering product lines, which include carpet, rug, carpet pad, ceramic tile, laminate, hardwood and resilient, in a broad range of colors, textures and patterns for residential and commercial customers. The Mohawk segment positions its products in all price ranges and emphasizes quality, style, performance and service.

 

The Dal-Tile segment designs, manufactures, sources, distributes and markets a broad line of ceramic tile, porcelain tile, natural stone and other products used in the residential and commercial markets (slightly weighted more toward commercial than other business lines).

 

The Unilin segment is a leading manufacturer, distributor and marketer of laminate flooring in Europe and the U.S. The laminate business is almost entirely residential. Unilin is one of the leaders in laminate flooring technology, having commercialized direct pressure laminate, or DPL, a technology used in a majority of laminates today, and has developed the patented UNICLIC glueless installation system and a variety of other new technologies, such as beveled edges, multiple length planks and new surface technologies. Unilin's high-end products and patented technologies allow Mohawk to distinguish its laminate flooring products in the areas of finish, quality, installation and assembly. Unilin is the only vertically integrated laminate flooring manufacturer in the U.S. producing both laminate flooring and related high-density fiberboard. Unilin sells its laminate flooring products under the Quick-Step brand through independent distributors and specialty stores in Europe and the U.S., as well as through traditional retailers in France, Belgium and the Netherlands. Unilin also generates royalties from licensing its technology to competitors and produces insulated roofing and other wood-based panels. In October 2005, MHK acquired Unilin for $2.6 billion.

 

Mohawk has the broadest product offering of any of its competitors, by product type and price point. Organically and through acquisitions, Mohawk has grown from a carpet company to the largest total flooring company in the U.S. Mohawk has strategically made acquisitions into higher growth, higher margin segments of the floor covering products market, while also paying an attractive price for these businesses. Mohawk entered the tile segment of the market largely through its acquisition of Dal-Tile in 2002. At the time, Dal-Tile had 25% market share, significantly more than any of its competitors. Since the acquisition, management has increased Dal-Tile’s market share to 30%+ by growing it at a 14% CAGR. Management also has realized significant cost synergies within distribution, manufacturing and general administrative overhead. Mohawk has similar plans for its Unilin segment, which it acquired in late 2005. Management has broadened Unilin’s product offering to extend into lower price points. Prior to the acquisition, Unilin focused on the high-end of the laminate market place. This should provide ample room for Mohawk to grow Unilin’s business faster than the industry, which has grown at 15%+ in the U.S. and 2-4% in Europe over the last several years.  Due to the significant downturn in the U.S. residential housing market, U.S. laminate growth has been significantly slower over the last 12 to 18 months, while the growth rate in Europe has been quite strong at 10-12%. With these two large acquisitions, Mohawk has two good avenues to grow in excess of the total flooring market.

 

Mohawk has several potential areas for growth: continued market share gains in the carpet, tile and laminate businesses (the latter two grow in excess of the total flooring industry), geographic expansion (into South America, Asia and/or Eastern Europe) and expansion into related products (such as countertops, roofing and ceiling tiles). Mohawk will likely continue to grow organically as well as through acquisitions.

 

Mohawk has been proactive at managing its business through increased efficiencies and vertical integration. The company has an attractive mix of in-house and third party sourced manufacturing. This mix allows Mohawk to achieve lower manufacturing costs through vertical integration, while not being significantly adversely affected in an industry downturn (because it simply decreases the quantity of production purchased from external parties). The company also can decrease manufacturing capacity through layoffs, which it has been doing recently. Mohawk constantly is searching for the poorest performers and cutting them out while being conscious that the company must leave an adequate level of infrastructure in place so as it can completely harness increased demand when a cycle rebounds. This balancing act is something management focuses on “every week.” Furthermore, fixed costs are not huge in flooring manufacturing, with raw materials and freight being the largest components of the cost structure. Thus, concerns regarding players cutting price to move volume in order to cover high fixed costs is not entirely relevant.

