Interface: A Strong 'Buy The Dip' Case Has Just Enough Concerns To Look Elsewhere

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About: Interface Inc. (TILE)
by: Vince Martin
Summary

Like so many construction-related plays, TILE shares have sold off sharply - and look like they've gone too far.

LVT growth has been impressive, and 2018 revenues, in particular, look strong.

But there are modest concerns in here in terms of execution and margins - just enough to look for value elsewhere in the sector.

The story at Interface (TILE) sounds awfully familiar in the construction/building products space. The manufacturer of carpet tile and, now, LVT (luxury vinyl tile) has posted strong results over the last few quarters. Organic revenue guidance has been hiked twice. Earnings should grow ~25% year over year for full-year 2018. Naturally, TILE stock has tanked:

TILE stock quote Source: finviz.com

Again, the trend isn't necessarily unique for the sector, which has been hammered amid fears of a cyclical downturn, weak new housing construction demand, and/or rising input costs. Backwards-looking earnings, no matter how strong, have been no match for those forward-looking fears.

I'm a strong believer that the sell-off is overdone. There are near-term risks, certainly, but some of the declines in the space suggest a major recession is on the way immediately. And from a long-term standpoint, multiples theoretically should be expanding at (or heading into) the bottom. The only way to justify the huge multiple compression across the sector - including for TILE - is if recent earnings were at a long-term peak, which I'm skeptical is the case.

TILE shares have dropped ~35% since early September - mostly through multiple compression. Here, too, the declines seem a bit much, with the stock now trading at ~7x EBITDA and ~9.5x EPS (both pro forma for its August acquisition of Nora Systems). LVT, in particular, represents a significant opportunity and Interface appears to be taking share in carpet tile as well. Margin improvement efforts have been delayed this year - essentially because Interface needed to focus on higher-than-expected current orders - but add a potential growth catalyst looking to 2019 and beyond.

That case has some validity - and here, TILE looks too cheap. But there is no shortage of cyclical 'buy the dip' candidates, and a few concerns here mean investors looking for value in the space probably should look elsewhere.

The Case for TILE

The core case for Interface here is reasonably simple: earnings should grow, but the stock isn't priced as such. After a disappointing 2016, Interface's performance has strengthened. Organic revenue growth was 5% in 2017, with full year adjusted EBIT margins strengthening 90 bps to 11.8%. Top-line performance has been even better YTD, with organic sales up 9%, per the Q3 release.

There has been some margin pressure, with adjusted gross margins negative in each quarter and projected to be down for the year excluding help from the Nora buy. An estimated ~$10 million in input cost inflation (about 80 bps) has been a key factor; meanwhile, planned productivity benefits were supposed to be realized from the expansion of a facility in Georgia that has been delayed. The midpoint of full-year guidance suggests EBIT margins down about 30 bps y/y - a reasonably decent performance in the context of industry-wide inflation.

This is a company that's disappointed in the past: back in 2016, I called out my growing concerns about management. But under CEO Jay Gould, who was promoted from CFO in March 2017, the numbers look better. 2018 performance is particularly important given that 2017 benefited from easy comparisons. As I argued a year ago in expressing caution toward TILE at ~$25, the two-year stack was unimpressive (on a full-year basis, revenue dropped modestly, and EBIT rose less than 3%). Accelerating growth this year, particularly on the top line, suggests progress in the right direction, not just a reversion to the mean.

And looking forward, there are still catalysts on the way. Interface was a bit slow moving into LVT, but it's had success quickly, with ~$25 million in revenue last year and a target of ~100% growth this year reiterated on the Q3 call. Interface still has just ~2% market share, and thus plenty of runway for growth, particularly given that LVT can be integrated with carpet tile.

In carpet tile, the company appears to have taken market share, given that ~half of the 5-7% organic growth this year is coming from that product. The Nora acquisition moves the company into rubber flooring, and cross-selling already has begun, according to the Q3 call. The reach across carpet tile, LVT, and rubber gives Interface exposure to the highest-margin categories in commercial flooring:

TILE stock quote

Source: Interface November presentation

Benefits from the manufacturing project in Georgia are delayed, not lost: Interface already has guided for ~50 bps expansion in gross margins next year. The use of recycled materials limits some of the direct exposure to oil and other input costs. And a long-term target of ~14% EBIT margins - up ~250 bps from here - remains.

The two obvious risks are the cycle and competition. Interface revenue fell 19% year over year in 2009, for instance. But there's now a nicely diversified business, with a 47/53 office/non-office split pro forma for Nora, per the above-linked presentation. Hospitality and retail, in particular, are potential growth drivers, and given how office furniture plays have fared of late, decreasing reliance on that end market seems like a good thing. Hospitality results actually looked disappointing in past years, but on the Q3 call Gould said that end market was "way up this year", and a significant retail installation boosted Q2 and Q3 results. ~45% of revenue comes from overseas (30% EMEA, 15% APAC). A global slowdown is going to hit Interface's numbers, but lighter and/or more localized weakness could be manageable.

