Mohawk Industries, Inc. (NYSE:MHK) Q4 2022 Earnings Call Transcript

Mohawk Industries, Inc. (NYSE:MHK) Q4 2022 Earnings Call Transcript February 10, 2023

Operator: Good day, and welcome to the Mohawk Industries Inc. Fourth Quarter 2022 Earnings Call. Please note this event is being recorded. I would now like to turn the conference over to James Brunk. Please go ahead.

James Brunk: Thank you, Jason. Good morning, everyone, and welcome to Mohawk Industries’ Quarterly Investor Call. Joining me on today’s call are Jeff Lorberbaum, Chairman and Chief Executive Officer; and Chris Wellborn, President and Chief Operating Officer. Today, we’ll update you on the company’s fourth quarter and full year performance and provide guidance for the first quarter of 2023. I’d like to remind everyone that our press release and statements that we make during this call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, which are subject to various risks and uncertainties, including, but not limited to, those set forth in our press release and our periodic filings with the Securities and Exchange Commission.

This call may include discussion of non-GAAP numbers. For a reconciliation of any non-GAAP to GAAP amounts, please refer to our Form 8-K and press release in the Investors section of our website. I’ll now turn over the call to Jeff for his opening remarks. Jeff?

Jeff Lorberbaum: Thank you, Jim. For the full year of 2022, Mohawk’s net sales were $11.7 billion, up approximately 4.8% as reported or 8.8% on a constant basis. And our adjusted EPS for the year was $12.85. The flooring industry entered 2022 with momentum from strong housing markets supported by record home sales, low interest rates and rising household formations. High home equity levels, shifts to larger homes and the desire to customize living spaces during the pandemic were driving remodeling investments. As the year progressed, the U.S. housing market declined under pressure from rising interest rates and inflation. In Europe, energy and overall inflation escalated and consumers reduced discretionary spending to pay for essentials.

In the first half of the year, the company implemented pricing actions and production that offset the inflation we incurred. With reduced home sales and remodeling in the second half of the year, our Flooring volumes decreased. Our pricing did not cover material and energy inflation. Throughout the year, commercial and new construction and remodeling activity outperformed residential. Even with the housing industry slowing during the second half of the year, we concluded 2022 with a strong balance sheet, low net debt leverage of 1.3 times EBITDA and available liquidity of approximately $1.8 billion to manage the current environment and optimize our long-term results. We acquired five bolt-on businesses during the year that extend the scope of our product offering and our distribution.

These include sheet vinyl, mezzanine flooring and wood veneer plant in Europe, a nonwoven flooring manufacturer and a flooring accessories company in the U.S. When we complete the integration of these acquisitions, we will expand their sales opportunities, enhance their operations and improve their efficiencies. We’ve just acquired Elizabeth in Brazil and are awaiting regulatory approval to close Vitromex in Mexico, Both of which will almost double our local market positions in ceramic, expand our customer base and product offering and improve our manufacturing capabilities. The teams are preparing to integrate the businesses, which will create significant sales and operational synergies. Turning to the fourth quarter results. Mohawk net sales were $2.7 billion, down 4% as reported or approximately 1.3% on a constant basis, and our adjusted EPS was $1.32.

Our revenues were driven by price increases and strength in commercial channel. Our sales across all our businesses were slower than we expected in the quarter as Residential sales contracted with rising interest rates, declining home sales and lower consumer confidence. As a consequence, our customers lowered their inventory levels and consumers reduced their spending for renovation. Unlike other products, Flooring does not require immediate replacement. So purchases can be deferred more than other durable goods. Commercial sales continued stronger than residential in the quarter, benefiting from ongoing remodeling and new construction projects. In the quarter, our Global Ceramic segment outperformed the others due to a higher level of commercial and new construction sales.

