Monday, October 10, 2011

A Housing Stock Not Reliant on a Big Recovery: Mohawk Industries

Back in July, when this article with some favorable things to say about Mohawk Industries (MHK) was first published, the company's stock was selling at a price (near $ 60/share) I considered not a large enough discount to value.

Barron's: A Housing Stock Not Reliant on a Big Recovery

The recent market sell off has made the price at least somewhat more attractive in my view.

More recently, Mark Massey of AltaRock put together some thoughts on Mohawk Industries in his letter to investors:

Massey on Mohawk Industries

I like Mohawk's business for a variety of reasons as a long-term investment if shares can be had at the right price. I have covered Mohawk in previous posts and  it has been one of my Stocks to Watch since the inception of that list.

Having said that, beyond a rather entertainingly wide and volatile trading range, I don't expect much from this stock near term.

Housing is in bad shape and will likely remain so for quite a while. To me, this means the chance to accumulate shares at a nice discount to value will likely continue for an extended period.

What seems impressive is that a relatively cyclical business like Mohawk has continued to be comfortably profitable in what is just an awful housing market. If they can make money in this environment I'm guessing they will do very well upon recovery.

In the last decade, after taking on an uncomfortable amount of debt (at least for my taste) and paying too much for some solid businesses (ie. Unilin and Dal-Tile...these are good businesses bought at high valuations that were financed too aggressively) they have increasingly cleaned up the balance sheet. Today, debt levels are far more manageable.

Management has done an impressive job using free cash flow to pay down the debt they needed to finance those expensive acquisitions.

Massey provides some useful background and thoughts on Mohawk that begins on page 6 of his letter to investors. Some excerpts:

"The company was largely built via acquisition during the 1980's and 1990's. With increased size from each acquisition came increased scale and additional opportunities for savings via vertical integration. However, the most important advantage was the reaching of a critical tipping point that enabled the company to forgo third parties and bring its distribution in-house. We believe that economies of scale and scope in distribution remain the most important and durable advantages of this franchise today."

"Mohawk's distribution platform allows it to service a diversified base of 25,000 retailers, most of whom are small mom and pop flooring dealers. Its largest customer, Home Depot, is less than 5% of sales - a level that has remained largely unchanged for a long time. Flooring is one of the few home improvement categories that the large home center chains have been unable to consolidate. Understanding why is the key to understanding Mohawk's competitive advantage."

Read Massey's full explanation of why flooring is tough for home center chains to consolidate here.

#1 Mohawk controls roughly 22% of the U.S. flooring market. #2 Shaw Industries (a unit of Berkshire Hathaway: BRKa) has 21%.

"These two companies effectively operate a flooring duopoly; the next largest competitor is only one fourth the size of Mohawk. Due to the economics of flooring distribution, we don't see this basic industry structure changing much over time. This makes Mohawk a particularly appealing long-term investment if it can be purchased at a cheap price."

Massey mentions that given some of the truly awful near-term trends in housing, investors are "understandably less than enthused about the sector" yet...

"...Mohawk, even in this extremely depressed environment is generating operating margins in the 6% to 7.5% range and we estimate it will earn around $3.70 in free cash flow this year. That you can acquire this very high quality company, which requires little additional capital to grow, for less than 7x very depressed EBITDA, is quite remarkable. We are confident that Mohawk will be doing a lot better in the future than it is today, a view that we are paying nothing for since everyone else seems to think things will never get better. Perhaps these are the same people that thought house prices would never go down, or that Mohawk at $103 in June 2007 was a sound investment."

"Jeff Lorberbaum, whose family owns 16% ($600 million) of the equity, ably leads Mohawk. We love it when management has a big stake in the future of the business, especially if we think they are smart, ethical, and focused on protecting and growing the competitive moat surrounding the enterprise. We believe that is definitely true when it comes to Jeff and his team."

Massey conceded that management overpaid for the acquisitions but as the largest shareholder they "experienced the psychological and financial pain from these past decisions". He also said that "we like the businesses they bought, it was the prices they paid, with which we had a problem".

"We like this investment a great deal. We own a super business with a durable competitive position."

Finally Massey added....

"Lastly, we reiterate that Mohawk is run by owner-operators who are passionately focused on its long-term success and who have enormous skin in the game. Based on very reasonable assumptions, we believe we will earn between 16-18% compounded annually through 2021. Our cost basis is just under $58."

The stock as of last friday was selling just under $ 47. Mohawk remains of interest to me whenever the price drops below $45/share (preferably well below) as I've noted in Stocks to Watch. So it is close to where I get interested in buying more shares again (the stock did briefly dropped into the high 30s recently).

It, along with Lowe's (LOW), remain my preferred housing related long-term investments.

Whenever Mohawk has been cheap enough, I've accumulated enough of a position to avoid a classic error of omission but leave room to grab more if the discount to value gets even bigger. In this case, I have little expectation of great near term performance yet expect very nice long run performance once housing recovers.

Sometimes ignoring the risk of short-term paper losses is necessary to make sure a meaningful stake is acquired.

This will probably make it so-called "dead money" and some will want to time it. My premise is that if you try to time it the risk of owning "an eyedropper" (or none) of something when a substantial amount was wanted becomes more probable.

When an investor understands and likes a business that's available at a fair price, it makes no sense to try and time it because of fear that it will be so-called "dead money". It's tough enough to find a business that you understand that selling at a large discount to intrinsic value.

I realize this might not quite fit the ethos of the fast money world we live in.

Adam

Long MHK, BRKb, and LOW
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