 

Mohawk’s excellent competitive position in a duopolistic market allows it to earn solid after-tax, un-levered returns on capital of approximately 20% (excluding intangibles) and generate substantial free cash flow (10.0% 2008E yield at the current price). The company plans to use free cash flow to pay down debt until it reaches a debt / total capital ratio in the mid-30%s (currently at ~37%). Subsequently, the company will likely continue to evaluate potential acquisition candidates as well as repurchase stock. With the substantial free cash flow generation and excellent competitive position of this company, we believe it is positioned to significantly increase value for shareholders over the next 3-5 years.

 

 

INVESTMENT CONSIDERATIONS

Management: 

Mohawk’s management team is experienced, smart and focused. Jeff Lorberbaum, Chairman and CEO, began his career with Aladdin Mills in 1976, and served as vice president of operations during Aladdin’s 1994 merger with Mohawk. Following that merger, Jeff was named president of Aladdin, and in 1995 he was appointed president and COO of Mohawk. In January 2001, Jeff became Mohawk’s president and CEO. He has served on Mohawk’s Board of Directors since 1994, and in May 2004, he was appointed chairman of the board. Jeff and his family currently own approximately 18% of Mohawk’s equity. His family became the company’s largest shareholder in 1995 after Mohawk acquired the Aladdin Mills.

 

Chris Wellborn, COO, was CFO and assistant secretary of Dal-Tile from August 1997 until its acquisition in March 2002. Following the acquisition, Chris was named a director of the company and the president of Dal-Tile. From June 1993 to August 1997, Chris was SVP and CFO of Lenox, Inc.

 

Frank Boykin, CFO, served as corporate controller from May 1992 until May 1999, when he was appointed vice president, corporate controller. In January 2005, Frank was appointed VP, finance and CFO. Before joining the company, Frank served as a senior manager at KPMG LLP. 

 

We believe Jeff, Frank and Chris are sound operators and capital allocators. While some analysts criticize Mohawk’s two large acquisitions over the past few years, pointing to lowered returns on invested capital post-acquisition, these acquisitions have positioned them very well to take advantage of future growth in tile and laminate – two of the fastest growing segments of the industry. Management has a long record of making the business as strong as it can be, whether that is through manufacturing efficiency, gaining economies of scale or positioning it in higher growth areas. Also of note is that management has a relatively modest compensation scheme with few stock options.

 

 

The size of the U.S. floor covering products industry was approximately $23 billion in 2006, down 3% from 2005. Flooring sales are 25% commercial and 75% residential, with 55% residential remodeling and 20% due to new residential construction. Of the $23 billion U.S. market, 63% is soft flooring and 37% is hard flooring products. More specifically, 63% of the total industry is carpet and rug, 11% ceramic tile, 10% resilient and rubber, 10% hardwood and 6% laminate. Comparing industry segments, hard flooring growth has outpaced soft flooring over the last decade. Most significantly, carpets and rugs have decreased from 74% of the industry to 63% between 1994 and 2006 even though carpeting is typically a much cheaper option than hard flooring.

 

Since the peak in late 2005, the U.S. flooring industry is down approximately 20% – a significant slowdown – and it seems likely that the industry will have further to fall over the next 12 to 24 months. While the flooring industry is experiencing a significant headwind, the industry will rebound at some point in the future. Past housing cycle rebounds have proven to be a boon for flooring manufacturers, not surprisingly. Notably, in 1983 carpet volumes increased approximately 20%. While we are not modeling-in such a drastic rebound from the current downturn, a return to long-term growth rates seems likely within the next 3-5 years.  Historical compound annual growth rates by segment are below:

 

Flooring Industry CAGRs:

Source: Floor Focus and management.

	’92-06 CAGR
Carpet & Rug	3.6%
Ceramic Tile	6.2%
Resilient & Rubber	1.2%
Hardwood	8.5%
Laminate	20%+(1)

(1) 1996-2006 CAGR. Industry data prior to 1996 is not available.

 

The flooring industry is sensitive to the following economic factors, among others:

§         Consumer confidence and income

§         Corporate and government spending

§         Interest rate levels

§         Demand for housing

§         Condition of the residential and commercial construction industries

§         Overall strength of the economy

§         Spending for durable goods

 

Interest rates are one of the primary drivers of the new construction piece of the business, while consumer confidence, the economy and income growth are the primary drivers of the replacement parts of the business.

