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Executives

Jeff Lorberbaum – Chairman and CEO

Frank Boykin – CFO

Analysts

Ray Onard [ph] – J.P. Morgan

David MacGregor – Longbow Research

Ivy Zelman – Zelman & Associates

Daniel Oppenheim – Credit Suisse

Susan [ph] – UBS

Mark [ph] – Cleveland Research

Sam Darkatsh – Raymond James

Stephen East – Pali Research

Laura Champine – Cowen

Carl Reichardt – Wells Fargo

John Baugh – Stifel Nicolaus

Keith Hughes – SunTrust

Mohawk Industries, Inc. (MHK) Q2 2009 Earnings Call Transcript July 31, 2009 11:00 AM ET

Operator

Good morning. My name is Cynthia, and I will be your conference operator today. At this time, I would like to welcome everyone to the Mohawk Industries second quarter 2009 earnings conference call. (Operator instructions) As a reminder, ladies and gentlemen, this conference is being recorded, today, July 31, 2009. Thank you.

I would now like to introduce Jeff Lorberbaum, President [ph] and CEO of Mohawk Industries. Please go ahead sir.

Jeff Lorberbaum

Thank you. Good morning and thank you for joining our second quarter conference call. With me on the call is Frank Boykin, our CFO, who will review our safe harbor statement and later the financial results. Frank.

Frank Boykin

I would like to remind everyone that our press release and statements we make on this call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, which are subject to various risks and uncertainties, including but not limited to those set forth in our press release and our periodic filings with the Securities and Exchange Commission.

This call may include discussion of non-GAAP numbers. You can refer to our press release at the Investor Information section of our website for a reconciliation of any non-GAAP to GAAP amounts.

Jeff Lorberbaum

Thank you. Our second quarter earnings per share of $0.67 surpassed our expectations. Our earnings per share was $0.79, excluding restructuring cost of $12 million. Operating income was $87 million, excluding charges primarily for the closing of a laminate flooring plant in Europe.

Our results improved from the first quarter as we benefited from increased sales, lower cost, and higher utilization rates. Second quarter sales were $1.4 billion, a 24% decrease from 2008, or 22% on a constant exchange rate.

During the quarter, we benefited from aggressively driving down costs, managing working capital, tighter control over capital expenditures, and an intense focus on our customers.

Even with weakened demand in the quarter, we generated over $200 million in free cash flow, paid $122 million of debt, and invested $126 million in capital expenditures.

We ended the period with a balance of over $225 million in cash. Our US residential and commercial businesses reflected macro conditions with low home sales, contracting business investment, and slow consumer discretionary spending. The European economy has contracted from the same conditions that are affecting the US economy.

The economic consensus is projecting that the recession will end during the second half of 2009 and begin growing in 2010. The benefits from the government stimulus package had impacted the economy positively, as the money is being spent increased the end of this year and next. Demand in both the US and European residential markets appear to have reached bottom and are showing signs of stabilization.

The US commercial business continues to decline and represents about 25% of our total business.

Frank, would you give the financial report please?

Frank Boykin

Yes, thank you Jeff. As Jeff mentioned, net sales of $1,406 million were down 24% as reported or 22% on a constant exchange rate basis. All of our businesses are off as the environment remains challenging.

Gross profit was $376 million or 26% of net sales, which is flat with last year, last year also being at 26%. Our gross margin, excluding charges, was 27% of net sales with raw material declines and capacity adjustments supporting our profitability. SG&A dollars were $292 million or 20.9% of net sales. The dollars were down 13% from last year as we continued to reduce costs, but were impacted by declining sales as we deleverage.

Our operating margin, excluding charges, was $87 million or 6.2% of net sales. Included in the operating margin, as reported was a $12 million restructuring charge related to the closing of our European laminate plant.

Interest expense was $30 million, slightly less than last year, which reflects our lower levels of debt. Other income and expense was income of $4 million, better than last year primarily as a result of favorable foreign-exchange gains.

Our income tax rate was 6% as reported, lower than what we had anticipated due to you to geographical income mix and unrealized foreign-exchange gains. Excluding charges, our tax rate was 12%.

Going forward in the third quarter and fourth-quarter, we expect our rate to be in the low to mid-teens, returning to the low 20% range in future years. Earnings per share was $0.79 per share excluding charges, and as we had mentioned, better-than-expected due to reduced raw material costs, timing of some expenditures, lower tax rate that I have discussed, and the more favorable foreign-exchange included in other income, and an overall good performance at Unilin.

If we jump to the segments, the Mohawk segment sales at $768 million was 21% below last year. This was impacted by lower volumes and negative mix, which both continue to impact us.

Our operating income came in at $21 million or 2.7% of net sales. This improved sequentially from the first quarter with lower raw material costs this quarter and higher plant utilization rates.

