Mohawk Industries Inc Q2 FY2022 Earnings Call

Good morning. My name is Victoria, and I'll be your conference operator today. At this time, I would like to welcome everyone to Mohawk Industries’ Second Quarter 2022 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. As a reminder, ladies and gentlemen, this conference is being recorded today, Friday, July 29, 2022. Thank you. I would like to introduce Mr. James Brunk. Mr. Brunk, you may begin your conference.

Thank you, Victoria. Good morning, everyone, and welcome to Mohawk Industries' quarterly investor call. Joining me on today's call are Jeff Lorberbaum, Chairman and Chief Executive Officer; and Chris Wellborn, President and Chief Operating Officer. Today, we'll update you on the company's second quarter and provide guidance for the third quarter. I'd like to remind everyone that our press release and statements that we make during this call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, which are subject to various risks and uncertainties, including but not limited to those set forth in our press release and our periodic filings with the Securities and Exchange Commission. This call may include discussion of non-GAAP numbers. For a reconciliation of any non-GAAP to GAAP amounts, please refer to our Form 8-K and press release in the Investors section of our website. I'll now turn the call over to Jeff for his opening comments. Jeff?

Thanks, Jim. Mohawk's second quarter sales rose to $3.2 billion, up 6.7% as reported or approximately 11.1% on a constant basis. Sales grew in all our segments, with our top line results benefiting from price increases, enhanced product mix, improvements in commercial and contributions from our small acquisitions. As the quarter progressed, the global economic environment became increasingly challenging, and our organizations implemented additional actions to support our performance. Our operating income for the quarter was in line with our expectations, even as material, energy and transportation inflation remained a significant headwind and our translated results were impacted by the strengthening US dollar. Over the past 18 months, all of our businesses have faced extraordinary inflation, and we have instituted multiple price increases to pass through these higher costs. We're also taking numerous operational actions, including cost controls, productivity improvements, mix and logistics enhancements. Across our markets, inflation is causing changes in consumers' discretionary spending. US housing sales have been impacted more than our other markets as mortgage rates have risen faster. Unlike past economic cycles, housing demand exceeds the available supply and foreclosures are not an issue. In Europe, interest rates have not risen as much as the US, though consumer discretionary spending is being eroded by energy and other inflation, which is impacting demand. Volatility in natural gas supplies have caused a dramatic spike in near-term prices and supplies and pricing remain uncertain. The European countries are considering strategies for alternative supply, ways to ration gas and subsidies to support those most affected. In most regions, investments in commercial construction and remodeling remain solid. Both projects that were deferred due to the pandemic and new projects are being initiated in greater numbers as the commercial sector continues to strengthen. As we navigate the near-term market dynamics, Mohawk's strong balance sheet provides many options for investments, including internal expansion, acquisitions and stock buybacks. During the second quarter, we announced approximately $440 million in new acquisitions, with the largest being an agreement to acquire Vitromex, a leading ceramic manufacturer in Mexico. In early July, we completed the acquisition of Foss Floors, a leading U.S. needle punch flooring manufacturer. In Europe, we are making excellent progress integrating our 2021 bolt-on insulation and panel acquisition. We're contributing to our results as expected. We continue to explore additional acquisition opportunities. Our expansion projects remain on schedule, including laminate, LVT, quartz countertops and European porcelain slab. These investments will help us satisfy current and future demand as well as deliver our next generation of product innovation and operational efficiency. Now Jim will review our second quarter financial performance in greater detail.

