Housing Woes Have Pushed This Dominant Company into Value Territory

One of the reasons Microsoft (Nasdaq: MSFT) was such a great stock for so many years was that it was essentially a monopoly. And even the most inexperienced investor should know that a monopoly is one of the best investments one can make.

Two months after a judge declared Microsoft a monopoly, the company hit its all-time high… and has never come close to it again. That’s why the second best investment one can make is in a duopoly. There’s a lot less risk the Department of Justice will come calling, and investors can still reap most of the same benefits.

This brings us to the world’s largest flooring manufacturer, Mohawk Industries (NYSE: MHK), which controls roughly 23% of the domestic flooring market. Along with the second largest company, Shaw Industries, which controls 27% of the domestic market, it’s pretty clear that limited competition can do wonders for a company’s financial results.

Astute investors might ask why a company that deals in anything having to do with building materials would even be worth talking about, given the devastation to the housing sector. It’s a fair question, but this is why being a massive player in a fragmented industry works to a company’s benefit.

Mohawk has several advantages that smaller players do not. Besides having all the raw materials it needs, the company can produce virtually every kind of flooring, use its own sales and support force and have built an efficient, broad-ranging distribution network that smaller players simply can’t afford. The distribution network, in particular, means that the return the company sees on capital invested into that network is stronger and more consistent than a smaller manufacturer.

Mohawk’s greatest advantage may be that it sells almost two-thirds of its product to mom-and-pop flooring stores. This approach is preferable to selling to big box home improvement companies like Lowe’s (NYSE: LOW), because the big boys can wield their own market share with consumers to negotiate lower prices. Without such pricing power, mom-and-pops must pay more for Mohawk products. In addition, because of the de facto duopoly, those retailers don’t have a lot of other choices. Walk into your local carpet store and look around — you’ll find the majority of products are Mohawk.

Mohawk, however, doesn’t behave like a Mafia-run protection racket with this pricing power. The company backs it up by helping out with advertising, superior service and providing support for its 27,000 clients. If you are essentially forcing customers to buy from you, why not make them glad they are? Good relations mean that should some other competitor eventually appear on the market, customers will think twice about switching.

Financially, the company is on very solid ground. Whereas Shaw has lost money three years running, Mohawk has been profitable. It even broke even in 2008 and 2009, at the height of the housing nightmare. For the first half of this year, the company already shows $88 million in net income, following $54 million of profit in the second quarter of last year.

However, it’s the cash flow statement that shines. Even during the troublesome past two years, the company still cranked out $910 million in cash flow. Debt service of $127 million annually is easily covered, while margins run consistently at around 9%.

Some investors may still be concerned about the housing market. What if foreclosures continue to increase? It’s true that Mohawk can’t get away from the fact that its business’ DNA is wrapped around housing. However, Mohawk’s 10-K filing states that its long-term market is more dependent on remodeling than construction by a factor of two-to-one. And when foreclosed homes get snapped up by distressed real-estate investors, what do they do? Remodel it and either flip it or rent it out.

Action to Take –> Mohawk is a buy for long-term investors. The housing debacle has depressed earnings, but its fantastic distribution network and massive product line give it and Shaw the advantage over everyone else in the marketplace.

An expected earnings growth rebound of +60% this year and +30% next year, then +14% compound growth during the next three years puts earnings at $4.26 per share in 2015. That’s a +26% average annualized growth in the next five years in total. To be conservative, I’d assign the stock a lower-than-average multiple of 20, which puts fair value at twice today’s price.