Mohawk Industries: Weak In 2019

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About: Mohawk Industries, Inc. (MHK)
by: Prasanna Rajagopal
Summary

Higher costs are pressuring margins.

Gross profit margins fall below 30%.

Mohawk may have to wait for global economic weakness to clear up.

Mohawk Industries (NYSE:MHK) had a tough year in 2018. It had to navigate material cost increases, increased transportation costs, higher energy costs, and a tight labor market in the U.S. This year - 2019 - could be even more volatile given the uncertainty in trade talks between the U.S and China, the global economic slowdown, especially the economic slowdown in China, the Brexit uncertainty, and potential for a below 3% GDP growth in the U.S. Even though the stock trades cheaply at a forward PE of 11, investors should stay away from it until the dust clears on the direction of the U.S. housing market.

Mohawk Business Segments

Mohawk Industries operates under three business segments:

  • Global Ceramic

  • Flooring North America

  • Flooring Rest of the World

The company is a vertically integrated global flooring manufacturer and distributor. The company generates 63% of its revenue from the United States and approximately 37% from rest of the world. In 2017 the company had $9.5 billion in revenue with Global Ceramic accounting for 36%, Flooring North America (Flooring NA) accounting for 42% and Flooring Rest of the World (Flooring ROW) accounting for 22% of the total revenue.

According to the company, the Global Ceramic Segment designs, markets, manufactures, distributes and sources a broad line of ceramic tile, porcelain tile, and natural stone products, including quartz and porcelain slab countertops. The company has its own distribution centers, service centers, and provides direct shipping and customer pick-up from manufacturing facilities. The company organizes its salesforce by product type and sales channel to better serve each type of customer.

Flooring NA Segment manufactures and distributes carpet, laminate, carpet pad, rugs, hardwood, Luxury Vinyl Tiles and sheet vinyl. Residential customers account for a significant portion of the total industry and the majority of the segment’s sales.

Total U.S. Market for Flooring

According to the company, in 2016, the U.S. floor covering industry reported $24.5 billion in total sales and had grown about 4.4% over 2015’s sales of $23.4 billion. In 2016, carpet and rugs, including vinyl and LVT, accounted for 47.1% of sales, rubber (15%), hardwood (14.9%), ceramic tile (13.4%), stone (5.7%), and laminate (3.9%).

Exhibit: U.S. Flooring Market

Flooring Product

% By Sales

% By Square Feet

Carpet & Rugs

47.1%

52.8%

Rubber

15%

19.7%

Ceramic Tile

13.4%

13.7%

Hardwood

14.9%

7.8%

Stone

5.7%

1.5%

Laminate

3.9%

4.6%

(Source: Mohawk Company Filings)

Hardwood and stone are expensive and command the highest prices and thus account for less than 10% of the flooring market.

Luxury Vinyl Tiles (LVT) has been a fast-growing segment of the flooring market. The company acquired IVC Group for $1.2 billion to enter the LVT market in 2015. IVC Group had operations in Europe and the United States with sales of approximately $700 million. In 2015 in the U.S., LVT accounted for 5% of the total flooring market, and sales are projected to grow more than 15% annually through the end of the decade. In the U.S. LVT is taking share from other flooring products and could become a significantly larger part of Mohawk’s product portfolio in the coming years. Changes in consumer preferences also had a negative impact on the company. Consumer tastes have changed and they seem to prefer luxury vinyl tiles over other flooring products that the company offers. The company had to acquire to increase its market share in the LVT space.

Mohawk Facing Economic Headwinds

There are various market and economic factors that determine the demand for its products. The economic factors such as consumer confidence, spending for durable goods, interest rates, inflation, and turnover in housing play a significant role in determining the fortunes for the company. Lately, the economic data is mixed at best.

The University of Michigan Consumer Sentiment had a reading of 90.7 and had dropped from 98.3 in December of 2018. It’s the worst plunge in Consumer Sentiment since October of 2016. The longest Federal Government shutdown that lasted 35-days coupled with the bitterly cold weather in many parts of the U.S. may have had an impact on consumer sentiment. The next few months of the consumer sentiment data may provide clues to the direction for consumer spending.

