Mohawk Industries: Poorly Managed With Serious Headwinds Ahead (NYSE:MHK)

Investment thesis

Our current investment thesis is:

• MHK is a business that has declined in attractiveness purely by its own doing, taking what is a cash generator and feeding it directly into an incinerator. The company has overpaid for acquisitions while investing heavily in Capex. This has yielded a meager 5% revenue growth rate and no margin improvement. As a manufacturing business, to have no margin improvement from M&A and scale is blasphemous.
• Compounding this is current macroeconomic conditions. US affordability is going through the floor, the value of houses is declining, and housing starts are softening. The demand for flooring can only go one way because of this, and so long as rates remain elevated, this will worsen. The issue with housing-related cyclicality is that a bounce back will only occur if affordability and demand sufficiently do. After a 2-year (ongoing) long cost of living crisis, we are skeptical this will occur.
• Investors may be tempted by the attractive FCF yield or low trading multiple relative to its peers/historical level, but we think this is completely justified. Management continues to make mistakes and so the trend can only be in one direction.

Company description

Mohawk Industries (NYSE:MHK), based in Calhoun, Georgia, is a leading global flooring manufacturer that creates products to enhance residential and commercial spaces. With a diverse portfolio including carpets, rugs, ceramic tiles, laminate, and wood flooring, the company serves customers across the globe.

Share price

MHK’s share price performance has been disappointing, significantly declining from its post-pandemic high and reverting to a wider downward trend since 2018. This is a reflection of the company’s changing financial profile during this decade.

Financial analysis

Presented above are MHK’s financial results.

Revenue & Commercial Factors

MHK’s revenue has grown well during the last decade, with a CAGR of +5% into the LTM period. Growth has been broadly consistent, although the business experienced issues between the FY18-FY20 period, before experiencing a post-pandemic bump. EBITDA has followed this trend, growing at +4%.

Business Model

MHK is a leading global flooring manufacturer that offers a diverse range of flooring solutions, including carpets, rugs, hardwood, laminate, and luxury vinyl tiles. The company is active in innovating, seeking to enter new verticals through product and channel development. Most recently, it has begun providing ceramic pavers for garden centers, among others, as well as hard surface products for e-commerce channels.

Its products are highly regarded for their quality, with superior relative function in many instances.

MHK strategically expanded its footprint in emerging markets where construction and home improvement activities were on the rise. This expansion has been delivered through both M&A and organic investment.

Management has aggressively pursued an M&A strategy, acquiring several companies in the flooring industry. These acquisitions have not only expanded its product offerings but also increased its market share and strengthened its competitive position. When considering the amount spent (>$3b vs. an MC of ~$5b), one would expect the company’s growth rate to be far higher than 5%. We discuss this in detail later but we are broadly unimpressed with this strategy beyond the commercial improvements mentioned here.

MHK operates a network of manufacturing facilities globally. The company has not faired positively with improving its operational capabilities, with Management seeking to overhaul this to drive financial improvement. Although Management is saying the correct things (”maximize productivity”, “improve quality”, “optimize automation opportunities”, etc.), we have seen limited improvements and no actionable criteria from which to judge the company.

MHK has strong relationships with distributors and retailers worldwide, owing to its substantial scale and supply capabilities. These partnerships enable it to reach a vast customer base, both residential and commercial. Its products are available in a variety of retail outlets, from large home improvement stores to specialty flooring retailers.

MHK’s revenue is broadly diversified by region and product, although is inherently tied to the flooring segment and thus the wider housing market. The 5% growth rate has been achieved through M&A, industry growth, product development, and entry into new markets. The company is well into maturity and so has limited levers to accelerate growth. This said, we do think there was better scope for growth than the organic level achieved given the investment made (capex is ~5% of revenue).

Margins

MHK’s margins have broadly remained flat over the historical period, although noting improvement between FY14-FY17 and a decline between FY18-FY22. The development of the company’s margins is a combination of factors, with M&A contributing to dilution in numerous cases. Further, MHK has experienced a product mix shift and increased competition. Finally, MHK has experienced fluctuations in raw material prices post-pandemic, impacting production costs.

