Flooring Industry Investment Report Focused on Vinyl

Stifel – LVT report and the impact on the flooring industry. This report is from September 2018. This does NOT constitute investment advice and it is not intended to be anything but a commentary on the workings of the American flooring industry. These are opinions that are not ours, but I read this and as it was dated, I felt it was ok to share at this time. I have only pulled portions out from the report… but it provides some great insights into the working of the industry. The 2019 and 2020 reports would be great to research if you wished to use any of this information to actually do investing… so again, do not use this for any purpose other than to learn the industry, the players (Factories and large American Retailers) , and understand that the changes that have occurred in the past 2.5 years have been so dramatic that investment firms are writing reports using words like ‘invasion of Luxury Vinyl Tile’.


To see the full report, visit this link https://stifel2.bluematrix.com/sellside/EmailDocViewer?encrypt=82b7726b-ceba-4157-a044-97203ed8b120&mime=pdf&co=Stifel&id=kemp@floorfocus.com&source=mail

In my opinion, any reference to LVT in this report also can stand for Vinyl flooring, SPC Vinyl Flooring, Waterproof vinyl flooring. The terms are changing over time and yes, LVT, WPC Vinyl and SPC Vinyl are all slightly different products … but the point is the same: Vinyl flooring and its various versions are taking over the North American flooring industry. It is the biggest change the industry has seen in decades.


Introduction (below are sections pulled directly from the Stifel September 2018 report):

LVT is a roughly $2.5 billion category representing about 10% of the wholesale market in the U.S.. Sales have grown at a 25-30% pace in recent years and show no signs of slowing. On the contrary, LVT growth could actually be expanding. This product category has represented the majority of domestic industry sales growth during the past two years and we believe the penetration rate could ultimately double in three- four years.

LVT is gaining market share for a number of reasons, which we discuss in more detail, but summarize briefly here:

1. Better visuals and textures providing a more realistic depiction of both wood and natural stone.

2. The products are typically waterproof, a benefit that’s easy to demonstrate and an advantage over the majority of other flooring types.

3. Fast and easy installation makes contractors much more likely to recommend these products given very tight labor markets. Product innovations have also made it easier for homeowners to take this on as a DIY project.

4. Attractive price points on an installed-cost basis compared to wood and especially ceramic tile.

The shift to LVT is clearly disruptive to the U.S. flooring industry and likely on-going for at least the next couple of years. The current and near term primary beneficiaries of the boom in LVT are those companies that import LVT from China (we assume no meaningful tariffs are assigned). Those companies that import heavily would include Shaw Industries (a Berkshire Hathaway company) and Metroflor, and many other private businesses, most of which are based in China. As we look at the domestic flooring manufacturers who are public, we don’t believe this shift benefits anyone currently for differing reasons that we outline in detail starting on page 16 in this note. The longer term outlook is more complex and nuanced.

Our lone Buy rating remains Mohawk.

ANY REFERENCE TO STOCK PRICE TARGETS ARE DATED! DO NOT FOLLOW THIS ADVICE - APRIL 2020 IS A VERY, VERY DIFFERENT ECONOMIC REALITY THAN SEPTEMBER 2018

Based on our research, the following companies are making some form of LVT in the U.S. currently (we go into more detail on each company below):

Armstrong

Mannington

Mohawk/IVC

Nox

Shaw/USFloors

Tarkett

Armstrong (AFI, Hold,$17.08)

For decades, Armstrong was the leading resilient flooring manufacturer in the U.S. Arguably, the explosion of LVT has been most harmful to Armstrong given its legacy of being a sheet vinyl, vinyl tile and VCT producer. The company did repurpose one of its sheet vinyl lines in Lancaster, PA, investing $45 million in capital to build a continuous production line of flexible LVT. While production began in 2016, the company spent most of that year ramping production efficiency and was likely not producing a significant amount of product domestically. This line was rated to produce 90 million square feet of capacity, or somewhere in the $135 million revenue range (assuming a wholesale ASP of $1.50/sq. foot) once fully operational and we believe the line produced approximately $50 million last year and will approach its full capacity in 2019 or later. Armstrong has discussed R&D plans to repurpose other production lines of both resilient flooring and wood flooring to make LVT, including rigid core LVT but this remains to be proven.