Thank you, Jeff. Sales for the quarter were just under $3.2 billion. That's a 6.7% increase as reported, or 11.1% on a constant days and FX basis, representing a second consecutive record quarterly sales. Favorable sales and mix across all segments and the benefit of our 2021 small acquisitions offset softening volume and negative impact of FX. Gross margin for the quarter was 27.7%, a decrease from the prior year 30.7% excluding charges. Although the dollar amount and impact of year-over-year inflation is primarily in raw materials and energy was more than offset by pricing mix and productivity, it was not enough to negate the impact of the lower unit volumes, temporary shutdowns and FX headwinds on a percentage basis. The actual detailed amounts of these items will be included in the MD&A of our 10-Q, which will be filed after the call. SG&A as a percentage of sales was 16% for the quarter as tight spending controls by the business drove a 90 basis points improvement versus the prior year. The immaterial increase in absolute expense was due to higher sales, price mix and inflation, primarily offset by cost-saving initiatives and the impact of FX. Operating income as a percentage of sales was 11.7%, which is a 220 basis point decrease versus the prior year, driven by lower volume as the business drove pricing, mix and productivity initiatives to offset significant year-over-year inflation and the impact of temporary plant shutdowns and FX. Interest expense for the quarter was $12 million, slightly down from the year and other income, other expense was income of $3 million. Our non-GAAP tax rate was 22% versus 22.5% in the prior year. We expect the full year tax rate to be between 21% and 22%. That leads us to earnings per share as reported of $4.40, or excluding charges of $4.41. Turning to the segments, Global Ceramic sales were just under $1.2 billion, a 11.5% increase as reported or 14.6% on a constant base and FX basis as pricing and mix actions more than offset the softening volume in the segment. Operating income for the quarter, excluding charges, was $154 million or 13.3%. That is an operating profit increase of 12.5% versus the prior year. The favorable product mix, pricing and productivity actions offset the impact of lower volumes and inflation, which is primarily due to rising energy costs. In Flooring North America, our sales were $1.1 billion for an increase of 1.7% versus the prior year with pricing actions offsetting volume declines. Growth in commercial, laminate and resilient products offset weakness in residential carpet and a significant adjustment in rug products during the quarter. The rug business is concentrated with major national retailers who dramatically cut orders to reduce their inventory levels. Now absent this adjustment, Flooring North American sales would have increased approximately 6.5% in the quarter. Operating margins as a percentage of sales was 9.1%, which is a 210 basis point decrease versus prior year, as improvements in price mix and productivity initiatives were unable to compensate for the lower overall volumes and increased input costs, primarily in raw materials due to year-over-year inflation. In Flooring Rest of the World, sales were $895 million or a 7.7% increase as reported or 18.8% on a constant FX basis. Pricing and mix actions drove the improvement across all product lines, led by panels and insulation, along with the year-over-year benefit from the smaller acquisitions. Operating margin as a percentage of sales was 14.1%, with a decline of about 560 basis points versus prior year. The main drivers for the decrease were higher inflation, mainly raw material, unfavorable productivity with temporary plant shutdowns and lower volume, especially compared to the peak output in 2021 Q2, partially offset by favorable price and mix initiatives. Corporate and elimination costs were $10 million for Q2, with full year corporate and elimination costs estimated to be between $40 million and $45 million. Turning to the balance sheet, cash ended the quarter at $224 million, with free cash flow relatively flat for the quarter, primarily due to increases in working capital driven by the impact of inflation and increasing sales. Receivables were just over $2.1 billion, with DSO slightly higher at 56 days compared to 53 in the prior year. Inventories finished the quarter at just over $2.8 billion, which is an increase of 36% from prior year of $740 million, 70% of which was inflation-related, and that was also an increase of about 12% versus Q1. Inventory days finished the quarter at 116 days, slightly up from Q1 at 111 days. Property, plant and equipment finished the quarter at just under $4.6 billion, with CapEx of $151 million and depreciation and amortization of $142 million. For the full year, depreciation and amortization are forecasted to be approximately $570 million and CapEx at $785 million. Finally, our balance sheet is in a very strong position with overall $1 billion of liquidity and net debt-to-EBITDA at 1.1 times, enabling our business to continue to grow through internal investments, acquisitions and stock buybacks. With that, I'll turn the call over to Chris for our operational review.

