I'm very familiar with Mohawk, having studied it a couple of months ago when the stock was in the mid-$70s; I read the financials, studied the industry, and talked to the CFO. My first hint that carpet was a great business was when I discovered that Berkshire Hathaway
But wait a minute. Isn't carpet and floor covering a commodity business? Can companies like Mohawk really have economic moats?
The U.S., despite its labor cost disadvantage, is actually the carpet capital of the world. It turns out that carpet manufacturing is a highly automated process, making for a low labor cost component. Not only that, but the carpet itself is heavy and relatively bulky, so transportation costs further insulate the U.S. from foreign competition.
Economies of scale are key in the floor covering industry. Floor covering retailers don't carry much inventory because carpets take up a lot of space. Instead of clogging up precious backroom and floor space with carpet inventory, retailers prefer something closer to a just-in-time system, where manufacturers are in a near-constant state of shipping to their customers. Only very large manufacturers have the economies of scale to create an efficient national distribution system. Mohawk alone has more than 1,000 trucks shipping to retailers like Lowe's
There's a lot more to it, but that's the nutshell explanation for the greatness of the carpet and floor covering business. Lately, Mohawk's shares have started to recover as fears over the residential housing downturn have cooled. Furthermore, broadloom carpet, Mohawk's main product, has high exposure to the price of oil, a key raw material. These factors helped keep Mohawk shares down, but the latest quarter demonstrates that the company's diversification can help it withstand the onslaught.
Mohawk made the key decision to diversify beyond carpet through acquisitions, and it now has leading market share positions in tile, laminate, and ceramic floor covering. While the broadloom carpet market grows at roughly the rate of inflation and has strong exposure to the residential housing market, the new flooring areas in which Mohawk has moved are growing much faster and have higher operating margins.
The benefits of this diversification were apparent in the latest quarter. For the fourth quarter, the carpet segment's sales were down 6% to $1.1 billion, and operating margins were down to 10.1%, versus 11% in the prior-year period. The tile and laminate segments, however, increased 4% and 24% on a foreign-exchange-neutral basis. Furthermore, despite the fact that carpet industry units for the fourth quarter were down 10%, Mohawk managed to increase sales by 5% to $1.9 billion, although excluding its recent acquisitions, sales dropped by 4%. Mohawk management remarked that all floor covering categories continue to be challenged by the residential housing slump, but that the company's results have held up extremely well. Thanks to its mix of higher-margin products, Mohawk's year-over-year operating margin improved 45 basis points to 10.6%.
Most importantly, cash flow generation has been off the scale. For the year, operating cash flow and EBITDA surged to nearly $782 million and $1.1 billion, respectively. Subtracting out $166 million of capital expenditures from the operating cash flow leaves us with $616 million in free cash flow (FCF) -- giving the company a price-to-FCF ratio of 10, or a 10% FCF yield. This is way too cheap for a company of Mohawk's quality.
Furthermore, the company used the FCF to pay down $600 million of debt, helping to shore up the balance sheet and cut its long-term liabilities to $2.9 billion. Thus, Mohawk's enterprise value ($6.3 billion market cap + $2.8 billion net debt)-to-EBITDA ($1.1 billion) multiple currently stands at about 8. This isn't too far from the multiple of 7 that I estimate Berkshire paid for Shaw, and Mohawk has much better exposure to the faster-growing and higher-margin tile, laminate, and ceramic segments than Shaw did. Value investors should take note.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.