Coming up with new companies to research is quite often the most difficult part of what I do. I could take Buffett’s suggestion of starting with the A’s and working my way through all of the publicly listed companies, but this is a bit too inefficient for my liking. Each day, I scour the news for fallen angels and hunt through a variety of websites looking for interesting prospects. One site I frequent is Market Folly, which tracks hedge funds and reproduces many investor letters. These investor letters can be great sources of secondary research and provide useful information about the investment processes of successful money managers.
Last week, Market Folly reproduced the recent investor letter penned by Mark Massey of AltaRock Partners LLC. I recall being impressed with AltaRock’s investing principles (also reproduced on Market Folly) and so I enthusiastically read Massey’s new letter for both greater insight into their approach to analyzing investments and hopefully for some leads on companies to research. I was not disappointed!
I was most interested in reading Massey’s take on Mohawk Industries, Inc (NYSE: MHK), a producer of floor coverings such as tiles, stone, hardwood, and laminates. Massey certainly knows the company well, having tracked MHK for nearly a decade and owning it for a multi year stretch beginning in 2003. He recently bought back in as worries over the housing market have hit the company’s shares hard. I won’t repeat all of Massey’s analysis here but the gist of it is that MHK has a strong competitive advantage thanks to its distribution system, and the company operates in an industry that tends to favour the supplier rather than the customer. Additionally, despite operating in the worst economic climate for this industry since the Great Depression, MHK is still profitable and earning healthy free cash flows which will set it up for a strong rebound as the economy recovers. Simply put, you just can’t kill this company!
I’ll show a few of the regular graphs of the company’s historical performance, and then I’ll get to valuation. Let’s start with the company’s historical returns.
Mohawk Industries, Inc. - Historical Returns, 1995 - 2Q 2011
Here we see a dramatic decline in 2008. Fear not for this was not the result of a massive decline in operating performance. Rather, this decline in returns was due to a one-time impairment of goodwill related to its earlier acquisitions of Dal-Tile and Unilin. Many companies were using the market crash as a chance to take a “big bath” and take overdue charges for past mistakes all at once. Evidently overpaying for these earlier acquisitions, the recession gave MHK the opportunity to write them down to more reasonable levels.
Let’s look at revenues and margins.
Here we see the effect of the slumping housing market on the company’s sales. The company suffered a dramatic decline in revenues across all of its operating segments (Mohawk, Dal-Tile and Unilin). Clearly the company has been hit hard by the recession, but it is important to keep in mind that the recession will not last forever, and that in time a strong and consistent operator like MHK (note the consistency of its pre-recession returns) will rebound along with the business cycle. In valuing cyclical companies like MHK, it is important to look beyond the last few years and consider what the company’s long-term earnings power might be.
In MHK’s case, we must separate out its segments and value each individually in a sum-of-parts analysis. Looking at the company as a whole over the last decade would obscure the fact that it has made two major acquisitions which makes it difficult to compare past periods with current periods for determining normalized performance. The general idea of a sum-of-parts analysis is to use the company’s reported segment data to get a feel for how the company can perform throughout a full business cycle, then value this normalized performance for each segment, subtract the (negative) value of corporate overhead (the administration costs of the parent company) and derive current value of equity.
I’ll walk through my process generally over the next two paragraphs. Feel free to skip ahead to the conclusion.
To start, I calculated an adjusted EBITDA margin for each year back to 2000 for Mohawk, 2002 for Dal-Tile, and to 2005 for Unilin. I then averaged these EBITDA margins to get a feel for the normal EBITDA figures that might be expected for this company over a full business cycle. I then created various revenue scenarios for each division, based in part on each division’s average revenues over the last five years. I feel this was a good starting point, as it includes both the highs of just prior to the recession and the lows throughout the recession. I created some bullish and bearish scenarios to accompany this base case. Multiplying the normalized EBITDA margins by the different revenue scenarios, I calculated a normalized EBITDA in each scenario for each division.
I found historical average EV/EBITDA multiples for firms in this industry (from Aswath Damodaran’s website here. Note, MHK is found in the Furnishings industry, which has a long-term EV/EBITDA multiple of 6.6x, and a range of 3.32x in 2008 to 8.17x in 2010) and used these multiples to derive an estimated enterprise value for the firm using its normalized EBITDA in each scenario. I used a much higher multiple (10x) to overstate the cost of administrative overhead. From there, I used the company’s current debt and cash to find the market value of equity.
The result? The company does appear to be significantly undervalued. A low end estimate of the company’s value would place it in the low $60s, or around 50% above the company’s current price ($43). The company traded in this range as recently as June of this year.
It is also worth noting that Massey believes the company is worth significantly more than low $60s, as he was willing to purchase before the company’s recent price collapse (his cost basis is $58), when I would have found the value potential to be less clear. Massey’s research has given him the confidence to include substantial growth expectations in his valuation. He discusses MHK’s expansion into China and its growth in Mexico and Russia to give confidence to an expectation of earnings growth of 16-18% per annum. I have not conducted nearly the depth of research that he has, so I would be less willing to rely on growth to support my valuation. Luckily, the company’s shares have fallen so much over the last two months that I don’t have to rely on growth; on its normalized performance it is certainly quite cheap.
I like what I’ve seen so far so I will continue to dig deeper into the company. Unfortunately, by the nature of what I do (the quintessential outsider!), I have much less access to the kind of information that Massey has, and so I tend to stick to the kind of analysis that I’ve done above and then hunt through the company’s public disclosures and any available industry data for things that go bump in the night.
In the meantime, what do you think of Mohawk Industries?
Disclosure: No position, but may initiate within 72 hours.