Mannington (Private)

The company is likely the fourth largest seller of resilient flooring in the U.S. but has a long history of making the traditional resilient products including sheet vinyl, tile vinyl and VCT which it actually sold to Armstrong in 2017. Mannington acquired Amtico in 2012. The company does manufacture flexible LVT out of its Madison, GA plant but it currently sources all of its rigid core LVT from off-shore. There is a plan to begin rigid core LVT production sometime in late 2018 but we don’t know the status of this investment.

Mohawk/IVC (MHK, Buy, $190.16)

Mohawk’s meaningful entry to into LVT came from the mid-2015 purchase of IVC, however IVC was well underway with plans to produce LVT before the acquisition. We summarize the evolution of IVC’s vinyl production and sourcing plans below:

2009- IVC begins sourcing LVT from China to sell in Europe 2010- IVC begins production of sheet vinyl in Dalton, GA facility

2012-2013- IVC begins production of LVT in Belgium to serve the European market and subsequently ceases sourcing from Chinese manufacturers. IVC also begins to sell LVT to the U.S. market.

2015- IVC’s sheet vinyl plant begins producing flexible LVT in the same year that Mohawk purchases IVC.

2017- Mohawk/IVC plans to add a second LVT line in Belgium to produce rigid core products by the end of 2017. At the beginning of 2017, the company also anticipated starting production of rigid LVT in the U.S. (having broken ground on this line in 2016), but by mid-year that had been shifted to being a 2018 event.

2018- Mohawk producing rigid LVT products in Belgium, which is reportedly two months ahead of pace of the U.S. facility. Mohawk is in the test phase of rigid production in the U.S. currently.

All in, Mohawk has stated publicly the objective of producing $1 billion in LVT world-wide and currently has capacity to produce $500 million. Each of the new rigid LVT lines (Belgium and U.S.) are planned to produce $250 million in annual sales capacity. We will review these details in our Mohawk comments.

NOX (Private)

This Korean-based manufacturer make the bulk of its LVT in Korea but did open a flexible LVT production line outside of Toledo Ohio in early 2016 with a $2 million investment and will follow that up with plans to install production in 2019 that would double capacity with the CEO quoted in a local publication as saying NOX “will probably be the biggest capacity LVT factory in the U.S. with the next two years’ investments.” Like many producers, the company is talking about making a rigid core product that it currently manufactures in Korean out of this facility.

Shaw/U.S Floors: (Private)

Founded as a carpet mill and still to this day, the largest carpet producer in the U.S., Shaw embraced sourcing and distributing vinyl flooring and LVT specifically before the bulk of its U.S. competition. Shaw invested heavily in inventory in the early innings and is estimated to be well above $1 billion in total resilient sales. The leader in resilient sales in the U.S. has repurposed an old area rug plant in Ringgold Georgia that currently produces an indeterminate amount of WPC LVT. Shaw is estimated to be selling well over $1 billion in total resilient flooring in the U.S. making it by far the largest player, but the bulk of its revenues are sourced overseas. In fact, five years ago, we believe Shaw was selling in the area of $200 million of resilient flooring and sourcing from IVC (now owned by Mohawk), Metrofloor, and LG. When Mohawk bought IVC in 2015, Shaw explored alternative sources for resilient flooring and subsequently, purchased USFloors in December of 2016 which is estimated to have added $400 million to its revenue stream at the time. USFloors was to our knowledge sourcing virtually all of its flooring from China but had developed the original WPC core LVT product it branded COREtec and had tremendous success selling into the U.S. marketplace as a first mover. We believe that USFloors was studying plans to build its first manufacturing capacity in the U.S. prior to the Shaw acquisition and the equipment that was on order was placed into the Ringgold plant. Shaw’s share of the total U.S. resilient market is an impressive 25% and likely growing as it has aligned itself largely as a sourced model. As SPC LVT floors have increased in popularity, the fact that all of that product is made in Asia has helped Shaw Industries grow at an above market clip.

