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How These Specialty Flooring Companies Hold Their Ground Against Competition

Both consumers and corporations have been turning to national home-improvement retailers like Home Depot and Lowe's for their flooring-product needs, such as tiles and carpets, for years. This allows buyers to consolidate their purchases so they can get better discounts and save time and effort involved in liaising with multiple suppliers. Furthermore, flooring retailers also price their products competitively because they save on the rental expenses associated with a physical presence. Despite these advantages, specialty flooring companies such as Tile Shop (NASDAQ: TTS  ) , Mohawk Industries (NYSE: MHK  ) , Interface (NASDAQ: TILE  )  have managed to stand their ground and thrive in their respective product niches.

Vertical integration
While most retailers that compete with the Title Shop purchase their tiles from third-party vendors, Tile Shop manages its entire value chain from the direct sourcing of raw materials to the manufacturing and shipping of the final products to its stores. Tile Shop's vertical-integration model provides it with two key advantages.

The first advantage is that Tile Shop is more cost-competitive by virtue of acquiring raw materials directly from the quarries, as it participates actively in product manufacturing and design and controls logistics and distribution. As a result, it enjoys lower costs and higher margins than its peers. In fact, Tile Shop's 70% gross margin is close to double those of Home Depot and Lowe's, which has raised some concerns.

Tile Shop's share price took a beating in November 2013, following allegations by Gotham City Research that Tile Shop used a China-based undisclosed related party and improper accounting to inflate its profits. In January 2014, Tile Shop released findings from an investigation conducted by an independent counsel and a "Big 4" public accounting firm which concluded that there was neither misstatement of financial results nor improper accounting treatment. This should help to address investors' concerns over Tile Shop's high gross margin.

The second advantage relates to Tile Shop's high proportion of private label products stocked. These products make up the majority of its 4,500 SKUs (stock keeping units). This helps Tile Shop avoid destructive price competition with retailers that offer me-too, undifferentiated products.

Unique customer benefits and customized solutions
Interface is the largest global manufacturer and seller of modular carpet, which essentially comprises carpet tiles cut into squares or rectangles that cover a floor. It used to sell predominately to offices, but it has subsequently diversified into other non-office and consumer markets, which currently contribute about half of its revenue. Modular carpet offers unique customer benefits vis-a-vis other competing flooring products.

Firstly, modular carpet results in the least disruption to normal business operations. Contractors can gain access to sub-floor wiring for telephones, computers, and other equipment easily with carpet tiles. Secondly, modular carpet can be maintained for longer periods. As certain floor areas (e.g. corridors) experience most of the wear and tear, the carpet tiles can be moved around to extend the average lifespan of a floor covering. Modular carpet's unique value proposition provides Interface with an edge over other retailers which sell other run-of-the-mill flooring products. According to the 2012 Floor Focus Top 250 Design Survey, about seven in 10 U.S. designers specifically request modular carpets to be used for their designs.

Furthermore, at least 60% of Interface's global modular carpet products in various geographical markets are made-to-order for its clients. These products tend to carry higher margins and enhance customer retention because they are tailored to customers' needs.

Commitment to innovation
Mohawk is the second-largest U.S. manufacturer of carpets and rugs, with 26% market share, behind Shaw Industries (31%), a subsidiary of Warren Buffett's Berkshire Hathaway. In a seemingly commoditized market, Mohawk has stood out for its commitment to innovation. Its recent award wins include the Council of Supply Chain Management Professionals' 2012 Supply Chain Innovation Award.

Mohawk's innovation products include SmartStrand Silk and Wear-Dated Embrace. SmartStrand Silk is a proprietary fiber developed by Mohawk that delivers unrivaled softness and superior protection against stains. Third-party tests found that SmartStrand Silk carpets were at least 42% cleaner than other nylon carpets. Customers also agreed. According to a November 2010 survey, 96% of SmartStrand buyers were satisfied with their purchases, while 98% said that they will buy SmartStrand again. Its Wear-Dated Embrace boasts twice the fiber of ordinary soft nylon, so it makes carpets twice as soft. In addition, Wear-Dated Embrace carpets are more durable, as performance tests suggest that they can withstand 30,000 foot passes.

Mohawk's unique technology and trademarked brands help to differentiate its products from those of its peers. The financial numbers speak for themselves. Excluding 2009 when results were affected by the Global Economic Crisis, Mohawk's gross profit margin has been remarkably stable, fluctuating within a narrow 25%-28% range.

Foolish final thoughts
The specialty-flooring companies mentioned above have adopted varied strategies such as vertical integration, specialty products, and product innovation to develop their own differentiated value propositions for their customers. An industry classification shouldn't define success or failure. Profitability is more about what you do than what you sell.

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Mark Lin

Mark is a private value investor and is the author of website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.

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