The Dal-Tile segment sales were $377 million, 22% down as reported or 21% down on a constant exchange rate basis. Both the residential and the commercial businesses declined with Mexico performing better on a constant exchange rate basis.

Operating income in Dal-Tile was $30 million or 8.1% of sales, impacted by lower volumes and fixed cost deleveraging.

The Unilin segment sales came in at $280 million or 32% down from last year as reported or 24% down on a constant exchange rate basis. These sales were impacted by lower volumes plus some pricing pressure in the board business.

Operating income, excluding charges in this segment, was $42 million or 15.2% of net sales. Unilin turned in a very strong performance, especially in light of this environment. They were impacted negatively by foreign-exchange by $6 million in the quarter.

If we turn to the balance sheet, we ended the quarter with a cash balance of $227 million, which includes over $180 million in short-term cash investments.

Our receivables at $779 million represented 49 days of sales outstanding. This is up from last year, impacted primarily by channel mix with our ageing, accounts receivable ageing still in good shape.

Our inventories at $937 million represented turns of 3.8 times, which is in line with last year and sequentially, I would say that we decreased our inventories from the first quarter by $50 million.

Our fixed assets at $1.9 billion included capital expenditures during the quarter of $26 million and depreciation and amortization of $77 million. We continue to expect full-year capital expenditures of $125 million, with depreciation and amortization for the full year at $290 million.

Our long-term debt for the quarter ended at $1.859 million, down $122 million from the first quarter. We generated $202 million of free cash flow and paid down all of our prepayable bank debt during the quarter. We had plenty of available liquidity and with the improving credit markets many alternatives to consider for our capital structure. We expect we will continue to have strong cash flow and balance sheet in the future, and believe that we are well positioned for the future. Jeff.

Jeff Lorberbaum

Thank you. We are transitioning to a leaner, lower cost structure to emerge in a stronger position when the industry improves. After reducing production levels and cutting inventories in the first quarter, we operated all our facilities at higher production rates. We further reduced inventory levels from the last quarter by $50 million and lowered headcount and other variable costs, by reducing the infrastructure, adjusting production levels with demand, and proven productivity and consolidating some of our distribution structure.

We are providing innovative products and services to bring value to our customers, redesigning processes, and managing our cash utilization. To streamline the business, we are investing in computerized process control and inventory management and distribution systems. In the first half of 2009, our initiatives have reduced our SG&A by about $80 million from the prior year. Our Mohawk segment sales were down 21% following the industry.

Residential volume seems to be stabilizing at a low level with commercial expected to continue its contraction. Our pricing remains disciplined with pressure in the commodity category. Product mix has been declining as our customers trade down to reduce project costs. After peaking, raw material costs improved and benefited our second quarter results. We anticipate third quarter raw material prices will be up slightly from the prior period.

Energy costs were down during the second quarter and are not expected to change significantly. During the quarter improving seasonal sales, higher plant utilization rates and lower costs helped to offset the deleveraging of our fixed overhead costs. We continue to cut controllable costs, including administrative, manufacturing and logistics costs, as well as reducing our infrastructure.

We are rightsizing our commercial assets to reflect the industry decline. Our SmartStrand collection of residential products has been well accepted by the consumers, and we temporarily exceeded our suppliers capacity, which will be corrected in the third period. Increased sales efforts are concentrated on multifamily and residential remodeling channels, which will lead the category out of the cycle.

Having acquired the Wear-Dated earlier this year, we're launching a new Wear-Dated DuraSoft collection this quarter, which features the softest nylon products in the category. Even our moderately priced rug sales are weakening, and we are value engineering new products to create lower-priced alternatives. The commercial business had emphasized in the healthcare education and government categories, which had outperformed other channels during this part of the cycle.

Our new commercial products are focused on style, value and environmental attributes and are being well received. The Mohawk brand also introduced significant updates to our ceramic, wood, and vinyl programs adding products which offer styling innovation still specific price points.

We are investing our product offerings and new systems for inventory, warehousing and customer management as well as updating our e-commerce systems. These investments will strengthen our business and support profitable growth.

The Dal-Tile sales were down 22% during the quarter or 21% on a constant exchange rate as a result of the difficult economic environment. Dal-Tile has been impacted by the present contraction of commercial business, which comprises about 40% of our sales mix. We continue to gain share in the marketplace with many of our regional ceramic competitors struggling with the industry conditions.

A new builder program is being implemented and it is increasing our penetration with regional as well as national builders. The Mexican market is following the US cyclical downturn, but we continue to grow our business by broadening our product offerings and expanding our distribution channels. We are making many long-term investments in Dal-Tile, including digital color applications, new systems for warehousing and distribution, new product innovations that include recycled content and antimicrobial protections.

