New stock to study: Mohawk Industries MHK

Mohawk Industries is a producer and distributor of residential and commercial flooring including carpet, ceramic and porcelain tile, hardwood, laminate and home textiles including area rugs. They also distribute resilient (vinyl) and vinyl composition tile (VCT) flooring through a partnership with Congoleum.

Mohawk and Shaw (owned by Berkshire) are the 2 largest floor covering manufacturers in the world-- this represents a near duopoly: together they own 46% of market share.

MHK was founded 130 years ago. Its distribution system is much admired in the industry. It has over 30,000 regular customers (mostly specialty stores), none representing more than 5% of the total revenues. Market Cap approx. 2.5 B. Share price is down 53% from 52 week highs.

Bull Case:

• duopoly and global footprint
• boring business with a slow rate of change
• very easy business to understand
  
• Management is shareholder oriented and communicates very clearly in all reports
  
• high insider ownership 18% of the company's outstanding shares are owned by the CEO
• one director bought about $7 M worth of stock at $69/share in late Aug '08
• value gurus have large stakes: Berkowitz, Ruane Cunniff and Wallace Weitz
• meets criteria for Graham stock: P/E 4.1 P/B 0.5 Current Ratio > 2, 5y EPS Growth Rate > 3, EV/EBIDTA is only 5.
  
• generated 371 M of cash flow in the first 9 months of 2008, actively paid down 271 M of a total of 2 B of debt. D:E is 0.47 well below industry average of 0.61.
• no debt matures until 2011
  
• Q3 results distorted by a quirky accounting rule that forced the company to write down a large non-cash charge v.s. goodwill (1.2 B) and tax deferral charges (0.25 B) triggered by the rapid and steep decline in MHK's share price.
• 60% of revenue is derived from renovations and remodelling, not new builds.
• MHK has been able to raise prices recently despite lower input costs from the drop in petrochemical prices which should help boost margins in the intermediate term
• Gurufocus backtested business predictability index rates MHK's 10 year financials at 4.5/5 stars.
  

Bear Case:

• 13.5% of outstanding shares have been sold short. The short sellers are probably right-- the share price is going to drop even further
• there is a debt covenant on one of the LOCs that stipulates that the debt:equity ratio must stay below 0.6 or the company will be forced to liquidate assets at less than favourable terms
  
• nat gas/oil prices (2/3 of costs of goods sold) are likely to rise again with the economic recovery and impact margins adversely
  
• there is no end in site for the housing bubble implosion. There is at least 8 months of new home inventory to clear before builders start to significantly increase demand for MHK's products and its very possible that the slowdown could drag on longer than expected.
• no dividend despite great and predictable cash flows!

This company is definitely worth further study. It would clearly be a long term investment 18 months to 3 years+. It is fundamentally cheap now; however, it's clear that the share price has further to drop. I would be interested at <$30/share and I would buy in small increments over the next 18 months, watching the company's liquidity very carefully. Housing in NA and Europe will recover one day-- I'm not sure when. The stock will likely rocket up (if the company survives, that is) 6 months or so before the recovery is obvious just because that's how the market works. With these kind of investments you need to commit during the times of maximum uncertainty, unfortunately.