Mohawk Industries: Continue To Observe How Margins Improve

Summary

• MHK shows promising signs of recovery with better-than-expected 1Q23 results, indicating a positive trend.
• Despite potential competition and pricing pressure, MHK's long-term prospects appear favorable, with factors such as lower energy and raw material costs acting as tailwinds.
• My recommendation is to hold and monitor MHK's progress, particularly in terms of margin improvement in 2Q23 and beyond.

Manuta

Overview

I reiterate my recommendation that investors need a long-term perspective to take advantage of the Mohawk Industries (NYSE:MHK) share price mispricing today, but they also need to be wary of the near-term dangers (given the weak 4Q22 results). In my opinion, MHK's 1Q23 results were better than expected, signaling the beginning of a recovery trend. For me, this puts MHK in a better position to profit from when the economy and the industry finally do stabilize. I expect volumes to level off through the end of the year, and the cost of both energy and raw materials is to flip into tailwind. However, not everything is rosy right now. Since normalizing freight costs will have an effect on MHK's ability to maintain current price levels, I anticipate that MHK will continue to face incremental competition from subscale players. Yet, all things considered, I still anticipate EBIT margin to rebound from its 1Q23 low as operating conditions stabilize and higher utilization rates across segments become possible. Overall, I would still remain a hold rating as I monitor how MHK improves it margin in 2Q23.

Demand

No one should be surprised by the continued weakness in volumes throughout the year, though I do anticipate a moderating of the growth decline as channel inventories normalize. To begin, in the United States, residential remodeling demand is being stymied by high inflationary rates, which are causing homeowners to put off renovations until they can afford them. However, a rather strategic move that management has done is to roll out promotions to consolidate market share during this period, which has been effective so far. Channel inventories should return to normal more quickly if the promotions gain traction. Contrarily, as construction backlogs normalizes and macro headwinds postpone new projects, the commercial channel is expected to weaken. Put together, it is hard to have a clear view on how things are going to turnout using 1Q data. As such, I made the recommendation earlier to wait until 2Q23, so that we have 1 more quarter of data and also management comments regarding early 3Q23. More specifically regarding 2Q23, management anticipates increased production and fewer shutdowns, but stress on pricing and mix. In my opinion, the moderating input cost is going to bring back subscale players that were not able to compete (thereby losing share to larger player like MHK). MHK's margins will be impacted as they re-enter the market and exert price and product mix pressure. The increase in aggregate demand (cheaper prices) should, on the other hand, entice back holdout buyers.

Margins

Even though I anticipate a turnaround in margins, I can't say for sure when that turnaround will occur (2Q, 3Q, or 4Q?). As I mentioned above regarding pricing, as competition comes back, I expect prices to fall, which will impact margins. Management anticipates this competitive headwind, especially in LVT, to worsen throughout the course of the year. Meanwhile, premium laminates are holding up relatively well. On the other hand, lower costs for energy and raw materials, which have been a drag on profits, will flip into a tailwind this year, in my opinion. Additionally, there are two opposing forces to consider below the gross profit line: while increased production and decreased downtime will reduce unabsorbed overhead costs, I anticipate MHK will maintain high marketing spend to protect its market share as competition returns. Therefore, when taken as a whole, it is difficult to predict how margin will fluctuate between quarters in FY23. Hence, I recommended to monitor how margins move before making a judgment.

Valuation

I still believe the catalyst here is improved margin reversion in the coming quarters, hopefully it has troughed in 1Q23 and the improvement starts coming online in 2Q23. Assuming margins expand as expected and top-line growth follows consensus estimates, EBITDA growth should be in the mid-single digits to ~10%. As this occurs, I anticipate the market attaching a higher multiple to MHK (at the very least reverting to the 10-year average), as investors anticipate further margin improvement and growth. All of this adds up to a market cap of $12 billion (FY21 levels), or $190 er share.

Own model

Conclusion

In conclusion, MHK shows promising signs of recovery. The 1Q23 results exceeded expectations, indicating a positive trend. Despite the potential competition from subscale players and the impact on margins due to pricing pressure, MHK's long-term prospects appear favorable. The normalization of channel inventories, strategic promotions, and an anticipated increase in aggregate demand are expected to support growth. Although the timing of margin turnaround remains uncertain, factors such as lower energy and raw material costs could act as tailwinds. Monitoring the margin fluctuations in the coming quarters will provide a clearer picture. With improved margins and consistent top-line growth, MHK's valuation is likely to strengthen. Therefore, I recommend keeping a hold rating and observing how MHK progresses, particularly in terms of margin improvement in 2Q23 and beyond.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Comments

[OverTheHorizon]

Will fall with housing:

“Mortgage demand plummets as interest rates soar near 7-month high”
www.foxbusiness.com/...

[Jackrabbitt]

You're forecasting nice margin improvement next year and in 2025 and you believe the stock will double to $190 per share. And yet, you rate the stock a Hold. What am I missing? Am I suppose to wait for the fundamentals to improve and buy after the stock has skyrocketed towards your price target?