Thank you, Jim. Of our three segments, Global Ceramic delivered the best performance during the second quarter with significant year-over-year operating income improvement, of which the greatest part came from the US ceramic business. Builder sales remained strong in most of our ceramic markets and an increased number of commercial renovation and new construction projects were also initiated. Most of our markets have seen some softening in residential activity as inflation and higher interest rates affected remodeling investments. The cost of natural gas continued to rise across the world, with European natural gas prices spiking again due to supply uncertainty. As energy and raw material price increases across our ceramic businesses, we continue to implement new pricing actions. Our US ceramic business expanded its operating income to its highest level in four years. The commercial and new home construction sector showed the strongest growth, with softening demand in residential remodeling and the home center channel. During the quarter, our mix and margins were enhanced by improved commercial sales. Our premium product introductions are gaining traction in the market as alternatives to higher-cost European imports. We continue to improve our sales and manufacturing costs with productivity initiatives and improved product discipline. To offset higher energy, material and transportation costs, we continue to implement price increases and freight surcharges. We have introduced new distribution strategies to mitigate the impact of rising fuel costs. Our countertop sales are growing in the high-end quartz, porcelain and stone categories. Our quartz countertop plant is operating at maximum capacity, and we are improving our mix by expanding our premium product offering. To meet growing demand, we are sourcing products and expanding our countertop production. Our European ceramic business improved sequentially during the quarter with higher sales and enhanced mix. Though our pricing actions during the quarter improved our margins, they did not fully offset inflation versus the prior year. We continue to invest in innovative new features to improve our mix and add capacity to satisfy growing demand for our porcelain slab business. Sales of our premium products increased during the quarter, while our low and medium price categories softened as they are more sensitive to price changes. Our inventory levels remain historically low and are further limiting our overall sales. Our R&D teams are reengineering body formulations with alternative materials and reducing the use of Ukrainian clays. Recently, reduced supplies of natural gas have significantly increased energy prices across Europe. Going forward, our volume and margins will be under greater pressure as our gas costs will be higher. We are initiating restructuring actions to lower our costs and manage these market conditions. In our other international ceramic markets, sales growth was primarily driven by pricing and mix with commercial outpacing residential. Our results in these regions could have been stronger if our sales were not limited by production constraints and low inventory levels. Our pricing actions and improved mix are offsetting higher energy and material costs. The impact of inflation on energy and materials in these regions has not abated, and we have announced additional price increases to offset higher costs. Across these regions, we are beginning to see softening in the residential sector as inflation and rising interest rates impact consumer spending and home purchases. In June, we agreed to acquire Vitromex, a leading ceramic tile manufacturer in Mexico, for $293 million. The company produces clay ceramic, porcelain, mosaic and decorative tiles and has a broad distribution network. Vitromex operates 4 manufacturing facilities and had approximately $200 million in sales last year. Ceramic is the primary flooring category in Mexico, and the market has grown even 11% per year in pesos over the last five years. In 2021, the Mexican ceramic tile market generated sales of $1.7 billion or about 2.9 billion square feet. During the past 10 years, we have significantly expanded our participation in the Mexican ceramic market by investing in state-of-the-art manufacturing and developing world-class operations and sales organization. Together with Vitromex, we anticipate many opportunities to expand the product offerings, distribution and efficiencies of the combined enterprise. In the quarter, Flooring Rest of World sales rose year-over-year, primarily from price increases, product mix and contributions from our small panels and insulation acquisitions. Inflation is increasing household costs and reducing consumer disposable income. We are seeing a slowdown in retail traffic, which is reducing industry volume in most categories. European energy prices are substantially higher than in other regions and are significantly impacting our raw material and electricity costs. We have raised prices as inflation continues to rise and announced further increases as natural gas and chemical prices escalated at the end of the quarter. Our wood costs are also rising as it is being increasingly utilized as a substitute for natural gas to provide heat and electricity. Our flooring sales softened as we progress through the quarter, and our customers are reducing their inventories. Laminate, LVT and sheet vinyl are following similar demand trends. In the period, our costs continue to escalate and material supply improved. We implemented price increases during the quarter and have announced additional price increases for the third quarter. We're taking actions to address the changing environment, including cost reductions, process improvement and postponing noncritical projects. Our insulation business continues to deliver excellent results with growth in volume as well as price. We have passed through rising chemical costs and are integrating our recent acquisition. Our new manufacturing plant is adding a second shift as we ramp up our sales and distribution. Sales of insulation products remain strong as they benefit from increasing investments to reduce energy costs. Our panels business performed well, though volumes slowed as we progressed through the quarter. We continue to raise prices and improve our mix with higher-value products. We're integrating the small French panels plant that we acquired last year and are improving its cost and output. We are expanding the distribution of our higher-end decorative panels and more durable HPL products. Our investments in energy production from waste wood are benefiting both our cost and the environment. For the quarter, our Flooring North America segment growth was primarily driven by pricing gains, stronger commercial sales and improved mix. The commercial sector improved across all channels, while the residential market is softening as consumers face the pressure of household inflation and rising interest rates. As our service levels improve, customers reduced their inventory in the residential channel. We continue to execute pricing actions to offset material and energy inflation, though lower plant volumes are reducing absorption and raising costs. We are strategically investing to maximize our share in the faster-growing LVT and premium laminate categories. We have launched numerous productivity initiatives to mitigate the impact of fuel, freight, energy and labor inflation. Our LVT sales continued to improve with our new products gaining traction in the market. We experienced fewer material disruptions in the quarter, which furthered operational improvements and benefited our margins. Our new West Coast LVT plant has begun shipping to customers, and we continue to refine processes to improve throughput, productivity and material costs. Our East and West Coast operations will provide superior service to our customers and improve our transportation efficiencies. Our premium laminate is mostly used in residential remodeling, and inventory adjustments in home centers impacted our sales in the quarter. Our waterproof laminate collections are increasing our sales in the specialty retail and new construction channels as an alternative to LVT. Our new manufacturing line continues to ramp up to targeted production levels and is fulfilling demand for our next-generation products. Though we have raised laminate prices, our raw material costs continue to increase substantially. As the commercial sector rebounds, sales and margins of our carpet, tile and commercial LVT collections are improving. All channels continue to expand with the recovery in the hospitality and corporate sectors accelerating. Based on the most recent Architectural Billing Index, commercial design activity remains strong with a pipeline of projects that support continued sales growth for the foreseeable future. To offset raw material and transportation inflation, we are taking additional pricing actions as well as reducing costs across the business. As our residential carpet volumes declined due to softening markets and inventory reductions in the channel, we are aligning capacity with demand, reducing expenses and announcing additional price increases due to continued material and energy inflation. Our rug business is concentrated with major national retailers. And during the quarter, they all dramatically cut orders to reduce inventory as their sales forecast weakens. With the impact of a $50 million decline in rug purchases, the segment's sales would have increased approximately 6.5% versus prior year. In July, we closed the acquisition of Foss Floors, a leading non-woven flooring manufacturer for approximately $150 million. Foss adds a new product category to our portfolio that complements our existing lines and includes needle punch, rugs, carpet, DIY tile and artificial turf. Foss' 2022 sales have been strong with a present run rate of approximately $100 million. To adapt to current conditions, we are taking actions to restructure our cost across the enterprise to improve our results. We are finalizing plans to rationalize older, less efficient assets and optimize processes to lower cost. The most significant actions will be in our Flooring North America segment, including reducing some yarn assets and rug capacity. In our Flooring Rest of World segment, we are consolidating insulation products and streamlining our organizations. And in Ceramic, Europe, we are simplifying administrative and manufacturing organizations. We estimate these initiatives will reduce our cost by $35 million to $40 million annually, with an estimated cash cost of $15 million to $20 million and a total cost of $90 million to $95 million. With that, I'll return the call to Jeff.

