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Summary
Following my previous coverage on Mohawk Industries (NYSE:MHK), which I recommended a hold rating as I wanted to monitor how MHK would improve its margin in 2Q23, this post is to provide an update on my thoughts on the business and stock. I reiterate my hold rating for MHK. While my model has a positive upside, this is contingent on MHK improving EBITDA margins, which, so far, are still weak. The improvement in margin is also an important driver that will lead to multiples inflection nearer to peers' levels. As such, I would continue to monitor the upcoming quarter's margin performance before turning positive.
Investment thesis
MHK's adj EPS of $2.76 for 2Q23 reported on July 27th was higher than the consensus estimate of $2.65.
Sales in the Global Ceramics segment were flat when compared to the previous year, but the segment's adjusted EBIT margin dropped 474 basis points to 8.6% due to higher inflation, lower volumes, and temporary shutdowns, which were only partially offset by favorable price/mix and productivity.
Sales at Flooring North America were down 9%. Due to negative pricing and mix as well as operating deleverage, the adjusted EBIT margin shrank by 303 bps to 6.0% even as inflation slowed. In order to boost sales and profits, management has stated their intention to maintain a tight rein on expenses while increasing promotional activity. Though some mix headwinds are likely to impact margin, I believe that US commercial remained a bright spot, as did cheaper sheet vinyl (which works well in this inflationary environment where consumers are trading down), both of which saw higher sales in the quarter. In my opinion, increasing absolute EBIT dollars is currently far more crucial than preserving EBIT margin, and as such, I am positive that MHK saw demand for sheet vinyl.
Sales in the ROW flooring market dropped 11% year over year, with an adjusted EBIT margin of 12.1% (down 199 bps) due to lower volumes, FX headwinds, and plant shutdowns, only partially offset by productivity gains. My take here is that a large part of the weak performance is driven by the inflationary environment that has weakened consumers' discretionary spending budgets. The margin decline is probably also attributable to the unfavorable mix shift toward sheet vinyl. To combat this, management is adjusting laminate and LVT production to meet demand and switching to rigid cores for residential LVT.
Overall, I'm unimpressed by the results because, as expected, the weak EBIT margin was seen across all business units. Still, the demand side is showing signs of a positive mix. Since residential construction is expected to remain weak for the foreseeable future, I think the commercial sector's outperformance bodes well for the growth mix. Importantly, management indicated that channel inventories have declined and could be at a bottom. This is a very strong statement, as I see it as a precursor to strong near-term growth as MHK customers stock up on inventory from the current depressed levels. Management is also preparing for promotional activities like retailer incentives and targeted product launches in an effort to boost revenue. However, I would caution that this does not mean that growth will surge immediately, as customers could slowly build up inventory as the housing market remains under pressure due to high interest rates and continued inflation.
Regarding the third quarter, management did warn of continued pressure on pricing/mix (customers' budgets remain tight, thus pressing pricing; and consumers trade down), partially offset by lower material and energy costs (as mentioned in my previous post). Historical data shows that the third quarter is traditionally MHK's slowest because of vacations taken during that time. The combination of lower consumer spending and lower production in Europe with this seasonality dynamic makes me skeptical that the third quarter will show a significant inflection that could drive the stock upward. However, it eased my mind to see that management had begun cost-cutting measures that would eventually amount to $35 million per year (half of which would be realized in 2023) in order to facilitate margin expansion. Management projected Operating EPS of $2.62 to $2.72 for 3Q23.
Looking at the MHK balance sheet, the business ended 2Q23 with $570 million in cash and around $3 billion in debt, netting a net debt position of $2.5 billion. This equates to a net debt-to-EBITDA ratio of 1.8x. This is an increase from 1.1x a year ago and 1.7x in the previous quarter. Given that the stock is already being pressured by the weak P&L given the macro conditions, I expect the increased leverage ratio to further pressure valuation. This is especially true when we compare the MHK leverage ratio against peers that have an average of 0.8x. For the coming quarters, I am looking for management to step up their efforts to extract synergies from their recent acquisitions. Synergies should come in the form of an expanded distribution network.
Valuation
I believe the fair value for MHK in the near term, based on my model, is $137. My model growth assumptions are the same as my previous model, where I expect MHK to see a dip in FY23 followed by a slow recovery in FY24 and FY25. EBITDA margin is the focus here, and I expect MHK to work its way back to its historical EBITDA margin level as the US residential market recovers (driving a lesser mix of low-margin vinyl demand) and the commercial pricing environment recovers as well.
Unlike my previous model, where I expected valuation to inflect to 9x forward EBITDA, I am now adopting a more conservative and realistic approach as I believe the revaluation will be much slower than I expected. It is likely that MHK will trade at its historical EV/forward EBITDA multiple of 9x when it achieves historically high EBITDA margins. Also, the MHK leverage ratio is something that I see continuing to weigh on valuation as it is much higher than where peers' levels are. On a relative basis, I believe investors would favor an asset that has less debt exposure in the current high-rate environment.
Peers include: Armstrong World Industries, Richelieu Hardware, and Interface. The median forward PE multiple peers are trading at is 13x, the expected 2Y revenue growth rate is ~4%, EBITDA margin is 8.3%, and leverage ratio is 0.8x.
Own calculation Bloomberg
Conclusion
My recommendation for MHK remains a hold. The company's recent performance has not shown the desired improvement in EBITDA margins, which I believe is crucial for the stock to re-rate. Although MHK's adjusted EPS for 2Q23 exceeded estimates, the weak EBIT margins across all business segments raise concerns. While there are positive signs of demand in certain sectors, the macroeconomic conditions and inflationary environment continue to pose challenges. The increased leverage ratio also further pressures the stock's valuation when compared to peers with lower debt exposure.