Tarkett (Not Covered)

Tarkett is the fifth largest seller of resilient flooring in the U.S. and is a global business that is headquartered in France and publicly traded on the Euronext Paris. The company manufactures a portion of its flexible LVT needs from facilities in Florence, AL and announced in early 2018 a $60 million investment in two facilities there over the next three years. The company is also investing in production capacity in Europe.

Marketing Opportunity

Waterproof flooring and pet resistant flooring are two very hot trends in flooring. Carpet and its padding tend to hold water and pet stains. Wood fiber (laminate cores) and traditional woods (both engineered and solids) have traditionally been prone to water damage.

One of the reasons given for the popularity of LVT is its inherent waterproof characteristics as the product is comprised of limestone, PVC and plasticizers.

Laminate flooring producers are moving aggressively to market the water resistant or waterproof nature of their product. The most striking example of this was Mohawk’s January introduction of RevWood that was marketed as “Wood Without Compromise”. There are two things Mohawk is trying to convey with its marketing. First, that it should be considered as a wood alternative as consumers struggle to identify the visual differences between laminates, solid woods and engineered woods. Secondly, the product is marketed as waterproof. RevWood Plus uses rolled edges to create a watertight seal. Despite this claim, the warranty does not cover damage from water.

How Are The Public Companies Impacted by LVT?

Obviously the objective of this report is to help investors better understand the shifting dynamics of the overall flooring industry caused by LVT and how that will impact the various publicly traded companies. We summarize our thoughts for each of our companies under coverage below:

How Are The Public Companies Impacted by LVT?

Obviously the objective of this report is to help investors better understand the shifting dynamics of the overall flooring industry caused by LVT and how that will impact the various publicly traded companies. We summarize our thoughts for each of our companies under coverage below:

Manufacturers

Armstrong Flooring (AFI, Hold, $17.08)

Armstrong is likely a beneficiary over a longer period of time as the growth of LVT continues, although we believe in the near-term, the LVT impact is probably neutral/negative for Armstrong. As of 2017, LVT represents roughly 15% of consolidated sales having grown at a nearly 30% CAGR since 2015. The company has commented that LVT has been growing at a double digit pace so far in 2018. Armstrong’s focus on differentiating within the LVT market with the Pryzm and Diamond 10 products is aimed at both the residential and commercial markets with the objective of moving up in price and margin. The company is still committed to growing LVT production in the U.S. and management has stated that domestic production is accretive to margins compared to a sourced model.

While the LVT growth is helping, we note the overall resilient business has only grown slightly over a multi-year period as LVT is simply cannibalizing other product categories, specifically sheet vinyl in the residential end market and VCT in the commercial end market. Armstrong has historically been “heavily invested” in these legacy products from a production and sales standpoint and the cannibalization has been painful. In addition, laminate flooring, which is a small portion of the “resilient business” as reported, has been under pressure from the growth in LVT. The good news here is that Armstrong sources laminate so it has not pressured manufacturing fixed costs.

In the engineered wood flooring category, Armstrong still produces and sources engineered wood but the Chinese have significantly eroded the margins of the lower end price points of this product group and LVT has likely taken unit share on top of this. Armstrong has just shifted its strategy in the lower end price points of engineered wood floors to license its name with one of its primary sourced suppliers which will reduce revenue but add to profitability. Armstrong’s difficulty in the wood business is probably only somewhat related to the shift to LVT, but there are also other issues at play, including pricing pressure from imported engineered wood products, lumber inflation, and the company’s shift in the go-to-market strategy.