Thanks, Chris. During the first half of 2022, we delivered solid results despite the pressure of significant inflation, rising interest rates and geopolitical instability. In the US, rapidly rising interest rates are impacting housing sales, and inflation is causing changes in consumer discretionary spending. Residential remodeling is softening as consumers postpone upgrading their homes. New home and multi-family flooring channels remain strong, and the commercial sector continues to improve as new and deferred projects are initiated. Though interest rates are lower in Europe, dramatically higher natural gas prices and constrained supply are reducing economic growth. Given these factors, we anticipate softening demand and increased pressure on our margins going forward. We're taking targeted actions across the enterprise to adjust to these changing market conditions. Material and energy costs continue to rise, and we're implementing further price increases in response. We're introducing higher-value products and enhancing our service levels to expand sales. We're reducing expenses and initiating new process improvements. We'll be implementing multiple restructuring projects across the company to reduce our costs. We also expect improvements in material supply and transportation as we go through the remainder of the year. In the US, we anticipate that rising interest rates will strengthen the dollar and reduce our translated results. Given these factors, we anticipate our third quarter adjusted EPS to be $3.33 to $3.43, excluding any restructuring charges. Mohawk has successfully managed through economic cycles many times before. Over the long-term, flooring grows at a faster rate than the overall economy. Around the world, a deficit in housing stock requires additional construction in most regions. In the US, housing demand exceeds supply by an estimated 5 million units and it will take years to satisfy. Additionally, over 20 million homes are between 20 and 40 years old and in need of significant renovation. Our business is well positioned to benefit from the long-term growth in new home construction, residential remodeling and commercial projects. We have a strong balance sheet that supports growing the business through internal investments as well as acquisitions and stock buybacks. We will enhance the performance of our acquisitions, and we'll continue to seek opportunities in new products and geographies. We remain optimistic about Mohawk's future, and the actions we are taking today will improve our results. We'll now be glad to take your questions.

