We are quite a ways into a bull market, which has left many great companies trading at premium valuations. But there are bargains out there if you know where to look.
Mohawk Industries (MHK 0.74%) and American Eagle Outfitters (AEO 0.18%) are trading well below their historical average price-to-earnings (P/E) ratios, which means both stocks could be substantially undervalued if the companies can keep growing sales and earnings over the long term. These are not fast-growing businesses, but each should be able to deliver a decent amount of sales and earnings growth. At these cheap valuations, that's all they need to do for shareholders to potentially double their investments.
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Mohawk is investing for the long haul
Mohawk is the world leader in flooring products such as carpet, ceramic, and laminate. The stock has been a rewarding investment over the past few decades: A $10,000 investment made at the IPO in the 1990s would be worth $181,000 today, and that includes the impact from the recent drop in the share price.
Since the beginning of 2018, the stock price has fallen 55%. The company has struggled due to a slowdown in home-improvement spending, rising materials costs, and competition from luxury vinyl tile. These problems were made worse when the recent tariffs on Chinese goods caused a surge in imports of ceramics ahead of the implementation of the tariffs. That, in turn, has caused a short-term glut in inventory across the industry. This situation has made it more difficult for Mohawk to grow sales.
The industry slowdown is creating a great opportunity for investors to buy a best-of-breed business at a bargain price of just 11.2 times next year's earnings estimate. The housing industry is cyclical, so this is nothing management hasn't seen before; the company has always managed to bounce back and deliver a satisfactory return to investors.
The tariffs on Chinese imports are expected to level the playing field for Mohawk in the long run, as China's dumping of cheaper ceramic on the U.S. market has made it difficult for Mohawk to compete. COO Christopher Wellborn explained during the second-quarter conference call that the U.S. government's recent 300% duty on Chinese quartz products is "enhancing the value" of Mohawk's new quartz countertop plant in Tennessee.
The near-term dynamics of the industry will shake themselves out. In the meantime, management is allocating capital in areas to improve growth and profit margins when demand returns. Last year, Mohawk spent $1.5 billion expanding internationally, investing in new product categories like luxury vinyl tile, implementing cost-saving initiatives, and buying back shares.
There are a few other reasons Mohawk should remain a worthwhile investment. Despite the current slowdown, home-improvement spending is forecasted to increase from $800 billion in 2018 to $1.12 trillion by 2025. And most importantly, Mohawk CEO Jeffrey Lorberbaum owns 14.4% of the company's shares, which aligns his interests with those of shareholders.
Mohawk should get through the near-term issues and emerge as a stronger business. Investors who buy the stock today could be looking at a two-bagger in the next five years or so, driven by a combination of earnings growth and investors assigning the stock a higher P/E ratio that is more in line with the stock's trading history.
American Eagle's top brands are performing better than its stock price
American Eagle has been one of the better-performing apparel retailers in recent years based on its consistent comparable sales growth. The company continued its streak of positive comp sales in the recent quarter, posting a 2% rise year over year. It was the 18th consecutive quarter of positive comps. This was on top of a strong year-ago comp of 9%, which makes the recent performance look even more impressive.
However, the stock is down 29% over the last year, stemming from concerns about tariffs and higher markdowns for some products, which has caused pressure on margins. Despite the positive comp performance, the second-quarter results were below management's expectations. But these are short-term problems that should self-correct in due course. Long-term investors should see a lot to like here.
AEO continues to see its denim and Aerie businesses perform very well. Denim has been a huge driver of the bottoms category for the last few years, in which jeans sales make up about a quarter of the company's total sales. Management doesn't see the momentum slowing down. In fact, it sees another record quarter coming for the denim business as the company struggles to keep up with demand.
American Eagle is looking to expand Aerie in new markets, and it continues to take market share from L Brands' Victoria's Secret. The Aerie brand made up 16% of total sales in fiscal 2018, and it's a fast-growing business. In the most recent quarter, Aerie comp sales surged 16% year over year -- the 19th consecutive quarter of double-digit comp growth for the brand.
Analysts expect total sales to increase by 7.2% in fiscal 2020, with adjusted earnings expected to improve by 8.1%. The company's consistent comp sales growth and forward growth assumptions make the stock's forward P/E of 10.3 a bargain. If that's not enough, the stock also pays a generous dividend yield of 3.32%.
No one knows where the consumer goods markets will be a year from now, but Mohawk Industries and American Eagle Outfitters are leading brands in their respective spaces and offer big upside potential from current price levels.