On the tariff front, we would tend to think Armstrong could benefit in the longer term from a higher tariff on imported products, although there would be near-term issues relating to what it sources (primarily engineered wood and SPC LVT products)/ For LVT, Armstrong is obviously invested in domestic production and we know that LVT lines are not optimized overnight. The flexible LVT line that was installed within an old sheet vinyl plant in Lancaster has been slowly coming up the curve in production. The line’s optimized capacity is rated at 90 mm sq ft and we would guess that it is running in the 40-50 mm sq ft range currently. If we assumed the revenue per square foot of this production was in the $1.50 range, it would imply $65-70 million of Armstrong’s $175 million of LVT sales were produced versus sourced. This is why we view the tariff issue as a mixed bag as we assume the majority of Armstrong’s LVT sales are coming from China currently and the company does not have the capability of producing SPC LVT which is growing in popularity.

Mohawk (MHK, Buy, $190.16)

Mohawk is a complex company that operates under a variety of brand names (IVC, Pergo, Unilin, Dal- Tile, and Marazzi just to name a few) in a variety of countries (U.S., Mexico, Europe, and Russia, among others) that has grown to be a dominate player in the U.S., where Mohawk has commanded a #1 market share position for a number of years and across the globe.

Investors are seemingly 100% focused on U.S. under-performance which we understand and will address in our comments here but we hasten to point out that fully 40% of Mohawk’s consolidated revenues on a pro-forma basis are outside of the U.S.(North American segment sales are not the equivalent of U.S. sales as this segment includes Canada and Mexico and excludes the U.S. sales of ceramic which are captured in the Ceramic segment). And these businesses in general are growing faster than the low single digit pace of the U.S.. Likewise, the capital spending dollars are not solely concentrated in the U.S. and some of the U.S. spending is on completely new products like quartz countertops. We think it is important to consider Mohawk’s global diversity and product diversity in the midst of the myopia around the explosive growth of LVT in the U.S..

Tariffs

Should tariffs be implemented in a meaningful way, Mohawk would clearly be a beneficiary longer term. This is a relative comment in the sense that Mohawk does import product from China and that portion of its business would clearly be impacted should a material tariff be implemented. Management has not commented on what percentage of its total revenues emanate from China as sourced product, but we believe that Mohawk has much less exposure than the competition, particularly in LVT. Clearly, if Mohawk can further develop its U.S. production capability in LVT it will further differentiate itself from the competition which sources the vast majority of its LVT. Other products like ceramic tile and engineered wood floors which are heavily imported from China would be impacted, indirectly benefitting Mohawk. There is a reason why Mohawk has specifically lobbied for the 25% tariff on engineered wood, vinyl flooring, ceramic tile, and laminate.

While Mohawk has not made many friends in the flooring industry with this position, it makes business sense. However, betting on meaningful tariffs is not a strategy and we assume that Mohawk is running its business as if it will see no meaningful tariffs in the long run.

Factors Impacting 2019 Earnings

While the focus of this report is obviously LVT and the impact of that category on MHK, we note this is still a minority of U.S. and consolidated sales. Approximately 40% of Mohawk’s pro-forma revenues are outside the U.S. and growth overall from its foreign assets remains quite strong. While growing quickly, the LVT product category for the U.S. flooring industry is currently only 10% of sales which is simply an effort to put into context where the recent pressure has been most accute. There are a number of factors that will impact earnings growth for Mohawk over the coming quarters and years which we have detailed in the past and briefly recap here.

We are not changing our 2018 EPS estimates on Mohawk although the revenue figures adjust slightly lower by updating our currency assumptions in our model for the change in currencies since late July. We have lowered our earnings estimates slightly for 2019 as we had been assuming price/mix would be a net positive over inflation in 2019 and believe it is more prudent to assume inflationary cost pressures on raw materials and transportation will persist that will make this more difficult to attain. We still believe there will be less overall pressure to margins in 2019 versus 2018 from this factor, but not to the magnitude we had previously assumed.

We have also slightly lowered our sales estimates in the ceramic and flooring North America segments to simply be more conservative of the level of cannibalization that could occur from LVT growth, both inside the company and in the industry. We do believe the company will have a sharp focus on cost controls in 2019 following a disappointing 2018.