Thank you. Our first question comes from Stephen Kim with Evercore ISI. Please go ahead.

Yes. Thanks very much, guys. It's Steve Kim from Evercore. Regarding your guidance, the 3Q guide, does this assume that inputs are fully offset by price and mix without any contribution from productivity? And then, I'm hoping you can speak to how volume did as you moved through the quarter. Is it fair to think that the exit rate of volume growth was maybe 300 basis points lower than for the 2Q as a whole? And has that worsened more in July?

Let's start with the order trends. The order trends slowed as we went through the quarter, and we exited with a lower order demand than we saw at the earlier part. When you look forward into Q3, it's normally slower than Q2 historically due to the seasonality. In addition, last year, we ran at higher levels to improve our service. Inflation is impacting discretionary spending and remodeling across the world, and we have assumed it's going to slow the business and demand down. Our view of European demand and cost is much more pessimistic today than it was a quarter ago. We anticipate having lower production in the third quarter, which will raise our costs as we align it with demand. In addition, don't forget the US dollar has really strengthened, especially against the euro since last year and will lower our translated results.

Thank you. It seems you're indicating that the volume will likely remain low in the third quarter, partly due to seasonal factors. You also mentioned that some of what occurred in the second quarter was related to inventory destocking. I'm curious if it's reasonable to expect that this aspect could improve in the third quarter and how significant that was. Additionally, regarding your management reorganization, it appears this is part of your savings program of $35 million to $40 million. I assume this primarily involves personnel, but considering that Mohawk already operates with a lean structure, I'm interested in how the management changes for York might impact the company's potential to seize a substantial rebound in demand if that occurs over the next few quarters.

Let's start with your first question again, Stephen.

That was the inventory destocking. Is that portion meaningful? And is it reasonable to think that, that could ease in 3Q?

We think it's possible. We don't have a clear view into all of our customers' inventory levels, and it differs by product, by category, by country. But we believe that they reduced them in the second quarter, and we think there could be some more reductions in the third quarter, but our visibility is limited at best. And the second part of it, the restructurings. We are not taking any meat out of the business. We are taking costs out in operations that we anticipate running less. We are in Europe doing some organizational changes in both our Rest of World business and our ceramic business in order to get them aligned with how we see the future business is going to be in Europe.

Perfect. Thanks very much, guys.

The next question comes from Susan Maklari with Goldman Sachs. Please go ahead.

Thank you. Good morning, everyone, and thanks for taking the question.

Good morning.

My first question is, Jeff, can you just help us think about some of the seasonality factors combined with the slowing macro? And how we should be thinking about the performance of the different segments as we look past the third quarter, but think about later this year and then going into the early parts of 2023?