Our Flooring Rest of the World segment softened as higher inflation and energy costs reduced demand in Europe. Our Flooring North America segment sales declined with lower residential activity and a reduction in customer inventory levels. The combination of weakening sales, plant shutdowns and the consumption of higher cost inventory decreased the segment’s performance for the quarter. In response, we reduced production rates and lowered our inventory, which increased unabsorbed overhead expenses. We curtailed spending across the enterprise, though inflation offset many of our initiatives. In both Flooring North America as well as Flooring Rest of the World, we’re taking restructuring actions in specific areas to align our operations with the present market conditions.

During the quarter, energy and material costs around the world began to decline which should positively affect our future results. While we’re managing the present economic cycle, we’re operating with a long-term perspective and expanding capacities in areas where we have the greatest growth potential when markets rebound. These include LVT, laminate, quartz countertops, porcelain slabs and insulation. We have reduced our planned capital spending until we see greater certainty in our markets around the world. We recently announced an agreement to resolve the securities class action lawsuit filed in January 2020. Though we believe the case is without merit, further litigation would be burdensome and expensive. We reached a settlement of $60 million, a significant portion of which will be covered by insurance and is subject to court approval.

We also settled a dispute with the Belgian Tax Authority regarding royalty income. Though we believe our position is correct, we settled the $187 million assessment for EUR3 million. I’ll turn the call over to Jim for a review of our fourth quarter financial performance.

James Brunk: Thank you, Jeff. Sales for the quarter were just under $2.7 billion. That’s a 4% decrease as reported or 1.3% on a constant basis. Favorable price/mix in the quarter was offset by reduced volume and unfavorable FX. The decrease was primarily driven by weakness In the U.S. as residential markets slowed more than expected in the quarter. Gross margin, as reported, was 20.9% and excluding one-time items, was 22.4% versus 26.8% in the prior year. The year-over-year decrease was primarily driven by higher inflation of $263 million, offset by stronger price/mix of $269 million and productivity of $16 million. The fourth quarter margin was further negatively impacted by a weaker volume of $95 million, temporary plant shutdowns of $69 million and FX headwinds of $12 million.

SG&A as reported was 18.6% of sales. And excluding one-time items was 17.9%, inline with the prior year. On dollar basis, the favorable impact of FX of $12 million and volume of $3 million was partially offset by price/mix of $6 million and inflation of $3 million. Operating margin as reported was 2.3% for the quarter. Restructuring and one-time charges, $58 million, including initiatives in Flooring North America and Flooring Rest of the World and our disclosed litigation settlements. The restructuring charges combined the initiatives announced in Q2 and a new project in Flooring Rest of the World to better align our LVT assets with market conditions. Operating margin, excluding charges, was 4.5%, and the year-over-year decline in operating income was primarily driven by higher inflation of $266 million, offset by price/mix of $263 million, productivity of $15 million, lower start-up and other items of $8 million, although these were not enough to counter the weaker volume of $92 million and increasing temporary plant shutdowns of $69 million.

Interest expense for the quarter was $15 million, and other income — other expense was a $10 million expense due to unfavorable impact of transactional FX. In the fourth quarter, our non-GAAP tax rate was 12.6% versus 18.9% in the prior year. We are forecasting the full year 2023 tax rate to be between 21% and 22% with some quarterly variations. Earnings per share, as reported, was $0.52 and excluding charges, was $1.32. Turning to the segments. Global Ceramics had sales of $988 million, that’s a 4% increase as reported and 5% on a constant basis. Actions to drive favorable price and mix across the segment and improved year-over-year volume in the U.S. offset weakening unit volumes in other geographies. Operating income, excluding charges, was $70 million, which is a 16.7% increase versus prior year and operating margin at 7.1% improved 70 basis points due to improved price/mix of $111 million, productivity gains of $17 million and favorable FX and other items of $8 million, offsetting the increase in inflation of $85 million, lower volume of $28 million and related increased temporary plant shutdowns of $14 million.