The U.S. existing home sales, which is a big driver of the repair and remodeling industry and in turn a driver for flooring products, fell sharply to a 3-year low. The National Association of Realtors said on Thursday existing home sales dropped 1.2% to a seasonally adjusted annual rate (SAAR) of 4.94 million units in January 2019. The interest rate hikes by the Federal Reserve may have put a damper on home sales. But the Federal Reserve has indicated that they may be willing to pause the interest rate hikes in 2019. The mortgage interest rates are down about 60 basis points from their November 2018 peak. But the housing market also remains deeply supply constrained. At the January 2019 sales pace, it would take just 3.9 months to exhaust the current home inventory. A supply of six months is viewed as a healthy balance according to the National Association of Realtors. Any further drop in existing home sales may mean further trouble for Mohawk Industries. In the Q4 earnings call, the company mentioned that the softer existing and new home sales coupled with the reduction in remodeling and inventory reductions in their channels contributed to lower flooring sales in North America. The Flooring NA segment saw Q4 sales of $974 million which decreased 3% from Q4of2017.

The Australian market has been hit by a steep housing downturn and a slowdown in consumer spending. Since China is Australia’s largest trading partner, the slowdown in China is having a negative impact in Australia. Europe, another of Mohawk’s market, is also in trouble. The Eurozone is projected to grow at a measly 1.1% in 2019. Things have gotten so bad in Europe that the European Central Bank is reviving its stimulus program. The company is hoping to offset some of the sales lost in Europe and Australia by increasing sales in Russia, Brazil, and Mexico. Investors may have to be skeptical of this plan. It seems like the global economy is entering a period of deep uncertainty, which could result in overall slow GDP growth for the rest of 2019. Moreover, in its Q4 fiscal year 2018 earnings call, the company’s CEO Jeff Lorberbaum mentioned that most of their markets were slowing. The slowing markets were coupled with inflation in material, transportation, and energy costs. The tighter labor market also contributed to their problems by increasing employee turnover, which had a negative impact on efficiencies and training costs. The company could not fully offset these pressures via price or volume increases due to imports and a strong dollar.

If there’s any good news in all this dreary global news, it’s that the Federal Reserve may be done raising interest rates for the rest of the year. There’s also a probability for a decrease in rates in the second half of the year. If there’s a decrease in rates, that could increase the existing home sales and potentially revive the repair and remodel market. That may be a positive sign for Mohawk Industries. On the flip side, lower rates could push home prices higher and cause affordability to fall.

Mohawk Industries - Beaten-up in 2018

The company’s stock experienced a couple of scary plunges in 2018. One such plunge occurred in July of 2018 when the company’s stock dropped approximately 18% in a couple of days of trading. That drop took the stock from $217 to $179. This drop in its share price happened after its soft Q2 results. The management blamed that on cost inflation, higher transportation costs, a stronger dollar, and a tight labor market. Another plunge happened at the end of October 2018 when the stock dropped another 23% and this time the stock went from $151 to $115 in a day. This plunge in its price happened after the Q3 earnings miss that company attributed to sluggish demand and higher transportation costs.

Exhibit: Mohawk Industries Stock Beaten-up After Q2 and Q3 2018

Chart Data by YCharts

(Source: YCharts)

In Q4 the company generated $2.4 billion in sales and had an operating income of $241 million with an operating margin of 10%. The company repurchased $274 million shares and reduced their share count by 2.3 million or about 3% of outstanding shares. The fiscal year 2018 saw gross margins drop below 30%. When gross margins drop below 30% that’s an ominous sign for any company. That puts a lot of pressure on net income and cash flows. In 2018, the gross margin was 28.4% compared to 31.6% in 2017.

Operating cash flow has been decreasing since 2016. In 2018, operating cash flow was $1.18 billion compared to $1.34 billion in 2016. That’s a drop of about 12%. Free cash flow yield has dropped to 3.9%. In 2016, the free cash flow yield touched 5% and it hasn’t gotten to that level ever since.

Exhibit: Mohawk Industries Free Cash Flow Yield

Chart Data by YCharts

(Source: YCharts)

Mohawk Industries faces a lot of headwinds in 2019. Economic slowdown coupled with higher costs can mean more pain for the company this year. Wall Street is projecting approximately $10.15 in earnings per share in the low end. That would imply a cheap forward PE of about 13x at its current price of $132. But even achieving that depends on the prospects of the housing markets in 2019.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.