Let's provide a broader overview and then we'll get into the specifics. We expect to see a decline in demand across all our different businesses. We're noticing similar changes in every region, with ongoing pressure on our margins due to the slowing economic environment. So far, we haven't observed any significant changes in materials. The residential remodeling sector is slowing down alongside new construction, while commercial remains strong in most regions. Europe is currently facing more challenges from energy issues, which will significantly affect our results, particularly in our ceramic business. We are taking pricing actions, introducing higher-value products, and enhancing our services to maximize sales. We previously mentioned our restructuring initiatives, and we have strategies in place to reduce expenses across all businesses moving forward. Could you assist with some insights on the segments?

From a segment standpoint, obviously, we're seeing pressure in the ceramic segment, mainly due to energy, but also remember, employing Rest of the raw materials. So the current environment really in Europe is somewhat unpredictable with geopolitical events. We are seeing some decline in consumer spending. All the energy and kind of chemical-based materials are rising and are costly. We continue, though, to push increases in prices. And we do have some advantages in our Flooring Rest of the World segment with investments that we have made in waste energy and wind mills as an advantage. I'd also say that with commercial being strong, that helps the ceramic business in the U.S. and in Europe and also the Flooring North American business as well.

Okay. That's very helpful color. And then just following up a bit on the restructuring actions, Jeff, how do you think about the areas where you're taking cost out? You mentioned carpet is one of the places where you are reducing some capacity relative to the areas where you are continuing to invest in adding production and growing? And how are you thinking about the way the business will look as we come through this macro slowdown and get to the other side of it?

Let's see. You asked a lot of questions, so let me address them all. We are still finalizing the restructuring plans we discussed, which are designed to adapt to the near-term conditions. The largest restructuring is in Flooring North America, but we anticipate significant changes in the European market as well. We are adjusting accordingly for the near-term. Regarding expansion, our current projects are focused on areas with rising sales opportunities and capacity constraints. In the U.S., we are seeing strong demand for laminate, and our new production line is fully committed. We are oversold on countertops and are importing products to meet demand. In Mexico, we are starting LVT production and expect to expand our business there. We also have sourcing options that can be adjusted if the economy does not grow as anticipated. Additionally, our premium ceramic line is oversold, and we are sourcing from other suppliers. All these technologies have been utilized in the past, so we do not expect significant changes that would increase startup costs. Lower investments are aimed at enhancing productivity and product features, and we have deferred some investments until we can gain better visibility on the overall situation.

Okay. Thank you very much for the color, and good luck.

Thank you.

The next question comes from David MacGregor with Longbow Research. Please go ahead.

Yes. Good morning, everyone. And Jeff, just a question with respect to the commercial strength that you're seeing right now. My recollection is that this is an area of your business where you had undertaken some rationalization during slower times. So, would this now require some additional investment in terms of feet on the street or distribution capacity? Are you able to dimension that for us within the context of this $35 million to $40 million savings restructuring program?

There is nothing in that that's affecting the commercial business. In the past, we announced that we were going to consolidate one operation in order to improve the productivity of it, and it's well along the way. We continue to invest in salespeople, new products. We believe that the commercial business is going to stay strong. We look at the projects being worked on in the marketplace, it looks like there's still a lot coming in. And we see that hospitality and retail have increased, and they're still recovering from the bottom point. There are projects that were delayed that are being reinstated. And in the category, we see hard surface growing faster than carpet tile. In the whole category, our margins are expanding with improved mix as well as volume.

Good to hear. And my second question, just with respect to maybe the residential business or just what you're experiencing there. How much margin recovery is achievable through the price increases that have been announced so far to date?

Let's start out with first. Our ability to project the inflation is really poor. Our current businesses are facing extraordinary inflation, and we're still managing some supply disruptions at this time. We've increased prices during the second quarter, and we've announced additional price increases, which are being implemented in this quarter. We're taking actions to control costs. We're taking actions to improve productivity. The businesses are trying to improve the mix, and we're restructuring in the different businesses that we've talked about where it's appropriate. The energy in Europe remains a problem. The pricing remains unknown and will pressure our margins, both in the ceramic business as well as in the other businesses as it evolves. And we have a very limited view of how it's going to impact the demand there. We'll have to all see together.