 

The U.S. floor covering products industry is essentially a duopoly with Mohawk and Shaw collectively capturing 47% of the market. Shaw is a close #2 behind Mohawk, with 22% share, and was purchased by Berkshire Hathaway in 2001. Shaw and Mohawk dominate the mid-to-low end carpet industry, while Shaw is the carpet industry leader with 32%. The carpet industry is somewhat fragmented on the very high end, but in the mid-to-low end Shaw and Mohawk have significant pricing power. Thus, while raw material costs have increased significantly over the last few years, Mohawk and Shaw have been able to pass on the price increases to the customer. Smaller players have essentially mimicked the two dominant players’ price increases. Due to the significant benefits of scale, owned distribution and value-add relationships with independent retailers, the two industry leaders have been able to continually increase market share over time, and there is no reason why this duopolistic industry structure will change any time soon. Below are the top 10 U.S. flooring manufacturers:

 

Top 10 U.S. Flooring Companies:

Source: Floor Focus.

 

	Total Flooring		Carpet & Rugs
	% Share		% Share
Mohawk	25%		27%
Shaw	22%		32%
Armstrong	7%		0%
Beaulieu	5%		7%
Tarkett	3%		0%
Mannington	3%		1%
Interface	2%		3%
The Dixie Group	1%		2%
Pfleiderer	1%		0%
C&A Floorcoverings	1%		1%
Top 10	70%		73%
Total Industry	100%		100%

 

The carpet segment is slightly more consolidated than the overall flooring industry, with the top two manufacturers garnering 59% share. The top 5 and top 20 carpet manufacturers have 71% and 87% share, respectively. From 1998-2004, the top 20 manufacturers grew faster than the overall carpet industry (4% vs. 3%).

 

The ceramic tile segment is more fragmented than the carpet segment. Over 100 tile manufacturers compete for sales of ceramic tile to customers located in the U.S., more than 50% of which are based outside the U.S. Imports are more of a factor because the size and weight of tiles does not make the shipping costs prohibitive. Although the U.S. ceramic tile industry is highly fragmented at both the manufacturing and distribution levels, Dal-Tile is the largest manufacturer by far, garnering 30%+ market share.

 

The laminate segment is even more fragmented than tile. The segment is a $1.3 billion market in the U.S. and approximately a $7 billion market in Europe.

 

In addition to the duopolistic structure of the industry, the carpet industry dynamics are attractive. The carpet industry is reasonably protected from the threat of Big Box retailers (e.g. Wal-Mart), significant further penetration by Home Centers (e.g. Home Depot) and online sellers because customer service is valuable in the sales process. From our fieldwork, we have found that carpet shoppers depend heavily on the advice and direction of their salesperson. Typically, flooring is purchased every 7-10 years. Due to the infrequent nature of purchasing and the high price of flooring products, it seems natural that customers want to solicit the advice of an experienced salesperson before they get comfortable with their purchase. Thus, the importance of customer service provides a nice buffer from Big Box retailers and Home Centers. Carpet sales by distribution channel are as follows:

 

Industry Sales by Distribution Channel:

Source: Floor Focus and Floor Covering Weekly.

 

Distribution Channel	% of Market
Independents	75-80%
Home Centers	15-20%
Other	2-8%

 

The carpet industry is also reasonably protected from low-cost imports. Factors inhibiting importer advantage include the fact that labor is typically a small portion of total flooring manufacturing costs, delivery time requirements to retailers, and transporting large items, such as carpeting, have high shipping costs. However, in the tile segment, imports are more prevalent and will continue to be a threat because of the cost of shipping is not as prohibitive. In the laminate segment, labor cost remains low at approximately 10% of production costs, while raw materials make up 80-85% of the cost. Thus, as with carpets, importer advantage is hindered by the trade-off between labor and freight costs. Mohawk plans to continue to both source and manufacture product in tiles, providing some flexibility when dealing with imports.

