MHK - Mohawk Industries

[Cigarbutt]

Short version:

Mohawk Industries makes and sells floor coverings (carpet, ceramic tile, laminate, vinyl and hardwood) on a global basis. It has a long history of consistent and growing operations with scale and a low cost moat. The company is going through a soft patch and the equity value is affected by a potential fraud issue. It’s not a terribly exciting idea but it seems like the stock represents, on a weighted basis, a reasonable opportunity to profit within the next 3-5 years (reversion to the mean and intrinsic value) with the added advantage that intrinsic value is likely to increase significantly over the longer term.

 

Longer version

 

-The industry

Historically, MHK was mostly involved in the American carpet business, which has some duopoly nature with Shaw (BRK sub) and has become, over time, more global and has diversified in ceramic tiles (their largest segment now; higher margins but more discretionary) and in other segments according to evolving trends (laminate, vinyl, hardwood). The segments are quite competitive and, apart from the carpet segment, the suppliers evolve in a fragmented market. MHK has grown organically and through acquisitions with, in addition to internal cashflows (no dividends), some equity issued for acquisition funding but debt has been the main vehicle for opportunistic funding. Sales of floor coverings are tied to general economic and housing conditions and have a discretionary component which can delay sales at times. The business has reasonable long-term prospects. MHK has mostly residential exposure but also some commercial exposure.

 

-The company

The company has a long history and was IPOed in 1992. MHK has developed global scale in most large markets and has maintained a low cost position among competitors. They are somewhat vertically integrated but have no direct retail exposure. They sell to: home centers, independent specialty retailers, builders and mass merchants. The business is quite simple but not easy and, over time, management has been able to deliver value. They went through the 2007-9 episode quite nicely and in fact benefited from the downturn to grow market share after. That’s the period when I held the equity for some time. They seem to be able to spot well acquisition opportunities, to integrate them and to find the right balance between decentralized and delegated operations and the ability to maintain a profit culture.

 

-The management

The CEO was “acquired” through an acquisition (Aladin Mills) in 1994. He has maintained about 12% ownership in the company. They had a long-serving CFO who left in 2018 and the CFO came back recently to give a helping hand going through this juncture(?). Management (IMO) have been very well paid but not outrageously so. Apart from the CEO, stock-based compensation has been mostly monetized over time. My appreciation of the top management is that they could be perceived as arrogant and they did title their 2013 annual report “Floor it” and used “aggressive growth” wording when describing their vision and strategy in 2016. My opinion is that the actual CEO has been, overall, a strong owner-operator.

 

-The numbers (unaudited)

Revenues (CAGR)

1995-2019: 6.8%  1995-2004: 12.5%  2004-2013: 2.5%  2013-2019: 3.5%

The 2004 to 2013 period included the unusual boom-bust sequence related to housing. The thesis here implies annual revenue growth between 4 and 6% into the mid to long term. Over the same years, the gross margin started at 21.9% and improved to 28.2% in 2006. After the housing downturn, the GPM climbed back to 31.6%, in large part because of the growth in the higher margin ceramic tile segment. In 2019, the gross profit margin is down to 26.6% and (IMO) reflects temporary cyclical and competitive dynamics. The story with net profit margins shows a convincing positive trend in the 90s with a previous CEO and with the actual CEO as the then COO, from 2.5% in 1996 to 5.5% in 2001, the year the COO became the now CEO. Then, NPM progressively moved up (with a drop and gradual bounce after the housing crisis). Maximum NPM was reached in 2016 (10.4%) and, in 2019, NPM was at 7.5%. The thesis here implies gross and net profit margins reverting (or at least going in the direction of) to previous levels. The thesis also assumes similar interest and tax burdens going forward.

The company is evaluated as if bought entirely but it is reasonable, valid and helpful to look at the EPS over time.

EPS (diluted)

1995 0.20  1996 0.95  1997 1.31  …  2000 3.00  2001 3.55  2002 4.39  …  2007 10.32  2008 (21.32)  2009 (0.08)  2010 2.65  2011 2.52  2012 3.61  …  2015 8.31  2016 12.48  2017 12.98  2018 11.47  2019 10.30

In 2019, net income was 744.2M, SE was 8126.4M (including goodwill of 2570M and IA of 929M.

The following is a reasonable approximation of return on equity over time:

https://www.macrotrends.net/stocks/charts/MHK/mohawk-industries/roe

Debt has been part of their capitalization structure. Debt levels have been generally moderate and, at times of major acquisitions, relatively elevated. They’ve always kept reasonable ratios (debt to equity and coverage), have not suffered (so far) from leveraged acquisitions that turned out poorly, have consistently been able to produce healthy free cashflows from operations and did go through the tough 2008-9 years and even came out stronger and in a position to expand and increase market share. Their debt is investment grade (although this does not say much in itself these days IMO). In 2019, their debt level (long term and current) was 2569.9M and their CFO was 1418.8M. The debt is spread through a senior credit facility, commercial paper and senior notes with a relatively short maturing profile.

My assessment of their capital allocation is positive in terms of capex and acquisitions. They have opportunistically bought back shares in the past. In 2018, they used 274.1M (average price per share 118.87). In 2019, they used 100.1M (avg price 124.16)

 

-Valuation

This can be looked at from several angles but to summarize a PE ratio of 12 is used on normalized earnings of 13$ per share and subtracting a margin of safety of minus present value of two years of earnings to come to an intrinsic value of 130$ per share and a discount of market value to intrinsic of about 0.6.