Flooring North America had sales of $946 million. That’s a 6.8% decrease versus prior year as weaker volumes was only partially offset by favorable price/mix. The volume decrease was primarily a result of declines in residential channels and customers lowering inventory levels with consumers deferring discretionary spending. On an adjusted basis, Flooring North America’s operating margin was approximately breakeven. The year-over-year decline in profitability was driven by weakening volume of $32 million, Temporary plant shutdowns of $33 million, and the impact of higher cost inventory and other inflation flowing through the P&L of $109 million, only being partially offset by price/mix of $71 million and productivity of $8 million. We expect many of these issues to carryover to Q1 then in Q2 with seasonally stronger sales, lower costs and increased production levels, we should see a solid improvement in profitability.

And finally, Flooring Rest of the World had sales of $717 million. That’s a 9.9% decrease as reported and 2% on a constant basis. Installation products continued with strong growth in the quarter, but it was not enough to compensate for declines seen in the flooring categories, primarily laminate and LVT as inflation resulted in consumers reducing discretionary spending and in turn, customers lowering inventory levels. Operating margin, excluding charges, was 7.7% for the quarter. Operating income declined versus prior year. It was a result of the decrease in volumes of $32 million, temporary plant shutdowns of $22 million, which contributed to lower productivity of $10 million and increases in inflation of $79 million, only partially offset by price/mix actions of $81 million for the quarter.

With the business concentrated in residential channels, we expect a number of these issues to impact Q1, which results improving as we move through the year as lower energy and material costs should drive higher consumer spending. Corporate and eliminations was $6 million in Q4 and $37 million for the full year. Moving to the balance sheet. The company generated free cash flow of $91 million in the fourth quarter and over $165 million in the second half of 2022. Receivables for the quarter ended at $1.9 billion with the DSO at 60 days versus 56 days in the prior year, due in part to customer and channel mix. Inventories ended at just under $2.8 billion or a 17% increase versus prior year, but declined 4% versus the third quarter. The year-over-year growth in inventory was primarily due to a spike in inflation.

And sequentially, the decrease is primarily due to lowering of production levels to better align with demand. Inventory days ended at 138 days for the current year versus 131 in the third quarter. Property, plant and equipment ended at just shy of $4.7 billion and capital for the quarter was $151 million versus D&A of $159 million. For the full year, CapEx ended at $581 million and D&A of $595 million. Our current view for 2023 is a forecast of $560 million for CapEx and D&A of $592 million, but we will adjust with the changing environment. And finally, the company maintains a strong overall balance sheet with gross debt of $2.8 billion and leverage at 1.3 times adjusted EBITDA. This strength gives us the flexibility to manage through the challenging environment.

And with that, I’ll turn it over to Chris.

Christopher Wellborn: Thank you, Jim. The Global Ceramic segment increased sales and earnings with a higher mix of new residential construction and commercial sales than our overall business. Residential ceramic sales in all geographies are slowing and operating margins are contracting due to lower volumes and manufacturing shutdowns. The cost of energy and transportation are declining, which will benefit our margins as these costs flow through our inventory. In the U.S., Ceramic sales and volume both increased as we benefited from our premium product offering, price increases and growing countertop business. Our collections with larger sizes and unique finishes, combined with specialized structures and shapes are enhancing our sales and mix.

We’re increasing our sales efforts in growing categories, including health care, hospitality and fitness as well as multifamily and build-for-rent homes. Cost inflation increased as higher energy and transportation expenses from prior periods were incurred. We are optimizing material supply chains and reengineering formulations to improve our costs. We reduced our inventories during the quarter by lowering production and enhancing our import strategies. We are reducing discretionary spending and limiting capital investments. To support additional growth in our quartz countertop sales, we are adding manufacturing capacity by the end of this year. Our countertop mix continues to improve as we expand our premium collections featuring our advanced painting technology.

