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Morningstar | Mohawk's Stock Unravels Following Third Consecutive Quarter of Underperformance; FVE to $169

Shares of Mohawk Industries closed the Oct. 26 trading down 24% after the no-moat-rated flooring manufacturer reported abysmal third-quarter results. It's been a tough year for Mohawk. The company has grappled with less-than-stellar top line growth and mounting input cost pressure. Mohawk had been a Wall Street darling with an impressive track record of beating earnings estimates. Based on Capital IQ data, between first-quarter 2012 and first-quarter 2018, Mohawk beat the consensus EPS estimate 23 out of 25 quarters. However, after stumbling the last two quarters, Mohawk has paid dearly--its stock is down 58% year to date. We still have some concerns about Mohawk's recent splurge on capital expenditures and acquisitions, and Mohawk's recent struggle to maintain a favorable price-cost spread supports our view that the firm doesn't have sustainable pricing power. However, the stock now appears to be oversold as it's trading at about 9 times our 2019 adjusted EPS estimate versus it's long-term forward P/E of about 17 times.

Uninspiring organic revenue growth and sliding margins have been a theme for Mohawk this year, and these trends continued during the third-quarter. Organic revenue, which adjusts for currency fluctuations and excludes acquired revenue, grew less than 2% year over year. GAAP operating margin of 11.3% contracted 420 basis points year over year and 140 basis points sequentially. Management noted that sales growth across all three segments missed internal expectations and price realization was weaker than expected amid stronger-than-expected input cost inflation.

After three consecutive quarters of weak financial performance, we tempered our long-term profitability assumptions. Specifically, we're now projecting a 12% midcycle operating margin, down from 13% previously. Our lowered profitably assumptions caused our fair value estimate to decline 13% to $169 per share.

For the sake of comparison, Mohawk's operating margins in 2015, 2016, and 2017 were 13%, 14.5%, and 14.9%, respectively. We're forecasting that the firm's operating margin will slump to 11.5% in 2018, but we think there's room for margin improvement going forward.

Mohawk has been a consistent free cash flow generator, but the firm has never paid a dividend or repurchased a meaningful amount of stock. Instead, the firm has plowed its cash into internal projects and acquisitions, which in our view, have driven growth but have also constrained returns on invested capital – another reason we don't award Mohawk an economic moat. Should a global recession occur in the next few years, Mohawk's $1.5 billion spend on capital projects ($780 million) and acquisitions ($700 million after including the recently announced Eliane acquisition) in 2018 will seem ill-timed. However, now that Mohawk's stock has sunk to prices last seen in early 2013, it appears that management has become open to repurchasing shares. Indeed, the company announced that the board of directors approved a $500 million share repurchase plan. We are in favor of share repurchases when a company's stock trades below its intrinsic value.