We're launching a new engineered stone program for exterior and interior uses as well as a commercial wood program to extend our Dal-Tile product offerings. The sales and logistics infrastructures in Dal-Tile provide differentiation and value to our customers. However, the fixed infrastructure has been deleveraged by the lower volume. We are cutting our logistics costs by combining some Mohawk and Dal-Tile regional distribution centers, consolidating some service centers, leveraging freight resources and reducing personnel. We have further reduced our cost with many initiatives on productivity, quality and product engineering.

Our yields have improved and direct labor reduced, resulting in a lower controllable unit cost. Unilin sales declined 32% as reported or 24% on a constant exchange rate. Even in this environment, our operating margin was 15% and EBITDA margin was almost 30%, excluding the restructuring cost.

All regions in Europe are being impacted by the economic downturn, and exports are being complicated by currency devaluations in Eastern Europe and Russia. Our laminate sales have declined with the residential remodeling and home sales. Our new introductions in longer and wider planks and our high-gloss products are being well accepted by the market.

We are broadening our distribution with private-label products and sales to big boxes and commercial channels. We are expanding our customer base with our warehouse in Russia to support local manufacturing in the future. Royalties were impacted by declining industry sales and new licenses. Some new value-priced laminate products are being offered to expand our offering, and to provide promotional price points to our customers.

Board demand is down in Europe, creating excess capacity and compressing prices in the market. We anticipate the industry will close facilities which are not low cost to reduce capacity. The roofing structure sales we have are also softening and selling prices have remained stable. A new insulation board in this category has been developed and a production line will begin this quarter, and we will begin shipping the insulation products to our customers in the period.

We have expanded our wood product line and are distributing it under multiple brands to penetrate both the US and European markets. A new click system has been developed for wood that is easier to install than others in the market. In the US, we are in the process of closing one wood plant and consolidating our production. We are reducing Unilin’s cost structure by cutting our SG&A, personnel, and improving productivity. Reductions in working capital, maintenance costs, and capital expenditures have been implemented.

In Europe, we have closed a flooring plant, and the cost has been expensed in the second period. We have restructured our European board organization to improve flexibility and costs. New investments are being made in technology, products and systems to reduce costs and maximize our future. In the second period, industry conditions were weak, and we anticipate the present trend continuing in the third quarter.

Residential appears to be stabilizing in the low-level with signs of improving home sales, which are supported by low mortgage rates. The commercial decline is occurring and we're adjusting the businesses to the demand level. Our carpet raw material costs are expected to increase slightly in the second half. The Unilin results are expected to be lower due to holiday shutdowns, higher period costs and lower royalties. We continue to take the right steps to manage through the downturn. Our third quarter guidance for earnings is $0.54 to $0.63 per share.

Excluded from this guidance is an estimated restructuring charge of $25 million, most of it being non-cash for reductions in manufacturing and distribution in all segments. Our restructuring efforts this year will reduce our fixed costs, and should have a payback of just over one year when fully executed. Over the last 12 months we have generated free cash flow of almost $500 million during the severe recession. Each of our businesses is managing the balance sheet to maximize our cash position, reducing expenditures, and remaining focused on our customers.

The investments in our products, systems and organization will make the business stronger and more competitively positioned as the economy improves.

At this point, we will take questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Michael Rehaut with J.P. Morgan.

Ray Onard – J.P. Morgan

Hi guys, and this is actually Ray Onard [ph] for Mike.

Jeff Lorberbaum

Good morning.

Ray Onard – J.P. Morgan

Just trying to drill down more on the Unilin margin there, you know, up very strongly both year-over-year and sequentially, just wondering if you could provide some additional color there what drove the quarter. Then also looking out in the back half of the year, you know given the European holiday and potentially customers trading down with a continued negative mix shift, how do you see the margins kind of playing out there, and should we kind of be expecting a sequential decline there, or can you guys maintain that double-digit margin in Unilin?

Jeff Lorberbaum

Let us see if we can answer that for you. You know, we started out in the first quarter of the year with the sales level down in the period as well as declining, reducing the inventories in the period. As we came into the second quarter we had higher plant operating level, which helped with the sequential volume improvement that went along with it. During the quarter we also had, we are able to reduce some of the marketing and maintenance expenses, which we pushed out. Some of them will hit in the third quarter and impact the third quarter results.

In addition, we have had some lower raw material costs in the quarter, and signed some new licenses as well during the period. As we look forward, we don't believe that we can sustain these unusually good results that we had in the period. What we believe is that the third quarter is going to be, after the struggle with the holiday impacts in Europe's and we're making the assumptions that the volume is going to be impacted a little more than usual, and the downtime because of the inventory levels, and normal other things would be run less, so we will run the plants less than we had in the second quarter. In addition, we are assuming that there is continued pressure in market pricing, especially in the board part of our business.