 

Another industry dynamic that is attractive is retailers’ lack of pricing power over manufacturers.  The retail distribution network is largely fragmented amongst independents – both retailers and contractors. With 75-80% of distribution comprised of this fragmented channel, the dominant manufacturers in the market have significant bargaining power vis-à-vis the retailers. The fragmented retailer network precludes retailers from pushing back on price increases, which manufacturers have been passing on continuously over the last several years as raw material costs have risen.

 

Additionally, manufacturers and retailers are able to drive strong ASP growth due to the infrequent nature of purchases. On average, customers replace their flooring every 7-10 years. The infrequent nature of purchases makes it difficult for customers to have reference points for prices, allowing manufacturers and retailers to enjoy price hikes without much push back from customers. Manufacturers are able to pass on a significant portion, if not all, of higher raw material costs to customers rather than incurring margin erosion themselves. With the rising costs of raw materials over the last few years, Mohawk has been successful at doing just that. Furthermore, there is a good chance the company can maintain these higher price levels if energy prices decrease, providing a boost to margins.

 

In sum, the structure and dynamics of the carpet and overall flooring industries are very attractive.

 

 

Competitive Position: 

Mohawk’s competitive position is superb. Mohawk currently retains approximately 25% share in the U.S. flooring industry. Over the last decade, Mohawk has increased its market share by 1,000 basis points through both acquisitions and organic growth. Following its two large acquisitions into tile and laminate, Mohawk is well-positioned to organically grow overall revenue in the mid-single digits or better over the next 5 years. The following displays Mohawk’s U.S. market share by segment:

 

Mohawk U.S. Market Share by Segment:

Source: Floor Focus, Lehman Brothers and management.

 

	U.S. Market Share
Mohawk	27% (#2 player)
Dal-Tile	30%+ (#1 player)
Unilin	#1 player
Total Company	25% (#1 overall player)

 

As shown above, Mohawk maintains a powerful position in each of its business lines as well as for the company overall.  Importantly, it was only a few years ago that Shaw, owned by Berkshire Hathaway, and Mohawk formed a duopoly.  Shaw’s position as a subsidiary of Berkshire is ideal in this regard since Berkshire companies tend to exert as much pricing power as they can.  One caveat is that as the manufacturers raise prices, consumers on the margin tend to pay the same price but get a lower quality carpet, with implications for Mohawk’s margins.

 

Mohawk is also well-positioned to capture future growth in the industry. With its Dal-Tile and Unilin segments, Mohawk is positioned to benefit from the flooring industry’s growing trend toward hard flooring. It is also worth noting that these two businesses are not only higher growth but higher margin as well. Thus, if Mohawk’s segments simply grow with their respective industries, Mohawk overall will reap margin expansion.

 

As mentioned in detail in the Business section above, Mohawk has the broadest product portfolio of any flooring manufacturer, both on a product type and product price point basis. By providing a number of products at different price points, Mohawk penetrates almost the entire market (absent the extremely high and low ends). This diverse revenue base is attractive, both on the risk and the reward side of the equation. On the risk side, Mohawk is protected if individual segments of the market (e.g. hardwoods) under-perform the overall flooring industry. On the reward side, Mohawk provides a broader product range to the retailers, making Mohawk a more attractive partner.

 

Mohawk maintains a manufacturing cost advantage through vertical integration within its business lines, and coupled with its huge scale to spread fixed costs over, the cost advantage is significant. Within the Mohawk segment, manufacturing operations are vertically integrated and include the extrusion of resin and post-consumer plastics into polypropylene, polyester and nylon fiber, yarn processing, tufting, weaving, dyeing, coating and finishing. Over the past three years, Mohawk has incurred capital expenditures that have helped increase manufacturing efficiency and capacity and improve overall cost competitiveness. As an example, Mohawk is backwardly integrated in fiber extrusion. Approximately one out of every three soda bottles ends up in a Mohawk plant, where it is converted to fiber. Overall, Mohawk operations provide over 50% of its carpet raw materials for end-market production.

 

The Dal-Tile segment operations are vertically integrated from the production of raw material for body and glaze preparation to the manufacturing and distribution of ceramic and porcelain tile. Moreover, Dal-Tile sources ~30% of its tile capacity from third party suppliers, allowing the company to manage production in a downturn efficiently.

