Interface Inc. (TILE) is one of the biggest manufacturers and designers of carpet tile specializing primarily in commercial interiors. Value Line estimates the company commands roughly 35% of the market share in carpet tile, making them the leader in the space. However, management has been diversifying its product portfolio by entering the lucrative Luxury Vinyl Tile (LVT) and the Rubber Flooring market, the latter through the acquisition of nora Holdings (“nora”) in 2018. The combined markets expanded TILE’s addressable market by $4.3B, adding to the $5B carpet tile TAM.
Trading at forward earnings of 4.7x, TILE is being heavily discounted by the market. For comparison, Mohawk Industries (MHK) trades at a forward multiple of 11.5x.
Why the big discrepancy in valuation? We believe the market is very skeptical about how TILE could perform in a post-COVID world in which the possible “death of the office” is a hot topic of discussion. TILE derives 49% of its total sales from the corporate office space.
That said, analysts are expecting EPS of $1.30 and $1.45 in 2021 and 2022, respectively, or year-over-year growth of 11.5%. We believe such targets are reasonable due to the variable cost structure of the company (30% fixed, 70% variable), and better performance from their LVT and Rubber flooring segments. During the second quarter, management noted flat growth in LVT and outperformance in nora. If such EPS targets are met, TILE would be trading at 4.7x and 4.3x forward earnings, making the company very cheap.
With the market pricing-in very low expectations, better-than-feared results could send shares in TILE higher as the market adjusts its outlook and prices the company at a multiple closer to its competitors.
Maybe expecting TILE to trade in-line with its 5-year average P/E multiple of 13x would be asking too much, but at 4.7x earnings, we believe the company is too cheap, priced almost as if it is going bankrupt. We believe TILE makes a solid value pick and we feel bullish about the company.
Weak Q2 results with continued headwinds in Q3
TILE reported second quarter sales of $259M, down 27.4% on a year-over-year basis, but beating analyst’s expectations by $7.8M. The company also reported non-GAAP EPS of $0.27, beating the consensus by $0.20.
The company has been impacted by the pandemic. While month-to-month trends have been improving, they still remain weak with negative growth. For example, orders in May were down 35%, followed by down 32% in April, and down 29% in June, on a year-over-year basis. July orders were down 27%, showing marginally better sales trends. Weakness was felt across all operating regions (Americas, EMEA, and APAC).
TILE expects order trends to remain in negative territory for Q3, as economies still adjust to the impacts of COVID:
We anticipate this order trend will put pressure on sales and operating income in Q3 similar to the way it did in Q2. – Q2 call
Gross margins fared much better, however, declining by 190 basis points to 37.5% during the quarter. Most of the impact on gross margins was the result of lower volumes and not price point pressures. Management noted that prices remained steady throughout the quarter. The resilience of TILE’s gross margin profile highlights the variable nature of its cost structure. With production down 37% for the quarter and only a 130 basis-point impact to gross margins, TILE has the flexibility to adjust their global cost structures to match demand, which consists of 30% fixed and 70% variable costs:
If you think about our manufacturing environment, it’s about 30% fixed, 70% variable, which gives us a lot of flexibility around the globe to flex our cost structure. – Q2 call
With that said, there were pockets of strength during their second quarter, mainly the performance of their “resilient flooring” category, which includes LVT and nora. That segment was flat for the quarter but nora was the highlight and has been their strongest category as they target non-office markets such as healthcare, education, and transportation. Management expects their second half to be “pretty good” for nora.
Opportunity to grab market share?
We believe there could be an opportunity for TILE to gain market share in the LVT space. Recently, competitor Mohawk Industries has been involved in a lawsuit regarding alleged financial misconduct by recording early revenues in their financial statements:
The Company’s scheme allowed Mohawk to recognize these failed “delivery attempts” as “sales” dollars in the current quarter even though the product never changed hands to a customer, in violation of generally accepted accounting principles (GAAP) and Mohawk’s stated revenue-recognition policies. – Case document p.21
The case filing document also alleges that Mohawk was overproducing LVT in order to drive down unit production costs, therefore, showing better product margins:
Second, to further inflate profits and margins, defendant Carson ordered Mohawk’s factories to perform overly long production runs that caused production to far outstrip demand. By overproducing product, Mohawk was able to artificially drive down the cost to manufacture each product by spreading the Company’s fixed manufacturing costs across more products. – Case document p.23
However, in an effort to increase production, Mohawk started experiencing serious problems with their production lines that consistently produced defective “scrap” LVT that was not saleable.
Although this lawsuit is still in progress and nothing has been confirmed, these are serious accusations that cannot be taken lightly. Mohawk’s stock price plunged approximately 19% the day the lawsuit came to light.
For companies like TILE, this could represent an opportunity to increase brand awareness and possible market share from any type of lost business from Mohawk. We believe the most damaging aspect of the lawsuit comes from the alleged “quality problem” at Mohawk’s production plants. If those allegations are true, then the company would take a huge reputational hit, which TILE can take advantage of to gain market share.
The Bottom Line
TILE is going to have a weak Q3; management already expects that. The company could also face more weakness in the next few quarters as economies are still coping with the effects of COVID. Many workers do not have a set date to return to the office, which puts a lot of uncertainties about what the future role of the office is going to be. With almost 50% of their revenues coming from commercial interiors, primarily corporate office spaces, there is going to be a lot of volatility in their future results.
That said, we believe the market is too pessimistic about TILE. Trading at a forward P/E multiple of 4.7x, it is almost as if the market believes TILE is at risk of bankruptcy, yet we do not see any financial risk soon. Management has recently amended its credit facility that provides enhanced financial flexibility through the end of Q1 2022. TILE ended its second quarter with $331M in liquidity and a leverage ratio of 2.9x.
The company could surprise the market if they can sustain their strong performance in non-office markets with their LVT and Rubber flooring products targeting the healthcare and resi markets. A rebound in tile carpets as the environment “normalizes” would be highly accretive. With the bar set very low, TILE could surprise to the upside by showing better-than-feared results, which would re-rate them at a higher multiple. We feel bullish on the company.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.