As far as competition goes, it is intense. Mohawk Industries (MHK) and Armstrong Flooring (AFI) are aggressively going after LVT - and beat Interface to market. Mohawk actually has had trouble building capacity to meet demand, one reason its margins have disappointed the last two quarters. In carpet tile, Engineered Floors (a private company run by Bob Shaw, who sold Shaw Industries to Berkshire Hathaway (BRK.A) (BRK.B)) has added capacity as well.

But Interface's LVT efforts are on track, with the company rolling out its first in-house design in Q2 and revenue hitting targets. Gould said on the Q2 call that Engineered Floors was targeting the lower end (~$10/sf) of the market - where Interface has just 9% share against 42% in the high end (again, according to the recent presentation). Interface remains the leader in the carpet tile space, and if it can add material share in LVT to that positioning - and get some help from macro factors - there should be years of growth ahead.

The Concerns

All else equal, that case looks strong enough with TILE at a single-digit multiple to pro forma earnings. Forced to choose, I'd bet the stock rises over the next twelve months.

But there are two broad reasons to stay away from TILE at the moment. First, I see better cyclicals out there, as pretty much anything with macro exposure has been sold off:

cheap cyclicals Image via David Schawel on Twitter

In the construction space, I'm personally long distributor GMS (GMS) and window and cabinet component manufacturer Quanex Building Products (NX). Mohawk has some self-inflicted wounds but, at a similar EV/EBITDA multiple, has an intriguing case, with bigger exposure to LVT, a less-leveraged balance sheet (under 2x vs ~3x for TILE), and easy comparisons on the way in coming quarters. And TILE's ~50/50 office exposure mirrors that of Knoll (KNL), which too has a similar valuation and more high-end (and thus potentially cycle-protected) exposure in its non-office business.

To take on cyclical risk at this point, the case needs to be compelling - not necessarily because the risk is that great (though it might be), but because there are so many potential options out there at low multiples. And there's just enough here to keep TILE off that list.

In terms of revenue, growth this year is better. But there's still an argument that it's not great. Organic growth (which backs out currency effects) is still going to be 2-3% annualized over a three-year stretch - and ~1% in the carpet tile business. In the context of what has been a strong economy - with US help from tax reform - that's not particularly impressive. And it seems to set up revenue declines with even a moderation in corporate spending.

Meanwhile, Q2 (organic growth of 10.6%) and Q3 (9%) benefited from a large retail installation. That installation pressured gross margins, as the company booked labor revenue as well. But it certainly helped the top line, and given the margin pressure, it seems like a material driver of revenue growth. That aside, carpet tile growth in particular seems weaker and the multi-year trend even less impressive.

From a near-term standpoint, the company cited a weak September as driving a 1% decline in organic orders. Gould called the month "an anomaly" on the call, but public company executives certainly have misread initial signs of cyclical weakness before (and no doubt will do so again).

There are some nagging worries on the margin front, too. Interface has been focused on SG&A spend for years now - and continually has fallen short of targets. Former CEO Dan Hendrix wanted spend at 25% of sales: it's heading to 27-27.5% this year, after original guidance for the low end of the range. Gross margin guidance seemed to have led to concerns after Q2; after Gould said on that quarter's call that "we feel very confident in the 39%" figure, the company moved the range to 38.5-39% after Q3.

The 50 bps target for next year seems more like a reiteration of a long-term goal rather than something that investors can model in, given misses in each of the last two years. The same goes for the 14% EBIT margin target; it seems possible, if not likely, that the current 11+% figure is closer to a ceiling, particularly if LVT competition pressures pricing as that business grows.

Interface's results over the last seven quarters have inspired some confidence - but the worries I've had over the past few years aren't completely gone, either. And it's worth noting that Interface has a tough comparison coming when it reports Q4 results next month. The company itself has guided for 2-3% organic growth, though it's not clear how that jibes with a 9% print YTD and full-year guidance of 5-7%, even considering that Q4 is the highest-revenue quarter.

Meanwhile, the company also somewhat quietly (no press release, only an 8-K) disclosed a restructuring plan last week. The company is cutting 200 employees, with estimated savings of $12.5 million. The cost reductions are going back into the business, however, leading to "negligible net savings" in the P&L.

It's not clear whether the move is part of overall optimization - or a response to the quarter. Management certainly hasn't tipped any such moves, and it could be good news that the company sees opportunities to reinvest the savings. But the lack of commentary, the lack of publicity, and the long-running inability to meet SG&A targets create some reason for caution ahead of the Q4 release.

These concerns might seem like nit-picking, admittedly. There is a growth story here, and a nice valuation. Again, forced to choose, I'd bet TILE is higher in January 2020, and potentially materially so. On its current path, TILE EPS next year can get to $1.80+, between organic growth from this year's $1.48 consensus, a $0.12-0.14 incremental contribution from Nora, and a guided ~$10 million in productivity help (~$0.13 per share after-tax). A 13-14x P/E multiple, toward the low end of the historical range, gets TILE back to summer levels and suggests 50%+ upside.

But a lot needs to go right - and this is not a market, even with the sector rebounding over the past few sessions, this is going to tolerate anything going wrong. And there's just enough here to have some worries that something will - and enough opportunities elsewhere to avoid that risk, at least for now.

Disclosure: I am/we are long KNL,GMS,NX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.