The next question comes from Phil Ng, Jefferies. Please go ahead.

Hey. Good morning, everyone. Given the nat gas shortages in Europe, and certainly prices have spiked. Assuming some incremental pressure in the winter months, do you have enough prices to cover the cost headwind? And when do you kind of expect to be caught up? And separately, are you seeing some of your higher cost competitors in ceramic or flooring in Europe alter facilities since it's not economical? And how are you kind of managing that risk around gas rationing potentially later this year?

Natural gas volatility in Europe is significant. It is driving up inflation and affecting demand. Additionally, it is impacting the cost of many chemicals and materials that we use.

Okay. Your comfort around getting gas, how are you kind of managing that risk with competitors shutting down just given the economics currently?

I think because of the cost of gas, some smaller competitors in Italy are shutting down. And so far, we've been able to get gas, but we can't predict it for the future.

Okay. And then on the productivity side and cost out, the team has obviously done a great job in the last two years in that $180 million to $200 million range from a productivity standpoint, which is great. When we look out to 2023 and beyond, outside of the $35 million to $40 million cost out that you're calling out for restructuring, in a declining environment, what's like a realistic target on productivity? And when we look at your cost curve globally, outside of some of the higher-cost stuff you're taking out in North American flooring, how does it look? Is it pretty flat, or is it still pretty steep where you still have some outliers where that could be an opportunity if demand remains pretty depressed?

When you go into recessions, you have a significant volume deterioration. Usually, it's difficult to take out costs and prepare for coming out of it and not have the margins deteriorate, and we would anticipate the same thing would happen now.

The next question comes from Eric Bosshard, Cleveland Research. Please go ahead.

Thank you. I have two questions. First, I would like to follow up on the restructuring. It seems like you are addressing this in real time. Could you clarify if there might be more expenditures and savings than what you have mentioned today? If current trends persist, does this account for other scenarios, or is this the final assessment?

We don't have any significant restructuring plans at this time. During a downturn, we typically reduce inventories, production, marketing investments, and staffing. We do not replace departing employees, which allows us to downsize the business while maintaining the capacity to rebound. This adjustment usually occurs every eight to ten years.

Mohawk has a strong history, and the management team in each segment is well equipped to monitor demand and costs, aligning them effectively. This is a situation we have encountered before, and I believe the teams are ready to face this challenge again.

And just as another note, going into this thing at this point, it's really different. The housing demand has been exceeding supply. Normally, we've been overbuilt that has to get taken out of the system. The rental markets are really at low vacancy rates and commercial is still expanding, and you have employment at high levels. I mean, this is a really unusual environment.

I'd remind you that the strength of the balance sheet that Mohawk finds itself in with strong liquidity and low leverage certainly gives us a lot of flexibility.

And then secondly, you've done a good job over the past four or five quarters of price and mix relative to raw materials. And I guess we'll see those numbers later today. My question is what should we expect where you expect in regards to pricing mix to be easier in an environment where the consumer is put at least one foot on the brake?

We're working to optimize our product mix and introduce items that customers are willing to pay a premium for. However, in a slowing market, raising prices becomes more challenging as demand decreases and all market participants are managing their resources. Typically, in such environments, material costs also begin to drop.

Thank you. The next question comes from Kathryn Thompson with Thompson Research Group. Please go ahead.

Hi. Thank you for taking my question today. I wanted to follow-up on the inventory question from earlier in the Q&A, focusing in on Flooring North America. The industry has implemented three price increases, the share of fourth in the works in a variety of categories. And we're hearing in the channel that we're starting to see a more meaningful slowdown in the last month of the quarter, last three, four weeks of Q2. How do you balance obscured inventory optics from retailers that are naturally buying ahead of price increases and construction cycles continue to be extended versus a fundamental slowdown? And what are, your building partners saying in terms of tapping the brakes to wait for inflation and debate versus more fundamental concerns about demand?