 

Mohawk's laminate flooring manufacturing operations are vertically integrated, both in the U.S. and in Europe, and include high-density fiberboard (HDF) production, short-cycle pressing, cutting and milling. The European operations also include resin production. Unilin has state-of-the-art equipment that results in competitive manufacturing in terms of cost and flexibility. Most of the equipment for the production of laminate flooring in Belgium and North Carolina is relatively new. The company's laminate flooring plant in North Carolina is one of the largest in the U.S. In addition, Unilin is the only fully integrated laminate manufacturer in the U.S. with its own HDF production facility. The manufacturing facilities for other activities in the Unilin business (insulated roofing and other wood-based panels) are all configured for cost-efficient manufacturing and production flexibility and are competitive in the European market.

 

Mohawk also has established a cost advantage and superior delivery times through its owned distribution system. Only Mohawk and Shaw own their distribution.  The rest of the industry has to go through third party distributors in order to go to market. The Mohawk segment distributes through its approximate 52 distribution centers using its fleet of company-operated trucks, common carrier or rail transportation. The Dal-Tile segment distributes through ~250 company-operated sales service centers and regional distribution centers using primarily common carriers and rail transportation. The Mohawk, Dal-Tile and Unilin segments all distribute their products to independent retailers, contractors, home centers, mass merchants, department stores, independent distributors, commercial dealers and commercial end users. Moreover, Mohawk realizes cost savings from integrating the distribution system amongst its three business lines. This factor plays a key role in acquisitions, where further cost savings can be realized from a scalable distribution network. As the Unilin segment moves some production from Europe to the U.S., lead times for U.S. distributors will be significantly shortened (from 8-12 weeks to one week or less). Overall, Mohawk has over 300 distribution points and 1,000 trucks. This vast distribution network allows Mohawk to deliver product to most parties in several days, quicker than smaller competitors are able to deliver. This allows Mohawk to have superior relationships with retailers and better inventory management.

 

While Mohawk’s superior delivery times are certainly preferred by retailers, the additional value-add services it provides to these retailers is another significant competitive advantage. The Mohawk segment offers marketing and advertising support through dealer programs like Karastan Gallery, Mohawk ColorCenter, Mohawk Floorscapes and Mohawk Floorz. These programs offer varying degrees of support to dealers in the form of sales and management training, merchandising systems, exclusive promotions and assistance in certain administrative functions such as consumer credit, advertising, insurance and training. The aim of these programs is to help retailers maximize selling prices and retailers’ margin. The critical point of these programs is that they tie the retailers into Mohawk and provide Mohawk leverage as the individual retailers are quite small. These programs also serve as a key barrier to entry for smaller manufacturers. Mohawk has “locked-in” over 2,500 independent retailers, making it difficult for smaller manufacturers to get picked up by retailers. Shaw also has some value-add relationships like Mohawk’s, though its programs do not seem to be as developed as Mohawk’s. While these relationships are not exclusive, the interlocking of manufacturer and retailer serves as a key barrier to new entrants, as switching costs are quite high (especially for Floorscapes dealers, who get the vast majority of their sales from Mohawk products).

 

It is worth noting that Mohawk also has a diverse customer base, serving over 30,000 customers.  No single customer accounted for greater than 10% of total revenues, and the top 10 customers accounted for less than 15% of the Mohawk’s revenues in 2006.

 

Mohawk also has a large, segmented sales force. The company’s sales force is organized based on product type and sales channels in order to best serve each type of customer. Mohawk segments the carpet business into three pieces: premium, stylized, and value. The premium brands of Karastan, Ralph Lauren and Custom Weave all go to market under the same sales force, as opposed to separate ones for each brand. This is also the case for the Wunda Weave and Horizon brands in the stylized segment. The only value brand in the portfolio is the Aladdin brand.

