Friday, April 24, 2009

Mohawk Industries

Mohawk (MHK) is a floor covering business that I like quite a bit. It along with competitor Shaw Industries control more than 40% of the $ 20 billion+ US floor-covering market. MHK's market share has been increasing over the past decade. It has broad distribution and product breadth in an industry that continues to consolidate around the two dominant players. The economics appear to be very good for the leaders in this industry.

Of course, it is a very cyclical industry and the past 2 years have been tough. Similar to other cyclical businesses, MHK's stock will routinely drop 50-80% from peak to trough during a business cycle (the intrinsic value certainly does not..that's more steady than Mr Market). However, if you buy it at a fair price during recessions I believe MHK makes a great complimentary holding to the more steady businesses out there.

So this one's likely to be a bit more exciting than the P&G's of the world.

Yesterday's impressive forecast of 2Q earnings may hint that things are getting better in housing related businesses. The current quarter loss looks ugly (being a cyclical business that's the nature of the beast) but management's forecast of 2Q looks like the business environment may be stabilizing. You can't buy businesses like MHK based upon Price/Earnings (In fact, in my view you cannot buy any business based solely upon P/E...but that's another discussion). Companies like MHK always look expensive on a P/E basis during recessions and cheap at the peak of an economic expansion. In reality just the opposite is true. As a result, what makes something like this tricky to value with an appropriate margin of safety is you either have to:

1) discount normalized future earning power

or

2) buy when the company's P/E looks expensive (as a result of a temporarily depressed earnings in a recession...P/E may go to infinity as the E disappears for a while) and sell when it looks cheap (due to inflated earnings that are not sustainable throughout the business cycle).

I prefer the 1st method.

It's too late to buy MHK considering the size of today's move. The opportunity cost of sucking one's thumb instead of buying promptly can be just as real as the paper losses. Unfortunately, satisfaction with gains is not symmetrical with the dislike of losses. Waiting to see how Thursday's earnings report would go seemed like a good idea. I will continue to watch it and hope for a pull back.

Not acting decisively when you think you have a good idea can be costly.

In my view, MHK will easily go up a factor of 5 (trough to peak) during a full business cycle. The trough was ~$ 17/share (so far). Currently, it is selling in the mid $ 40's/share. At today's price MHK does not have sufficient margin of safety.

I'd expect future intrinsic value to grow to $90-100/share within 5 years (as I've said in previous posts I am not talking about the stock price but what I believe the company will be worth). I put MHK's current intrinsic value at $ 60-70/share.

The challenge with owning a cyclical business is ignoring the paper losses and volatility. With the inherently higher risks (both business specific and the current economic environment) I'd want to buy this at a 50% discount to intrinsic value. So we'll see if it gets below $ 35 again. If not...I missed it.

Adam

Long MHK

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