Mohawk Industries (MHK) has enjoyed a well-deserved 10X share price rally since the financial crisis bottomed out in 2009. However, we think the growth story for MHK has come to a temporary end and a significant decline in the short term is much more likely as key fundamentals in the industry shift in 2016.
MHK produces carpeting, hardwood, and laminate flooring products like Mohawk, Pergo, and Unilin. They control about a third of the U.S. market for such products, which gives them scale advantages, however, branding isn’t as critical in the housing/remodeling market, so their competitive barriers are low.
Growth in the housing market, low interest rates, and a boom in remodeling and home improvement have certainly provided some significant tailwinds to MHK over the last few years. Additionally, one of the understated advantages they have enjoyed over the last 18 months has been the dramatic decline in energy commodities, which has lowered their cost of production.
Unfortunately, the same factors that have provided support for MHK are changing. The market for flooring is commoditized such that if interest rates increase (already happening), energy prices start to rise, or demand for housing falls MHK will likely not be able to raise their prices to maintain their margins. We believe pressure from other producers like Berkshire Hathaway (BRK-A) and retailers like Lumber Liquidators (LL) – who are going all-out just to survive – will constrain growth within the sector.
Additionally, MHK is losing patent protection on its “Uniclic” products in 2017, which should put additional pressure on the company as competitors offer similar flooring in the near future. We expect that the impact from the loss of this patent protection will start to show up in additional discounts for the stock in 2016.
From a technical perspective, MHK has been an underperformer within the S&P 500 this quarter, and the potential for a breakout to the downside in 2016 is compelling. As you can see in the next chart, the stock was unable to break resistance at $198-200 following the FOMC report on Dec. 16. The following days formed a confirmed bearish engulfing pattern, which we expect to add weight to that same resistance level.
At this point, we like a short position in MHK as a bearish hedge going into an extremely uncertain 2016. The market could rally, but the catalyst for that is an unknown, and seems unlikely. Based on what we learned from MHK’s margin collapse in the first quarter of 2015, it wouldn’t take much of a decline in top-line revenue to reduce earnings to nearly breakeven. Higher interest rates, a slower housing market, and potentially flat or rising energy costs next year could easily send the stock lower.
A break of trendline support at $186-184 or the September 2015 lows at $176 could be used as a trigger point for a bearish entry. As usual, a bearish position like this should be considered high-risk and a long-term short position is not recommended. Assuming a target PE ratio of 13-15, we believe the downside target should be set near $112-125 per share.
We believe that the spike in building permits and housing starts in the fourth quarter of 2015 was just future demand pushed into the last several weeks to avoid an increase in mortgage rates. However, if that turns out not to be the case, our bearish analysis will need to be reevaluated and shorts may want to plan an exit.
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InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.