Photo by Thanos Pal on Unsplash

Our Ceramic business in Europe remains under pressure with slowing demand, customer inventory reductions and inflation. Our cost in the quarter were impacted by peak energy prices in the third quarter and reductions in plant volumes from temporary shutdowns. We are receiving energy subsidies in Italy, but we remain disadvantaged to some competitors who have long-term energy contracts. Natural gas prices have declined substantially, though disruptions could impact future costs. As Ceramic sales slow, the market is becoming more competitive. We are introducing new technologies to enhance surface textures, expand design capabilities and improve our costs. We are completing the expansion of our large porcelain slabs to support continued growth and enhance our styling.

We have successfully reformulated our body composition to use alternative materials. Sales in both Mexico and Brazil decelerated in the quarter as inflation and increasing interest rates reduced residential demand. We anticipate continued near-term weakness and have reduced production levels in both countries. To cover inflation, we are managing mix and pricing. Natural gas prices in the regions are declining in line with the worldwide market and will lower cost as it flows through inventory. We have completed the acquisition of Elizabeth in Brazil and are awaiting regulatory approval to close Vitromex in Mexico. These acquisitions will position us as top producer in two of the world’s largest ceramic markets. We anticipate significant synergies in all aspects of the businesses, which will enhance our sales and margins.

We should be well positioned to leverage our combined strengths when the markets emerge from this downturn. During the fourth quarter, our Flooring Rest of World segment was impacted by high inflation in energy prices and consumers reduced investments in Home Improvement. This caused a decline in Residential sales, which comprise a majority of the segment’s business. As consumer spending slowed, our customers further reduced their inventory levels, which lowered market demand even more. In response, we implemented temporary plant shutdowns and reduced our inventory levels, compressing our margins. Natural gas prices in Europe peaked at an unprecedented level in the third quarter, raising our material and production costs. Our pricing and mix did not fully cover inflation, which remains a headwind.

We remain focused on optimizing volume with selective promotions as well as controlling costs until the business improves. To enhance our competitive position, we are increasing our supply chain from outside the European Union. We have initiated additional restructuring actions to align with current conditions. Since the beginning of 2023, gas prices have declined substantially and material costs should follow. Assuming this trend holds, Europe should see lower overall inflation with higher wages, consumer spending should increase. During the quarter, all of our European Flooring categories experienced significant volume declines with many residential remodeling projects being postponed as inflation eroded consumer discretionary spending. Our product/mix was impacted as homeowners purchased lower-priced flooring to maintain their budgets.

We are launching new product collections and expanding promotional activities to improve our sales. Higher cost inventory will compress our margins until it flows through our costs. Our sheet vinyl sales outperformed our other flooring categories as consumers chose lower-priced alternatives. We are improving the small polish sheet vinyl plant we acquired in the third quarter by increasing its output, reducing its cost and expanding its distribution. We are expanding our rigid LVT offering as it takes some share from flexible. We are increasing our existing operations and improving our formulation to lower our costs. We’re adding new rigid production that make smaller runs with additional patented features. We will phase out of the residential-flexible LVT products and will close the supporting production.

The cost of this new restructuring initiative is approximately $45 million with a cash cost of approximately $7.5 million, resulting in annualized cost savings of $15 million and significantly increased sales. Our Insulation business is growing as conserving energy has become a higher priority and building requirements have increased. We selectively increased pricing to cover higher material costs, and we lowered production in the fourth quarter to reduce inventory levels. We are growing our sales and distribution in the U.K. as we start up our new insulation plan. Our Panels business has faced the same pressures as our other categories with softening demand and rising material prices. During the quarter, our customers continued to reduce their inventory levels, further impacting our sales.

Anticipating higher winter wood and energy costs, we maintained our inventory levels going into the first quarter. Our investments in green energy have benefited our performance by reducing our reliance on higher cost gas and electricity. The integration of our recent mezzanine acquisition in Germany is progressing as planned. We are defining best practices and utilizing our own manufacturing to replace source boards. Our business in Australia and New Zealand are slowing with the local economies as inflation and mortgage rates are impacting foreign sales. We are taking actions to align our cost and inventory levels with the expected volume decline. We have announced additional price increases and are initiating selective promotions to maximize our sales.