Capital expenditures have been elevated in recent years (grew substantially in 2017 to $900+ million and 2018 is estimated at $780 million), and projects associated with that capex are in the startup phase and dragging earnings. Management called out roughly $35 million in startup expenses in 2017 which estimated to increase to $65-70 million in 2018 or $30-35 million incrementally. While management has not called out a specific number for 2019, we’d expect to see a meaningful decline in start-up expenses next year. Capital spending is targeted at $280 million in the back half of 2018 versus $500 million in the first half and we would expect overall capital spending in 2019 to lower than 2018 although official guidance on that assumption has yet to be rendered.

Productivity gains in 2018 are expected to be down y/y as the company spends much of this year reducing inventories in the North American businesses, primarily due to the pressures on sales in the U.S. marketplace for reasons we detail in this note. We note the company generated $178 million in productivity gains in 2017 and YTD 2018 has only achieved $44 million. While we do expect the back half to be slightly better in productivity gains, the year 2018 will prove to be well short of normal levels. This should be a meaningful incremental EBIT benefit to 2019 versus 2018 if we assume that the bulk of the inventory reduction efforts are completed by year end.

We expect the full year ownership of Godfrey Hirst will add approximately $20 million to EBIT next year.

We are now assuming organic revenue growth for Mohawk on a consolidated basis to approximate $400 million or 4% before currency changes and assume a 25% flow-through to EBIT. The 4% assumption is obviously a consolidated figure. We highlight the North American growth estimates for 2019 which pegs growth at 5.8% in our model (remember that the North American segment does not contain U.S. ceramic sales which we estimate will grow nominally next year). Essentially, we believe that through increased sourcing and increased domestic production of LVT, Mohawk will grow somewhat faster than the overall LVT market next year in contrast to the slower growth in 2017 and 2018. Additionally, we should see the benefit of more pricing in 2019 versus 2018 with more catch-up in pricing to offset the rampant inflation incurred in 2018. This supports our thesis that Mohawk will close the gap it has experienced in its North American sales growth performance which in our view will revert to some level of market share gain next year versus market share losses in 2018. We assume that the company will produce $100 million of incremental LVT on its U.S. line and source approximately $50 million more of LVT. These assumption in LVT account for 365 basis points of our 580 basis point increase in revenues next year for the North American segment revenue. We should note that we do not assume that Mohawk is running its domestic LVT line two at a $250 million run rate exiting 2019 but more conservatively at $150-175 million in making our estimates.

Interface (TILE, Hold, $24.00)

Historically a soft-surface only company, Interface added LVT to the product portfolio through a sourced model in 2017. While the company is likely unable to get the same type of margin on a sourced product than internally produced carpet, where the company has years of experience, the ability to deliver commercial customers with a more complete product portfolio is important as LVT has taken share from carpet in the non-residential markets. Growth in LVT is certainly handicapping Interface’s growth prospects in the U.S., but as a category, LVT has put more pressure on other vinyl products in the non- residential space than on carpet, which has been in a slow overall decline. We point out the company now generates 45% of sales outside of North America following the nora acquisition. The company anticipates selling approximately $50 million of LVT this year which puts the percentage of its revenues at less than 5%.

Interface would be negatively impacted by a meaningful tariff on imported product, although the magnitude of the impact would probably be minimal in comparison to the company’s consolidated results, as imported LVT is still a small portion of sales.

Retailers

Floor & Décor (FND, Hold, $37.18)