And then we talked about the cuts in marketing and maintenance costs being pushed from the second quarter, some of those falling into the third, and then the royalties, which we get, we are assuming the industry volumes going to continue under pressure and impact those. So we think that the margin sequentially will not be able to be maintained at those highs levels.

Ray Onard – J.P. Morgan

Okay, great that is very helpful. Just a follow up question to that on the Mohawk margins, you know, on the flip side those came a little bit weaker than our estimates. We thought maybe you guys are getting more raw material benefits in the quarter, and then given your commentary that raw materials are expected to be flattish or rise slightly in the back half. So you are expecting margins to be in kind of that low single digit range for the rest of the year?

Frank Boykin

There's going to be continued pressure on the margins. There is a chance that the margins could improve a little bit as we move forward in this segment, as we get the cost that we keep cutting out of the business, reducing the cost. So we're hoping that we will be able to see some improvement, but there are still a lot of problems with the industry volume coming down. We are trying to adapt to the unabsorbed overheads, but we are spending a lot of effort cutting those costs. With the same thing with all the businesses there is the mix trading down, which customers are really using the lower priced materials which is also impacting the margins in those things.

But we think all the cuts in costs we're doing is helping the profitability as we go forward.

Ray Onard – J.P. Morgan

Great. Thank you.

Frank Boykin

You are welcome.

Operator

Your next question comes from David MacGregor with Longbow Research.

David MacGregor - Longbow Research

Good morning everyone.

Jeff Lorberbaum

Hi David. Good morning.

David MacGregor - Longbow Research

Jeff, you are talking about SmartStrand, and you talked about the fact that you had stressed your supply channel this quarter. I guess I'm just wanting to get your sense of whether you are becoming at all concerned about your suppliers rationalizing capacity at a time when everybody seems to be cutting costs and cutting capacity. Are we going to have supply channel tightness that could lead to may be greater than expected raw material costs, pressure over the next two, three, or four quarters.

Jeff Lorberbaum

I don’t believe so. There is so much excess capacity, and the industry is off at 40% from the peak, and there has been some shut down, there is mix changes going on, but I don't see any significant shortages of capacity from there. There is more room to be related to the oil prices, and in the world market of chemicals. And so far I haven't predicted those too well, neither has anyone else. I don't know where they are going to be.

David MacGregor - Longbow Research

Great. Normally, it would be focused on other than the fact that you mentioned that you stressed that supply channel, was that something odd going on there that was really unique to this quarter?

Jeff Lorberbaum

Well, we have a relationship with DuPont. It is a niche business with them. We're their only customer in the residential channel, and we try to manage our sales level to the infrastructure, and our business picked up a little bit more in the category than we anticipated. And so we had to adjust to it. They have another plant in China, and so we have been shipping stuff between those and started to, but it takes a while when you are in China and rearranging the piece to get the supply leveled out.

Frank Boykin

We will be at good shape with that when we get towards the end of the year, third or fourth-quarter time frame.

Jeff Lorberbaum

We don’t perceive it as an ongoing process.

Operator

Your next question comes from the line of Ivy Zelman with Zelman & Associates.

Ivy Zelman - Zelman & Associates

Good morning everyone, and good quarter guys.

Jeff Lorberbaum

Thank you.

Ivy Zelman - Zelman & Associates

Your overall improvement in margins is very impressive in the face of such weak sales, and I think your comments Jeff, clearly you're saying the sustainability of Unilin is not likely to be realized in the face of the challenging environment you are in. I think when you look at the outlook for 2009 and into 2010 realizing that you have got lots of headwinds, would you kind of prioritize for us with respect to the challenges in the market, where you see the greatest risks, and then maybe talk about some of the areas, where you think that we can see some surprises on the upside may be being new (inaudible) or it is just commercial for example. And within commercial, you mentioned education, government and healthcare. You know roughly speaking, can you break down sort of the buckets and how you guys market and prioritize your business mix?

Jeff Lorberbaum

Our business mix, I will start, the commercial businesses is really the biggest wild card at the moment that how far it has been a decline, how fast it has declined and the timing of it, we have no idea. We're just trying to prepare ourselves to adjust to it as we go through. In each of our businesses, Unilin basically has almost none in that area. So the impact is on the carpet business and the ceramic business. In those two, the ceramic business has a much higher percentage of commercial, which has served us well over the past couple of years, and now as it goes through it is going to impact it more as we go forward.

With each of those, we're trying to adapt again to the climate and the restructuring cost that we are doing, we're doing across all the different business segments trying to reduce the infrastructure to the business to get them in line with where we proceed. It will be needed for at least the next few years and get them cut back. We have spent a lot of time. I think we have done a good job in cutting our SG&A cost and pieces as we come down. And I guess we will still stay behind it, because they have a hard time projecting out, how bad it is going to get, and so we're sort of behind the curve, but we think we are getting better at it and closer with it.

