Through continuing acquisitions and under the superb leadership of Jeffrey Lorberbaum (who owns 14% of equity capital), Mohawk grew from a mundane American carpet maker to becoming the world’s largest flooring company, with leading positions in carpets, rugs, ceramic tiles, laminates, wood, stone and vinyl flooring.
Scale provides a massive competitive advantage, for low prices and geographical coverage are decisive factors to gain and retain market share. In North America, where Mohawk operates as a near duopoly with Berkshire Hathaway-owned Shaw Industries, consolidation also eliminated rampant price-cutting competition.
In addition, vertical integration enables the company to control part of its supply and distribution costs, while its superior balance sheet gives it both the resources to expand and staying power in an otherwise cyclical — because housing-related — industry.
Mohawk was famously discussed by Bruce Berkowitz in the sixth edition of Security Analysis as a prime example of a company which reported profits understated its true earning power — a.k.a free cash-flow. Back then, Berkowitz argued that economies of scale would allow for reduced capital spending and lower working capital requirements.
But management chose a different path and the precise opposite happened. Capital intensity increased dramatically over the past decade, as investments to introduce new products and enter new markets overseas — both via greenfield development and acquisitions — have been substantial ($8.4bn in total between 2010 and 2018), consuming all cash generated by operations.
This enabled Mohawk to double its revenue (from $5.3bn in 2010 to $10bn in 2018), and triple both its operating earnings (from $314mil to $1.1bn) and cash-flows (from $480mil to $1.5bn). The track record is excellent — with unlevered returns on invested capital north of 80% in average — although it remains impossible to discern the net impact of investments from the uplift due to the recovery of housing markets.
Cash-flows dynamics are one peculiarity of this company — and of all distributors for that matter. In good years, as discussed above, growth — that is, investments in working capital, capital expenditures and acquisitions — consumes substantially all cash generated by operations. In bad years, however, releases of inventories and receivables free up large amounts of working capital, boosting free cash-flow in return.
In such situations, reported GAAP earnings may dramatically understate true profitability, thereby provoking a market inefficiency to be taken advantage of by contrarian, long-term oriented investors. If the past is any indication, GAAP earnings and free cash-flows tend to reconcile perfectly well in the end — but over the full cycle only.
Valuation-wise, punished by a market wary of a new downturn in housing, the stock abruptly declined from its heights of $270 to $130. At such price, Mohawk trades at roughly $10bn, or 11x its average net earnings over the past three years. In response, management promptly launched a large buyback program and repurchased for $274mil worth of shares at an average price of $120 per unit.
These features color Mohawk as a potentially attractive investment if indeed housing starts to suffer again, for the business is resilient, well-run, and insulated from competition of new entrants — at least in its domestic market. Note to self: revisit if share price falls below $100.