This Company Is Built to Last

The real estate crash has claimed no shortage of victims, especially in the building materials sector. Wallboard producer and Berkshire Hathaway stock holding USG (NYSE: USG) is down nearly 90% from its peak. The even less fortunate have found themselves before a Chapter 11 bankruptcy judge. If you produced building materials going into this recession, then the combination of shrinking demand, overcapacity, and commodity-like competition has surely affected your results.

Yet given the overarching conditions, some material manufacturers have performed quite admirably. Flooring company Mohawk Industries (NYSE: MHK) is just one example. Although its second-quarter report revealed flat quarterly sales of $1.4 billion, its operating income still rose 20%, and free cash flow totaled $111 million for the quarter. In fact, despite a devastating recession, Mohawk has managed itself remarkably well.

Mohawk Industries summary results

Source: Company filings and presentations. Non-percentage numbers in millions.

Even with last year's sales down 32% from their peak, Mohawk's margins have remained positive. This year, they're rebounding sharply from their lows, as the company continues to raise prices and cut costs. As fast as the macro environment is changing, Mohawk is adapting to it.

The number 10
Back when I was at UC Berkeley, I would spend hours in the microfilm library looking up old annual reports. I mean old. And when I got to Mohawk, I learned quickly to value its consistent profitability. For as long as I dared look, I saw a history of operating margins hovering near 10%, almost regardless of the greater economic environment. It was so remarkable that I just had to know: What made Mohawk's earnings so much more stable than its sector peers?

I can point to three key reasons today:

1. Market share. Mohawk controls a large percentage of the U.S. flooring business. In 2009, it sold 23% of the market, while Shaw Industries, a Berkshire Hathaway (NYSE: BRK-B) subsidiary, sold 22%. The next closest competitor managed only 7%.
2. Vertical integration. Mohawk controls all aspects of operations -- from raw materials, production, and distribution, all the way down to advertising and support for its retail store clients. That allows the company to manage better through the market cycles.
3. Customer power. Mohawk serves more than 28,000 clients. Surprisingly, major retailers like Home Depot (NYSE: HD) are not their primary focus, nor are builders such as Toll Brothers (NYSE: TOL). That's a good thing, because big customers like that flex a lot of muscle to bring down prices. Mohawk transacts 65% of its business with smaller specialty stores, many of which lack the majors' purchasing power.  

A tale of two companies
When I compared Mohawk to USG, they looked remarkably similar on many of these same marks -- at least at first glance:

Source: Company filings and presentations.

They were both large, integrated companies serving the same volatile real estate sector. So why has one maintained profitability throughout the recession, while the other has reported 11 straight quarterly losses?

There are small but noteworthy differences. Mohawk controls more of the operational process than USG, which allows it to squeeze out more savings in costs. Mohawk's customers are more attached to the company because it helps them with advertising, service and support. And its small, fragmented customer base has much less power to bargain on price. Throw in a very large market share, and you've got a recipe for consistent operating profitability compared to your industry peers.

As for USG, it doesn't quite have those same three competitive advantages. Judging by its recent share performance, it  really could have used them.

For related Foolishness:

• Three Reasons to Buy USG Today
• Does Bill Miller Think Home Depot Is Attractive?
• Show Me The Money, Lowe's