On a forward basis, other than that I think that the raw material costs look like they will be fairly stable overall at this point. We don’t see any seeing dramatic changes. There is some upward pressure that we see because of oil on the carpet side. I don't think that we think will be reasonably stable. So then the other big risk I guess is the competitors in the marketplace and how we all react relative to the marketplace, and the impact on pricing pressures.

I have to say that so far we have been relatively that we as a company have been disciplined, and we hope that the marketplace doesn't get crazy. So far based on history, it looks like we're all doing reasonably well given the environment that we are in. I guess the upside -- we try to be as optimistic as we can on our going forward projections, and given the limited forward view we have, we make our best guesses at the pieces, and think we have done all these things. I think that somewhere along the line the existing home sales, you know seem to be turning more positive.

The interest rates are still low. So the question is, is there a point at which the remodeling piece moves up, and so the biggest upside is if this happens sooner than later, and it is anybody's guess that at some point it should have a positive effect on the industry capacity.

I think if the industry changes, our cost structure is going to be much larger than they were two years ago, and I think as the business improves in the future, I think we are well positioned.

Ivy Zelman - Zelman & Associates

That is very helpful Jeff, and just on a follow up with respect to mix you mentioned, the customer continues to go down price point in looking for more value, roughly within residential with Dal-Tile, obviously it is higher end ceramic choice for the consumer. What would you say the mix is from a, I guess, low-end value oriented product versus sort of the mid-to higher end, if you hadn’t tried to categorize the residential piece?

Jeff Lorberbaum

I am sorry, the question is --

Ivy Zelman - Zelman & Associates

In the whole company?

Jeff Lorberbaum

The question is -- not sure I understood what you wanted to know?

Ivy Zelman - Zelman & Associates

I'm kind of trying to understand is like what would you perceive to be high-end product mix or mid-to high-end versus your low-end product offering, because there are products within the family of offerings that are considered to be mid-to-high end. I just don't know how big it is.

Jeff Lorberbaum

Across the whole piece. It depends where you draw the line. Typically, we all talk about commodity products, and commodity products are basically almost are helping price points of the piece, and depending upon which business they could be, you know, 20% or 40% or more of the volume, just the commodity, what we consider the bottom opening price points depending upon which business and which channel and then it keeps going up from there, and we make higher margins on the high-end pieces. On the other hand, we have higher SG&A costs associated with it. So if the mix comes down or we do lose margins as the customers trade back.

Operator

Your next question comes from the line of Daniel Oppenheim with Credit Suisse.

Daniel Oppenheim - Credit Suisse

Hi, thanks very much. Just wondering if you can talk about your plants in the inland business, you talked about some more value products. In the past, you talked about how trying to stay away from the low-end where it is more commoditized. Can you sort of give your overall strategy in terms of the product focus there?

Jeff Lorberbaum

Sure. Historically there is opening price point that the lowest value providers in the marketplace provide. And our Unilin piece, it is a very small portion, close to zero of it. We still have -- our goal is really not to become the low price leader in the marketplace because we have so much more to sell than price. On the other hand, we are introducing products that we think add more value that fit right above that category that bring more to the marketplace. And we can get added value for them, but it allows us to participate in the markets that we are not in. At the same time in both Europe and the US we're looking at broadening the distribution through using multiple brands to get to the marketplace as well as going through different distribution channels again though with not the goal of being the leader in the commodity price points.

Daniel Oppenheim - Credit Suisse

Thanks very much, and I guess one other question. You talked about the initiative in terms of working with builders. Certainly you hadn't done as much there. How large an initiative do you think this could be, just if you can describe that, it will be great?

Jeff Lorberbaum

We always in the Dal-Tile business had a large builder business. What we're trying to do is expand our relationships with both the regional and national builders. Even though the timing is at a low level, we think it will help us in the future. We have put together additional programs, and they are historically both the Mohawk brand and the Dal-Tile brand had gone through after the ceramic part of the builders. And what we're done in the past year or so is focus the ceramic business through the Dal-Tile brand to those accounts. And we think we can bring them a broad selection that will offer them value and increase our business and penetration in the marketplace, and we are having good results.

Operator

Your next question comes from the line of David Goldberg with UBS.

Susan – UBS

Good morning. It is actually Susan [ph] for David.

Jeff Lorberbaum

Good morning.

Susan – UBS

Going back to the kind of product mix, can you talk a little bit about how you think, in terms of your promotion, are there any promotions you can do that sort of help to move people back up the price points at all or how should you get them back into the higher margin goods?

Jeff Lorberbaum

I hate to admit it, but most of the promotions tend to be value oriented in this marketplace. You know, the customers are really driven by trying to attract consumers in their stores and so they tend to use price across the board, and they tend to expect you to help support them do that. At the same time, we try a lot of things to raise the customers up. You know, we talked about SmartStrand, we talked about the new branding strategy on the Wear-Dated brand. We are bringing different brands as well as different product innovations to the market place to improve the marketing value to the store as well as the customer, but in general, the marketplace is moving down. Those people are trying to conserve their capital on an individual basis.