Broadly, however, we are disappointed. The company has significantly grown during this period and so should have more operational efficiency to show for itself. We see little evidence to suggest any operating cost leverage has been achieved (S&A spending remains ~18% of revenue). This looks to us as a company bloated with acquisitions, lacking the post-acquisition integration work that can help realize synergies.

Quarterly results

MHK’s recent performance has materially deteriorated, with top-line revenue growth of +3.6%, (4.0)%, (6.9)%, and (6.4)% in its last four quarters. In conjunction with this, margins have materially softened, as inventory levels have risen beyond demand.

We believe this is a reflection of the wider macroeconomic environment. With elevated interest rates and inflation, consumers are reducing discretionary, large, and non-core spending, as a means of protecting finances. Businesses are feeling the impact of this, alongside supply-side issues, contributing to reduced capital spending to protect cash.

The impact of this is seen in the following Q2 revenue results:

• Flooring North America segment – (8.9)% revenue decline, (3.1)% margin decline.
• Flooring Row segment – (11.4)% revenue decline, (2.0)% margin decline.
• Global Ceramic segment – (0.3)% revenue decline, (4.7)% margin decline.

Compounding this for MHK the current economic outlook, with the following datasets considered forward indicators in our view of demand for flooring:

• US Fixed housing affordability – US housing affordability has fallen to a record low, which implies consumers (of a median income) are in no position to afford the costs of a (median-priced) home. This implies capital spending, be it on renovations or to move home, is very unlikely. The impact of this will play out over the coming years rather than just in the near term.
• US Housing starts – Given the home shortage in the US, there will always be an upward trajectory of builds. This said, it is concerning to see the significant pullback since 2022. This implies home builders expect an extended period of difficulty and so are not incentivized to build homes. This again is not a near-term indicator solely, as there is a plan-and-build timeframe associated with building homes and so inherently factors expectations over a longer period.
• US medium price for existing family home – In many instances, consumers will spend money renovating or decide to move home when they are in an equity position at their existing home. We have seen a noticeable pullback in sold prices in recent quarters, implying a decline in valuation, and thus equity value. Compounding this will be the attractive mortgage rates consumers currently have and so are completely disincentivized to move home.

In addition to these factors, we think the following are also important to consider:

• [Downside] US GDP growth has been revised down.
• [Downside] Shift to working from home, in conjunction with soaring interest rates on commercial assets, is contributing to greater vacancies.
• [Upside] Low unemployment rates in the US and Europe.
• [Upside] Inflation is declining, particularly on the supply side.
• [Upside] Housing shortage across the US and Europe.

Management recently stated, “Residential remodeling remains the industry’s greatest headwind due to lower home sales and deferred home improvement projects.” The impact of these metrics should not be understated in the coming quarters.

Key takeaways from its most recent quarter are:

• Management is pushing hard with restructuring projects, seeking to cut costs and find the efficiencies it has lacked for many years. This is some of the noise below EBITDA. Savings are expected to exceed ~$35m annually.
• Management is continuing to grow capacity, positioning it for the inevitable bounce back in demand.
• Acquisitions from 2022 are currently being integrated, with progress in line with expectations.
• Interestingly, Management has stated, “we are limiting future capital investments to those delivering significant sales, margin and operational improvements”. Investors have clearly pressured Management with many of the points we have highlighted here (seemingly inefficient capital allocation which we will discuss next).

Balance sheet & Cash Flows

MHK’s balance sheet is relatively clean, with an ND/EBITDA ratio of 1.8x. Management has not allowed its acquisitive nature to allow debt to run away, remaining within a controllable level.

FCF generation has been low relative to margins, which is attributable to quite sizeable capex spending as Management has invested to grow the business. This said, Management could do far better with working capital management, as inventory turnover has declined from ~4x in FY13 to ~3.1x.