We are updating our product offering and enhancing our merchandising to capture greater market share. As in other categories, commercial sales are stronger than residential and we are increasing our participation in specified projects. For the quarter, Flooring North America sales decreased faster than anticipated, primarily due to declines in residential channels, rug and customer inventory reductions. With inflation and interest rates at high levels, many consumers defer discretionary spending or traded down to lower cost products. Earnings in the segment were compressed due to lower sales, consumption of higher-cost materials, reduced inventory levels and temporary plant shutdowns. Our hard surface products outperformed soft and the commercial sector remains stronger than residential with hospitality showing the most growth.

In response to slower market conditions, we are completing our restructuring actions, deferring capital projects and reducing discretionary spending. During 2022, we reduced our costs through process enhancements and rationalization of less efficient facilities while absorbing historically high inflation. We continue to adjust our strategies to manage the near-term market conditions, reductions in energy and materials should become a tailwind in the second quarter. Our commercial business remains solid as remodeling and new construction projects continue. We maintained strong margins in the quarter with pricing and mix offsetting inflation. Our flexible LVT products are a preferred alternative that provides versatile styling with easy installation.

The combination of our carpet tile and LVT collections enables the customization of commercial spaces with unique designs. Our integration of a small flooring accessories acquisition is proceeding well. The company produces rubber baseboards and stair treads used in commercial installations and broadens our current flooring accessory business. In the fourth quarter, sales of residential soft services declined more than other categories, sales weakened as retailers reduced inventory with declining consumer sentiment and home sales. The multifamily channel was the strongest performer, and we are realigning resources focused more on this sector. As demand dropped in the quarter, we increased temporary shutdowns, which resulted in higher, unabsorbed costs.

We have significantly lowered inventories in the fourth quarter and are reducing costs by eliminating less efficient manufacturing, enhancing productivity and adjusting production to demand. Participation in our recent flooring roadshows was at a record level with leading retailers expressing optimism about the year ahead. Our rug sales were lower as national retailers continue to adjust inventories with reduced consumer spending. We are restructuring our rug operations to lower cost and align production with demand. The integration of our nonwoven rug and carpet acquisition is progressing well and provides new opportunities with our existing customers. Our resilient sales grew in the quarter as we leveraged our WetProtect and antimicrobial technologies to differentiate our collections.

We offset inflation through pricing and mix, though increased plant shutdowns resulted in higher unabsorbed costs and lower margins. We are introducing new collections to expand our offering while eliminating less productive SKUs. Our sheet vinyl sales were higher as consumers pursued budget friendly flooring options and the multifamily channel strengthened. The first phase of our new West Coast LVT plant is operating at expected levels. We are preparing new technologies that will improve our cost and add differentiated features. We will install additional production lines and train personnel throughout this year. Our Premium Laminate sales were impacted by slowing retail traffic and customer inventory adjustment. Our laminate is gaining acceptance as an alternative waterproof product in all channels.

During the quarter, we offset inflation through pricing and mix, though our margins were impacted by lower absorption from temporary shutdowns as we reduced our inventory. We are beginning to see reductions in material inflation, which should help us recover our costs. Our new manufacturing line, which began last year, is operating at planned levels and will deliver our next generation of laminate features. With its industry-leading design and performance, our laminate business is in an excellent position to capitalize on the growing waterproof flooring category. Now I’ll return the call to Jeff for his closing remarks.

Jeff Lorberbaum: Thank you, Chris. The flooring industry is slowing due to higher interest rates, sustained inflation and low consumer confidence. The visibility of the depth and duration of this cycle is limited and conditions differ across the world. Mohawk has a strong record of managing these downturns by proactively executing the necessary actions. We’re adjusting our business for the current conditions by reducing production level, inventory, cost structures and capital expenditures. We’re implementing restructuring actions in both Flooring North America and Flooring Rest of the World to streamline operations, reduce SG&A and rationalize higher-cost assets. In the first quarter, we anticipate more pressure on pricing and mix due to the low industry volumes.