Susan – UBS

Okay, and then can you also just talk a little bit about as you think about continuing to take costs out of the business, how you think about the trade-offs between your longer-term goals and your near-term needs to kind of take cost out?

Jeff Lorberbaum

Well, there is no simple answer to that question. The -- what we try to do is look over what the present needs are. We try to say how far can we reduce them before we impact negatively the long-term viability of the business that with that as the volume goes down, we have fixed infrastructure cost that are hard to take out. The labor pieces. We tend to be fairly good at raising and lowering those as the volume goes up and down. We believe that most of the labor fees that we can add back over time, and fill it back in as long as it will maintain the infrastructure.

And then with the fixed pieces, you hear us taking restructuring and write-downs to consolidate facilities and to write-off assets. In many cases this has forced us to become, this downturn has really forced us to become much more productive, and we are getting more of the present assets, which will allow less assets to be used to support a much higher level of business in the future than it has in the past. There are no right answers to how much and every time we do it, we look through and if they weren’t any questions, we would have cut it where it is today two years ago. So as we keep seeing how the business is changing, we keep adapting to those changes and it has an estimate of, we are assuming now that it is going to be at least a not jump back to the level it was 2, 3 years ago overnight. So we think that we can build it back if it recovers.

Operator

Your next question comes from the line of Eric Bosshard with Cleveland Research.

Mark - Cleveland Research

Good morning, this is Mark [ph] in for Eric.

Jeff Lorberbaum

Good morning.

Mark - Cleveland Research

First of all on the pricing environment and the fact that carpet margins were a little bit softer than kind of the mid-single-digit range you would have expected in the second quarter. Can you talk at all about any incremental pricing pressure within carpet, and then the fact that you are seeing your raws go up in the second half within that segment, your ability to get further pricing from here.

Jeff Lorberbaum

Well, let's start. First is that we are trying to increase our margins in this segment. We think that the cost that we have taken out the business and the levels we are going to be able to run at in the third quarter will help those, unless we get some unusual surprises. So they think those will help margins in that category a little bit as we go forward. I mean, it's a difficult environment, you know, weighing how much price you can get versus the marketplace is dependent upon the competitive situation that you react to, the combination of your own needs as well as the competitive marketplace.

At this point, I can't tell how much the raw materials are going to change over time. It just looks like that it won't go up a little bit. I just want to make you aware of it. But it is not a surprise as we see it, and most of that is just based on how we proceed. This is the chemical and oil prices, but as you see week-to-week it is changing 10%, 15%. So, I don't know where it is going to end up. I don't know what else to tell you.

Mark - Cleveland Research

In terms of demand, does the stability you are seeing within residential, are you seeing your drops in residential become less worse or just not getting worse. How should we think about the statement about residential as we move into August?

Jeff Lorberbaum

We are really looking at more on a sequential basis. On a sequential basis, it looks like maybe we thought about and the question is, you know, we don't know what it is going to be next month any better than you do.

Frank Boykin

So the rate of decline looks like it's maybe stabilized. That's what we are trying to do.

Operator

Your next question comes from the line of Sam Darkatsh with Raymond James.

Sam Darkatsh - Raymond James

Good morning Jeff and Frank. How are you?

Jeff Lorberbaum

We are well, how are you?

Sam Darkatsh - Raymond James

Living the dream. A couple of questions for you.

First of, this is more of just a housekeeping. The -- first of nice job both in earnings and also on the inventory management. The inventory was down sequentially in dollars. Was that down in yards or units also or was that an impact of the lower input costs?

Jeff Lorberbaum

I would guess it is some of both.

Sam Darkatsh - Raymond James

Okay, and the second question would be -- if we could just get you to clarify, specifically Unilin margins, expectations for Q3. You said it be lower and this will be unsustainable. We are just trying to get a sense of by how much approximately or by -- if there should be some sort of quantification to help us model it.

Frank Boykin

Good try, but historically we have not broken down each of the segments. We are trying to get you at least a method to get that to get you in the ball park with our estimate, but I have to give you more than that.

Jeff Lorberbaum

Our estimates aren’t right either. So the more -- the further we break them down, the worse they get.

Operator

Your next question comes from the line of Stephen East with Pali Research.

Stephen East - Pali Research

Good morning guys.

Jeff Lorberbaum

Good morning.

Stephen East - Pali Research

If the, following on (inaudible) question about cost structure, if I ask it a little bit differently, if you look at the pull outs that you've taken to date since this downturn started, how would you -- relatively speaking, how would you characterize those between permanent structural pullouts versus just purely volume related pullouts?