 

Although we do not view brand equity in the flooring industry to be of the utmost importance, it is at worst a small positive for Mohawk. Mohawk has industry leading brands across most segments of the market, and the company utilizes advertising campaigns to support and enhance brand strength. National Floor Trims magazine polled retailers who voted Unilin’s Quick-Step the #1 brand of laminate in the U.S. Quick-Step was rated highest for quality, design, durability and ease of maintenance in each category. Unilin owns a number of patent families, totaling approximately 150 patents and applications in Europe and the U.S. The most important of these patent families is the UNICLIC family, which protects Unilin's interlocking laminate flooring panel technology. The patents in the UNICLIC family are not expected to expire until at least 2017.

 

Overall, Mohawk benefits significantly from its leading market position, scale, large distribution network, value-add services to retailers, product breadth, operational efficiencies and strong brand. We believe these characteristics will support Mohawk’s growth over the long-term.

 

 

Price: 

Mohawk’s shares currently trade at 11.1X 2007E P/E, 7.5X 2007E EBITDA, 11.2X 2007E Free Cash Flow and 10.0X 2008E Free Cash Flow, reflecting concerns around negative industry growth, the housing market and margin pressure from rising raw material prices.  Due to Mohawk’s exceptional competitive position in a duopolistic industry and its manufacturing and operating flexibility which allow the company to successfully manage its business in a downturn, we believe that macro headwinds are depressing Mohawk’s stock price significantly below intrinsic value. Assuming management allocates capital efficiently, the company will also likely drive shareholder gains through value-creating acquisitions or share buybacks. We believe Mohawk will be a high teens to twenties return at current prices over a 3-5 year time horizon, and even in a downside scenario (where housing falls off more precipitously and significantly adversely affects Mohawk’s business), the return is likely in the mid-to-high single digits.

 

 

RISKS

Slowing Industry Volumes: 

Industry volumes are currently down approximately 20% from their peak in late 2005, and it seems likely that declining volumes will continue for the next 12-24 months. As units continue to decline, Mohawk’s growth and margins will be pressured in the short-to-intermediate term. Although units have been trending negative, price increases have helped mitigate the sales decline. However, Mohawk is having a tough time in the current environment passing on all of the raw material cost increases, as noted by management on the most recent earnings conference call. That said, eventually units will begin to grow again, although the timing of this depends largely on consumer confidence, the housing market and interest rates.

 

Acquisitions:

Mohawk has been highly acquisitive, and this trend is likely to continue in the future, albeit perhaps at a more modest pace.  Management has accomplished their goals of both consolidating the industry and also repositioning the company into growth areas.  This should lead to fewer big acquisitions going forward. Nevertheless, as with any acquisitive company, there is the risk that management will allocate capital poorly and overpay for acquisitions. An important point to highlight is that there is a meaningful difference between returns on tangible capital (~20%) and returns on invested capital including intangibles and goodwill (~10%). Note that paying a higher multiple for higher growth businesses like Dal-Tile and Unilin will lead to a lower return on capital in the short run. However, in the long-run, these acquisitions are likely to be accretive to Mohawk’s return on capital.

 

Rise in Cost of Raw Materials:

In recent years, Mohawk’s raw material costs, which are mostly energy-based, have been rising. Mohawk will likely be able to counteract this increase with price increases, which has been historically the case largely due to the duopolistic industry structure. The company believes there is a 4–6 month lag between rising prices of raw materials and pushing those onto the retailers. Of course, this will affect the entire industry, and as one of the industry’s low cost manufacturers, Mohawk is well-positioned to deal with this risk.  Also worthy of note is that Shaw and Mohawk will likely keep most if not all of recent price increases even if raw material prices fall. 

 

 

CONCLUSION

We believe an investment in Mohawk is a very compelling risk/reward.  Mohawk has an excellent competitive position in an attractive duopolistic industry, is run by a focused and smart management team, and is currently trading at a price that represents a significant discount to intrinsic value.

Catalyst

Although this investment is not at all “catalyst” based, and is more representative of a Buffett type purchase of buy and hold, there are several catalysts that may increase the stock price. Among them are:

1. Analysts and investors realizing the true cash generation power of the company, which is partially masked by the amortization of intangibles flowing through the P&L;
2. Continuing to acquire companies at prices that are accretive to shareholders’ value;
3. Eventual return to unit growth in the industry, although this will likely be 12-24 months away.