Our inventory costs remain elevated in most products due to the higher material and energy that we incurred in earlier periods. Additionally, we will not raise production as normal in the first quarter to prepare for future demand, increasing our unabsorbed costs. Our cost of energy have fallen and should benefit our global margins as our inventory turn. Our second quarter results should have sequentially stronger improvement with seasonally higher sales, increased production and lower material costs. Significantly lower cost of energy in Europe should enhance consumer spending, discretionary purchases and flooring demand. We’re refocusing our sales teams on the channels that are performing the best in the current environment. We’re introducing new innovative collections and merchandising as well as targeted promotions to improve sales.

Given these factors, we anticipate our first quarter EPS to be between $1.24 and $1.34, excluding restructuring and other charges. Around the world, the long-term demand for housing will require significant investments in new construction and remodeling. Mohawk is uniquely positioned with a comprehensive array of innovative products, industry-leading distribution and strength in all sales channels. We’re implementing structural changes to navigate the industry’s challenges while optimizing our future results. We anticipate coming out of this downturn in a stronger position as we benefit from our bolt-on acquisitions, enhanced market positions in Brazil and Mexico and strategic expansion of our high-growth product categories. Our balance sheet is well positioned to manage the current cycle and to drive future growth and profitability.

We’ll now be glad to take your questions.

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Q&A Session

Operator: Our first question comes from Phil Ng from Jefferies. Please go ahead.

Phil Ng: Jeff, a quick question. In terms of your price/cost despite demand is actually weaker last year, you managed price/cost actually really well, but you did highlight you’re seeing a little more competition on pricing. But raws are falling as well and kind of flowed through a little more in 2Q. So how should we think about that price/cost equation looking in the current backdrop in 2023 and how that progresses through the year? Any pockets where we’re seeing a little more pricing competition in particular you want to flag?

Jeff Lorberbaum: So the energy and material costs are moving. The low amount of volume we’re seeing across the world, we’re seeing additional promotions and pieces. So far, it’s been controlled pieces across most of the marketplaces, and so we think that’s going to continue. In our first quarter, we said we expect more pressure on pricing and mix at the lowest part of the year. And then we think that we’re going to see some balancing of the cost and pricing better in the second quarter as the costs flow through inventory. We’ll have to see how the rest of the year goes. We’re going to have to continue to manage it and change as required.

James Brunk: And Phil, from a year-over-year perspective, we would expect that you still have the higher cost inventory layers that are going to come off in the first quarter. And with that renewed pressure on price and mix, I would expect the gap between price/mix and inflation to be greater in the first quarter than the fourth quarter, and that was included in our guidance.

Phil Ng: Got you. So it feels like your margins are going to bottom out in 1Q and get progressively better throughout the year. That’s really good color. And then help us think through productivity. You talked about you’re rolling out some restructuring efforts in North America and the Rest of World. But demand is a little weaker and you’re seeing more start-up costs with new capacity coming on. So give us a little color how to think about productivity for this year? And then how is the acceptance of some of these new capacity that’s coming on? I think you’re bringing on laminate, you got some LVT coming on as well. How’s the product acceptance so far?

Jeff Lorberbaum: The productivity piece is driven by multiple pieces as we slowdown — some of it we isolate — some of the costs we isolate into temporary shutdowns, but we don’t catch them all. So the productivity ends up a catch-all for all of those things that change as they go through. We think due to the volume — the volume differences between last year and this year, the productivity is going to be less in almost all the businesses. If you remember last year, we were coming out of COVID in the first half, we were building inventories and running most of the businesses at very high levels. This year, we’re going to be running at much lower levels and that’s what’s going to show up in the productivity decrease as we go through.