Jeff Lorberbaum

I don’t know if I have the -- I'm not sure we look at it in that fashion. I mean, basically we have lowered the labor force somewhere around 20% in the piece. We have cut all the overtime pieces, and we have been able to cut the cost through productivity improvement and pieces. We are working short times and those things of the labor piece. So besides the 20% that is gone, there is another significant percentage that is much lower than it was. I don't know whether to call it temporary or permanent or both of it. You can change them back to the other direction with limited time.

The facilities, we have shut down the high cost facility in all the various businesses. We continue to have more restructuring in the third quarter that we are going to reduce some more infrastructure. We have cut our distribution pieces significantly and what happened is prior to the downturn, we were building distribution to accept a much greater volume of business. So, what we have was exceeding our present needs.

We are writing those of, we are consolidating those, we are in the process of consolidating some Dal-Tile and Mohawk distribution pieces. The Dal-Tile business, we have started centers around the country, where we have multiple ones in the same marketplaces in some cases, when the leases allow us, we are consolidating them to reduce that infrastructure, reduce the people in the infrastructure with the Dal-Tile SG&A. What else?

Longer term, the things that are going to be needed in an upturn would be more ceramic capacity. We are looking at capacity in the Mexican market to supply the Mexican marketplace. We will need some more capacity to support the US market place long-term. In the short-term, we have always used the world marketplace of manufacturing to support our needs in ceramics.

So, as the industry turns up we can -- we had as much as 30%, 35% being imported to support the business and now it is down in the teens, where it is more directly related to unique product category. We have capacity to support our Unilin business and Mohawk businesses for the most part. I think we will look at other expansions. We've talked about Russia that we believe in order to have a significant portion of the Russian marketplace, we will have to make some investments in Russia at a point in time. We believe that possibly we can use some excess equipment we have and do it relatively inexpensively to get in that marketplace and support it. So those would be the major investment needs.

Stephen East - Pali Research

Okay.

Jeff Lorberbaum

As I think turns up, which I think tries to answer the question a little differently.

Stephen East - Pali Research

Okay, that's helpful. If you know over the last year or so you have been trying to implement price increases as you saw the raw materials going up. You have obviously had a mix shift down. So we get that, but can you shed a little light on what you are seeing on the pricing front and have you been able to hold prices. I know it takes a while for you to get and implement it. Has that basically -- that effort disappeared or where do we sit with it?

Jeff Lorberbaum

Again, you have to look at each of the businesses. In the carpet business the commodity areas, which you would expect have had pricing pressure and give back in the pricing of the commodity product, and you get above the commodity product. For the most part, the pricing has been reasonably stable across those. The Dal-Tile piece, I think more pressure has been on the mix rather than the pricing.

Dal-Tile historically did not play a large part of the business in the commodity. They had a commodity business but they limited this to match the capacity and to provide the product mix to the customers they were dealing with, but they didn't want a -- they didn't use it as a large part of the business. As the volume has dropped off, we have taken more of the commodity business. So it is more of a mix problem in that aspect, and then Unilin tends to play in the mid-to high end places with very limited amounts there.

Well, we have gotten hurt in the Unilin business is the excess board capacity that we have. Those businesses that we said before there is significant excess capacity in the marketplace and those selling prices are going to close to cash costs in the European marketplaces, and it is going to take the closure of the high cost businesses to get it up a little bit, but then you have in those same businesses when business picks up, you can expect a significant change in the selling prices at some point.

Operator

Your next question comes from that line of Laura Champine with Cowen.

Laura Champine - Cowen

Hi, I know you usually disclose your unit growth by segment in your 10-Q. Can you give us a sense of that now or at least talk about direction?

Jeff Lorberbaum

I don't think we've got that in front of us now, Laura, but if you want to call me back later, I can talk to you about what's going to be in the queue.

Laura Champine - Cowen

Okay, but when you talk about the residential demand stabilizing, is that just a Mohawk segment or is that across all segments.

Jeff Lorberbaum

It is across all the businesses, it is the sequential volume that we are doing. It looks like possibly that the sequential volumes may not be going down any further.

Laura Champine - Cowen

Except, I think for the seasonal downtick you see in the laminate business?

Jeff Lorberbaum

But the seasonal things you are going to have, but going from second quarter to third quarter is what we assume now. The seasonality of the industry we're not going to change.

Operator

Your next question comes from the line of Carl Reichardt with Wells Fargo.

Carl Reichardt - Wells Fargo

Hi guys. Just a follow-up on the residential question. Has there been a diffidence in trends if I look at the different distribution channels you have. I mean, is there deference in direct to builders versus big box versus the traditional small retailer. That would give us a sense of the residential improvement as more related to remodeling or new.