Further, as we have already mentioned, the company has been incredibly acquisitive, spending over $3b on acquiring companies.

We are not sold on Management’s capital allocation strategy. With ~5% of revenue spent on capex and another ~$3b on M&A, we would expect this cash investment to generate incremental returns at the level historically achieved, at a minimum. This has not been the case. As the following illustrates, ROE, no matter how the statistic is manipulated, is on a downward trajectory. This implies the return on capex is less than the existing level and/or the business is overpaying for acquisitions.

We hesitate to say investor money is being wasted but it is certainly not being allocated efficiently.

Outlook

Presented above is Wall Street’s consensus view on the coming years.

Analysts are forecasting mild growth in the coming years, with a CAGR of 2% into FY27F. In conjunction with this, margins are expected to incrementally step up.

The revenue forecast is a concerning one in our view, although does not look unusual. The company’s growth has been strongly supported by acquisitions and with Management potentially being more selective now, its organic trajectory will be more important.

Further, with more focus turned internally, there will likely be good room for margin improvement, although we are not convinced the level forecast is achievable.

Industry analysis

Presented above is a comparison of MHK’s growth and profitability to the average of its industry, as defined by Seeking Alpha (10 companies).

MHK is an underperformer within its industry. The company has seen weaker revenue growth, particularly in the 3Y/5Y period, owing to the limited organic growth and inability to sufficiently exploit the post-pandemic period. Even if we exclude its faster-growing peers (which would be unfair as MHK has spent over $1.2b on acquisitions since FY17), MHK is still slightly below average.

Additionally, MHK is underperforming on a margin basis, although has a slightly superior EBITDA-M. This is surprising to see and disappointing given the company’s substantial (and global) scale. This is a further indictment of its poor operational management.

Valuation

MHK is currently trading at 6x LTM EBITDA and 5x NTM EBITDA. This is a discount to its historical average.

A discount to its historical average is warranted in our view, owing to the company’s poor financial progression and inability to achieve attractive organic growth. The business has inefficiently invested and only has a revenue growth rate of ~5% to show for it. This said, the degree of discount appears extreme.

Further, MHK is trading at a ~64% discount to its peers on an LTM EBITDA basis and ~5% on a NTM FCF basis. This discount is reasonable in our view, reflecting the company’s poor relative financial performance and greater cyclicality (as evidenced by forward forecast). Similarly to the above, we believe the LTM discount is likely above reasonable.

Based on this, MHK appears undervalued, although not substantially so. This is reflected in its FCF yield, which is ~12%. This said, we do not consider the stock attractive for anyone beyond speculators.

The company has been poorly managed, with this hidden by top-line acquisition-led growth. We are not seeing returns that justify ~5% of revenue capex spending and we do not see accretive returns from acquisitions. Management has been happy to take margin neutrality without giving sufficient consideration to the purchase price, with ROE trending down.

Potentially harsh, but we feel this is a business that should be growing organically at close to 5% (factoring in its global strategy), with an EBITDA-M of ~18%. Investors likely feel something similar, with its valuation trending consistently down during the last decade.

We do not see this trajectory changing until a strategic overhaul is delivered.

Key risks with our thesis

The risks to our current thesis are:

• Effective execution of its margin improvement initiatives
• Expanding market share in growth regions.
• Faster than expected economic recovery.

Final thoughts

MHK is a great business in our view but it appears to be poorly run. We struggle to see where the money has gone. Over $9bn in cash has been spent on M&A and Capex during the last decade, only to achieve the same margins as FY13 and a growth rate of +5%.

Importantly, the business does have substantial scale and relationships. With due focus on operational capabilities and efficiencies, it will be possible to deliver margin improvement and an uptick in growth rate. This said, we do not know if this management team is capable.

The biggest issue presently is the current macroeconomic environment, with all metrics suggesting the demand for flooring will decline in the remainder of FY23 and likely into at least half of FY24F, potentially longer. MHK has shown no ability to respond to this, with greater cyclicality than its peers.