The company has enjoyed rapid growth as new stores are being added while existing stores grow at a double digit pace (slowing to a projected high single digit pace). There are a number of nuances as it relates to LVT growth and the impact on Floor & Décor. First we point out that FND generates roughly 60% of sales to pro customers vs. DIY, so to the extent that LVT is growing rapidly due to the ease and speed of installation, we believe FND would likely see a faster share shift than other retailers as the installers that are shopping at FND are more likely to convince consumers to substitute that product so that they can move on to the next job. The Pros are volume based incented and they simply can install many more LVT floors than ceramic for example. Tile (ceramic and porcelain) is the company’s largest category at about 30% of sales. We believe the LVT impact on tile sales is in the early stages, so cannibalization in this category is probably going to continue. On one hand, LVT products sell for higher ASPs than tile (FND sells tile from the $0.70-5/sq. foot range with a median price that we would estimate around $2 vs. LVT products that are probably concentrated closer to the $2-4/sq. foot range with the line centered in the $2.50-3.00 range. However as a result of the ease of installation, LVT sales do not typically come with other installation materials attached to the ticket, which is a high margin category for FND. These include the substrate floor, grout, adhesives, spacers and tools for the installation of stone and ceramic. The decorative accessories category is nearly 20% of FND’s business which we believe is not likely to be subject to much threat from new products like LVT. We did note that in Q2 the ceramic business dropped 180 basis points in mix percentage and wood and stone also fell with all of the growth being in laminate/luxury vinyl planks (LVT). This is a materially share shift in one year’s time and in our view, not the end of this shift.

From a tariff perspective, FND would be likely to be meaningfully impacted by any level of tariff on imports from China, which currently are 47% of the company’s products sold. Obviously management will be working to diversify the supply chain away from China and we would expect the company to lean more into domestic supply as it grows anyway given the need to have a deep and steady supply of inventory. That said, there would obviously be a margin impact as we do not believe FND would be keen to raise prices as that is a primary competitive advantage today.

In summary, we view FND’s exposure more to the tariff issue than LVT conversion.

Lumber Liquidators (LL, Hold, $17.66)

Still recovering from the Chinese laminate and formaldehyde debacle, Lumber Liquidators is likely seeing more of a benefit from LVT than downside. The company has always tried to skew towards DIY customers interested in getting a good deal (although the recent focus has been on luring in more pro customers), so the easy installation story is a big selling point for LVT and the company is selling LVT for generally higher prices than laminate and earns a better margin on LVT than on wood (although there’s an ASP tradeoff there). The tariff impact would be similar to others in the trade and would probably have a near-term margin impact as roughly 40% of COGS is from China, although we expect that the company has been diversifying away from China ever since the formaldehyde problems with laminate surfaced. We believe that LL has less of a sourcing edge in LVT versus what it enjoyed with engineered woods and laminate where it was an early adopter of the sourced model and became a meaningful customer to numerous producers. LL remains largely a “wood look” store so we will watch for a shift in visuals in LVT to ceramic and stone which we expect, to see if it will impact the wood visuals in a meaningful way.

Tile Shop (TTS, Hold, $7.60)

The Tile Shop is one of the lone flooring retailers simply not entering into the LVT category. Management is steadfast in the belief that the core Tile Shop customer is a higher income consumer that does not want a “fake” product and will pay accordingly. While the customer here clearly skews higher, we do wonder to what extent not having the fastest growth category in flooring where the visuals will increasingly mimic stone and ceramic will put pressure on The Tile Shop’s top line. There will certainly always be a buyer for real stone and ceramic/porcelain floors. But the cost differential inclusive of installation is so dramatically different between LVT and the natural products that we would be concerned that as the visuals improve, the preference for LVT will grow through time.

Management has commented that half of products are sourced from Asia and that China is “well represented” (we would assume roughly half). This puts TTS as vulnerable should there be a meaningful tariff assessed to ceramic and stone imports from China. There has not been any particular decision on how the company will manage through a tariff, but we would point out Tile Shop would likely be successful in implementing pricing and or getting vendor support to offset a 10% tariff but 25% would be much more challenging.


ANY REFERENCE TO STOCK PRICE TARGETS ARE DATED! DO NOT FOLLOW THIS ADVICE - APRIL 2020 IS A VERY, VERY DIFFERENT ECONOMIC REALITY THAN SEPTEMBER 2018


The above was portions copied from a Steifel investment report from Sept 2018. To see the full report or contact Stifel directly please visit:

https://stifel2.bluematrix.com/sellside/EmailDocViewer?encrypt=82b7726b-ceba-4157-a044-97203ed8b120&mime=pdf&co=Stifel&id=kemp@floorfocus.com&source=mail


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