Jeff Lorberbaum

I mean, the new -- there is no go -- there is not much new going on,

Carl Reichardt - Wells Fargo

But if is just getting better --

Jeff Lorberbaum

I think what the news is that it has reached a point. I think whether we build 300,000 homes a year and so, you know, it has flattened out at the bottom. So I don't believe it's got any further to go. So it's down at the bottom and it appears that possibly that the remodeling piece may have hit the same bottom too.

Carl Reichardt - Wells Fargo

Okay, and the second question is related to Unilin and the royalties and just I'm curious, the royalties, are they tied directly to the volume that those utilize a technology are producing. Is there of fixed payment component of the royalties or it's something in the timing of the accrual of them that would have impacted the margins directly this quarter that we wouldn’t see next quarter.

Jeff Lorberbaum

We have different arrangements with different groups of every type you can imagine, but a significant portion of the total is based on industry volume, and, you know, it is going to go up and down as the industry changes.

Frank Boykin

The other thing that will impact us Carl from quarter-to-quarter as Jeff mentioned earlier, is when we sign up new licensees and, you know, we could have some one-time nonrecurring royalty revenue that we might not repeat.

Carl Reichardt - Wells Fargo

Okay, I understand. Thank you very much.

Operator

Your next question comes from the line of John Baugh with Stifel Nicolaus.

John Baugh - Stifel Nicolaus

Good morning. I guess I just wanted to drill down a little more on the carpet side, and there are a lot of moving parts. I'm curious as to where you ran capacity in the first half of the year. You know, you've been making changes all along assuming capacity bringing that down. Where you'd expect a run, say in the second half. Where you bringing inventories down in carpet as well so that even if we saw flat volumes going forward you'd run at better rates, and what's the interplay in volume with commercial still going down sequentially, the residential flattening. Do we still see lower, overall unit sale sequentially of carpet. I know that's a little long-winded question, but I'm really trying to grab at where you can get those margins to in terms of utilizing your plan in light of the fact that makes us down, when volumes are so depressed.

I think as you look at the first quarter to the balance of the year, the first quarter was probably offering 10 to 15 percentage points below. As we go from the second quarter and the third quarter, we are assuming that we are going to run at similar rates plus or minus a little less, whatever we shut down in places. In the second quarter, we shut down a European land plan. In the third quarter, we have some plans that aren’t really executed. So I really can't go through all the details of it. We will be glad at the end of the quarter of the detailed list. But we are going to take out some capacity as we go into the third -- to come out of the third quarter.

John Baugh - Stifel Nicolaus

When you look at Mohawk Jeff, if we were in say a year from now and we ran volumes sequentially flat for the next four quarters given what you have done to date assuming everything else stays the same mix, price, and raw materials. Would we be looking at a material lift in EBIT margins, given all the costs you have taken out. I guess that'll be SG&A as well as, manufacturing cost. Thank you.

Jeff Lorberbaum

I mean the margins -- the cost should be down with the things we are doing and the margins are going to be based on what happens to selling price, the raw materials in addition to that.

John Baugh - Stifel Nicolaus

Thank you.

Operator

Your final question today comes from the line of Keith Hughes with SunTrust.

Keith Hughes - SunTrust

On the SmartStrand, how much is that represent of the carpet business right now?

Jeff Lorberbaum

It's still a niche product at the bottom. It's not a -- it is not in line with the top three raw materials, which would be vinyl and polypropylene and polyester, but it's a growing niche for the piece. Again, it used to be considered polyester and with the government change they made a new product category out of it.

Keith Hughes - SunTrust

There were still single digits of the volume you're doing.

Jeff Lorberbaum

It's still a limited part of the program.

Keith Hughes - SunTrust

Okay, second question. You referred to $25 million of plant and cost-reduction charges in the third quarter. Within the Mohawk segment, what kind of things would you be doing in the third quarter there?

Jeff Lorberbaum

Reducing manufacturing capacity and reducing distribution capacity and infrastructure.

Keith Hughes - SunTrust

The manufacturing capacity, have you taken out testing and extrusion or is it still getting rid of the spinning mills and things like that?

Jeff Lorberbaum

I'm really hesitant to walk you through the pieces, because they are all not finalized and they are all not executed at this point.

Frank Boykin

We can talk a little bit more about it Keith as soon as we announced it.

Operator

Ladies and gentlemen, we have reached the end of the allotted time for the question and answer session for today. I would like to turn the call back over to Mr. Lorberbaum for closing comments.

Jeff Lorberbaum

Thank you for joining us. I think we are making the hard decisions you have to make to run the business in the atmosphere we are in, and I think it will be a much better off company. You are too down the road when the industry improves and we will have our cost positions much lower and lenient. Thank you for joining us.

Operator

Ladies and gentlemen, this concludes today's conference. You may now disconnect.

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Source: Mohawk Industries, Inc. Q2 2009 Earnings Call Transcript
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