 

-The potential ‘fraud’ question

The company faces a class action (questions about channel stuffing as well as inventory levels and valuation). This has been going on for months and, recently, legal filings revealed more details (with an anecdotal component) and the SEC has asked (subpoena) for related documents. In fact, MHK has postponed Q2 2020 earnings release to this week in relation to these recent developments.

For the channel stuffing part, this is not a forensic analysis but, going over about 20 years of reporting, it seems like their relevant reporting and incorporation of standards are consistent and adequate. Specifically, in the cashflow section, they report their change in accounts receivables, net of acquisitions and it is reasonably possible to reconcile over time the growth in the accounts receivables accounts although disclosure about acquisition is often not detailed enough to come up exactly with the numbers reported. Here’s a chronological list of the ratios of sales over AR over time:

2000 9.5  2001 8.5  2002-2012 7.8 to 8.5  2013 6.9  2014 7.2  2015 6.4  2016 6.5  2017 6.1  2018 6.2  2019 6.5

First, the ratio varies over time, reflecting, in most years, typical volatility related to business conditions. Second, the ratio has come down after 2012 but this is happening in a period when the company was transforming to a significant degree and expanding globally in new markets (products and categories) and taking into account the fragmented nature of their buyers (see -The company above) helps to reconcile the decreasing ratio in some periods. Over the long term, the specific and relevant reporting elements have been consistent. For a long time (ended in 2017), MHK used AR financing but it was on-balance sheet (the receivables were “sold” as a factoring transaction for collateral but remained in the AR asset account).

For the inventory question, it looks like inventory rose when business conditions slowed and with various levels of competitive pressures.

Anything is possible and the usual incentives are potentially applicable but I find it hard to consider that the revenue recognition issue has been widespread and chronic in a company so large. It’s possible that problematic transactions occurred in some corners. The potential outcomes are wide but I put a small odd on an existential blow. After some kind of review of legal precedents, if applicable, various scenarios are possible. A relatively similar situation (allegations were more than allegations though) happened in 2004 (SEC vs Bistol-Myers-Squibb, transactions involving channel stuffing with the two largest wholesalers). It was established that consignment sales did not apply and accrual for rebates had been understated. The outcome meant various remedial actions and a 150M fine. There are other precedents but most cases are contaminated with various other forms of bad behaviors but fines tend to be less elevated. So, a fine is possible and maybe management change but that does not really change the long term value of the business. It certainly creates a black cloud at this point.

 

---o---o---

 

So, this looks like an interesting opportunity. In the event that the market offers this at absurd levels within the next few years, position sizing now may take into account for the possibility to average down going forward.

[mwtorock]

The allegations are problematic if true. It supposedly happened in recent years (2017- 2019), so I don't know previous years of 

reporting would prove anything. The timeline also matches the events of the financial results and stock performance, so the management might be under pressure to juice up the results. Even if the fraud is limited in some corners, the management should have investigated internally and come clean with shareholders.

 

I have not looked into it deeply mainly because it did not strike me as a good business (although WB owns bunch of flooring companies). But it does look cheap if the allegations proved false.

 

 

Just for the discussion:

"The complaint alleges that the Company (1) engaged in fabricating revenues by attempting delivery to customers that were closed and recognizing these attempts as sales; (2) overproduced product to report higher operating margins and maintained significant inventory that was not salable; and (3) valued certain inventory improperly or improperly delivered inventory with knowledge that it was defective and customers would return it. "

[Cigarbutt]

^Fair enough.

The fact that the recent CFO left suddenly is also a red flag.

One mitigating factor, if the fraud is true, is that it would involve mostly an inter-temporal movement of revenue and income recognition without really having a highly material impact on the overall fundamental end result.

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Relevant addition to the initial post concerning debt since i failed to include recent developments.

In Q2, the company issued debt and lengthened its maturity profile:

-500M USD  3.625%  2030

-500M  €    1.75%    2027

[Cigarbutt]

So, this one has been humming along. MHK has announced a new CFO who has grown in-house, with the recently resuscitated CFO quietly going back to retirement, with the overall effect of a significant decrease in the potential previous fraud risk mentioned by some before (opinion). On that front, it is slightly ironic that MHK was slow to react in Q4 in building sufficient inventory levels to meet rebounding demand.

 

Sales and profitability have recovered and then some and normalized earning power is becoming visible much faster than anticipated. As a result, leverage ends up being relatively low and free cash flow remains comfortably high despite significant buyback activity. In the last 3 years (up to end 2020), the company paid about 504M for an about average 123$ per share, at levels less than conservative intrinsic value (quite unusual corporate behavior these days (opinion)).

 

With a two-bucket framework (first bucket: buy below intrinsic value and sell when intrinsic value is reached, second bucket: buy and enjoy the intrinsic value growth ride), this one was mostly a bucket #1 opportunity but it is also a (potentially) modestly satisfying long-term compounder.

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The WSJ had a piece yesterday with the following subtitle*: “The strongest housing boom in more than a decade is boosting home values.” So, the contrarian side of me (mystic crank?) hopes that this (MHK) becomes, again, another opportunity, somehow, down this long and winding road.

*quote from the article (housing health is critical for MHK business):

“Prices are rising so rapidly they are outweighing the benefit of rock-bottom borrowing rates, NAR said. In the fourth quarter, the typical monthly mortgage payment ticked upward to $1,040, from $1,020 a year earlier, NAR said, even as mortgage rates declined."

 

 

i wish this would make sense and it is unclear how (low?) high this can go?