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Mohawk Goes With The Free Cash Flow

By Will Ashworth

Tickers in this Article: MHK

New and existing home sales are significantly lower than they were at this time last year. Consumer confidence is also at the lowest level in five years, and the general outlook for the next six months is bleaker than it's been in 35 years, according to Thompson Financial News. Investing in home-related stocks at this point is sheer insanity, right? Perhaps not.

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A Silver Lining
One-year returns for home-related industries such as home building, furniture retail, textiles, banks and most others are in the red. It's not been an easy time for anybody involved in the housing industry. However, most of these same industries are either up year-to-date or down moderately. The blood bath that was 2007 seems to have subsided for now.

If you look for one or two gems to buy at a discount, it's clear that many are cheap for good reason. They are mere shadows of their former selves. Decimated by business lost and not soon coming back, many are hanging on; hoping conditions will turnaround. But not every housing-related company is drowning in red ink.

And The Winner Is...
Mohawk Industries (NYSE:MHK) is a leading producer of residential and commercial flooring. Carpet, ceramic tile, hardwood: you name it Mohawk makes it. In 2005, it bought Belgium-based laminate producer Unilin for $2.6 billion, adding $1 billion in annual sales. In 2007, this segment of the business contributed 20% of total sales and 36% of the operating income. Management successfully integrated this acquisition and from 2006 to 2007 Unilin actually grew sales by 20% from 1.2 million to 1.5 million, the only segment to do so.

Yes, Mohawk's top line sales were 7.6 billion, 4% lower in 2007 and operating margins below 10% for the first time in the last five years, but Unilin still managed to produce $875 million in operating cash flow while paying down $534 million in debt. It's a well-run business, which might actually benefit from this recession. If the Unilin acquisition is any barometer of management's ability to understand its operations, they will make the moves necessary to become even more competitive.

Cash Flow Is King
In uncertain times, a company's ability to generate cash flow is critical to its success. If you're not producing enough cash to pay your bills and grow the business, you'll be out of business. A company can have less money coming in then is going out and still be profitable. If this situation continues for too long, it may face extreme financial difficulties. That's why it's so important to look at the cash flow statement in addition to the income statement and balance sheet. (To begin with the basics, check out Analyze Cash Flow The Easy Way.)

Cash Flow gives an investor a better picture of the true financial condition of a company. Going a step further, many use free cash flow to determine actual profitability. The definition is operating cash flow less capital expenditures. If you take a company's free-cash-flow per share and divide that into the current stock price, you get free-cash-flow yield. This number should be as high as possible.

Mohawk's Cash Flow
In a recent interview, Bruce Berkowitz, CEO of Fairholme Capital Management and manager of the $7.3 billion Fairholme Fund, talked about some of his favorite stocks. One of them was Mohawk. He estimates it will generate $7 per share in free cash flow in 2008, yielding 9.7% at current prices. That's $478 million in excess cash that the company can use for future acquisitions, etc. When you consider the deal for Unilin closed at the end of 2005, it's been able to reduce long-term debt from $3.2 billion to $2.0 billion in just two years. The net result, the company's return on equity today is 15%, 3.2% higher than at the end of 2005. Shareholders win.

Bottom Line
You can take my word that Mohawk has a bright future ahead of it, or you can listen to Bruce Berkowitz, whose fund owns 4.5% of Mohawk stock. Since the fund's inception in 1999, annual returns are 16.27%; the S&P 500, in the same time period, returned -0.03% annually.

To learn about the accounting tricks often used to abuse FCF, check out Free Cash Flow: Free, But Not Always Easy.

By Will Ashworth

Will Ashworth lives and works in Toronto, Canada. He's worked in and around the financial services industry for much of his adult life. He loves investing and is passionate about helping others learn how to put their money to work.

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