You have to put it in perspective of where they came from, when the industry and us, when our service levels were poor, they were trying to maintain their operation. So they raised their inventories, because they couldn't depend on us, and the rest of the industry to deliver it, on time at the last minute. So through that, they raised inventories. In the last quarter, I can't speak for the industry, but our supply has gotten much better. So they need to happen, but they have to take out, and they don't have to have those investments as they go through. Remember, in our business, flooring is one of the last things you put in a home when you build it because you don't want all the people walking through it doing the things they are, scratching it and the owner comes in and doesn't like it. So it's a tail of it.

How do you manage continuing your expansion projects in the US and Europe amidst uncertainty that has led to cutbacks? How much do you prioritize those expansion efforts and what drives that decision?

First, you have to start out with, that most of the expansion projects, the big ones, we've been discussing for over a year.

Okay.

The orders for the equipment are beginning to arrive, but some will take a while to receive. Generally, these projects span from the initiation to completion, often taking at least 18 months and possibly up to two years or more. They are all long-term commitments. We are at various stages with some of these projects. Currently, we have decided to delay our investments in Brazil and have postponed some smaller projects, but the larger ones that are three quarters complete cannot be halted.

Yes. Understood. Thank you. Best of luck.

The next question comes from Michael Rehaut with JPMorgan. Please go ahead.

Good morning, everyone. I wanted to clarify some earlier comments regarding price mix versus cost. Specifically, could you briefly review your three segments or provide a consolidated overview of your price and cost situation during the second quarter? Do you anticipate that the third quarter will show improvement, decline, or when do you expect to reach a positive position? If not in the third quarter, might it be feasible in the fourth quarter, assuming raw material prices stabilize?

Well, Mike, first of all, as I said, we'll release the Q after the call. So we'll have all the detail. But I would share the fact that. So in Q1, we were about $11 million behind when you look at price mix versus total inflation. We're a little bit better than that in Q2. So we've closed that gap, again, price/mix versus total inflation. As you look forward, as we've said, it's a little bit more unpredictable with the rise of energy in Europe, especially impacting both our consumption of natural gas and our chemicals. So we would expect a little bit spreading of that gap in Q3, and that was all considered in our guidance.

Okay. Appreciate that. And also I just wanted to circle back to a couple of the top-line headwinds that you highlighted in 2Q. The first, some of the channel inventory reductions and then the impact from the rug business. It would be very helpful, if possible, if you could kind of give us a rough sense of what the channel inventory reductions, what type of headwind in terms of sales growth, what type of hit to sales growth that caused? And looking forward into 3Q, I assume you have some type of an assumption on channel inventory reductions as well as the rug impact. And I was curious if you could share that with us as well.

As you can imagine, we don't have precise insights into our customers. Much of our understanding is based on intuition rather than concrete data. Additionally, due to the size and variety of the segments, there are many differences among businesses and channels. In the retail sector, where there are substantial inventories, we believe that many retailers are reducing their stock in response to a decline in demand. This situation has been exacerbated by elevated inventory levels resulting from lower service levels over the past year and a half. While we don't know the exact figures, we anticipate that there is still more to reduce. Regarding the rug segment, based on information about the top ten retailers and countries, we know they are all overstocked. They are making efforts to cut back in various ways to manage their inventories, leading to a significant decline. We believe that a substantial portion of the excess inventory has been addressed, and we expect moderate improvements in the rugs compared to other categories moving forward.

Okay. Thank you.

The next question comes from Keith Hughes with Truist. Please go ahead.

Thank you. I had two questions on mix. One, you said in the prepared statement that, mix in Europe was positive in the quarter, a little bit more. And then in some of the mix pressure you're seeing in North America, is there a lot of variation by product category, how much pressure are you seeing?

We got the mix things in Europe.

I'm sorry, can you repeat the last question? It was hard to hear you.

Yes. The mix pressure you're seeing in North America, does it carry by product category in terms of severity, or is it pretty uniform?

The first part of the question concerns the product mix, particularly in Europe. In the second quarter, ceramic Europe performed well by effectively managing the energy-related inflation. Overall, with a growth in commercial products, this has positively impacted the margin profile in both ceramic and North America, in addition to ceramic Europe. We are also focusing on promoting our premium products despite the ongoing inflationary pressures.

And in North America, is there any amongst the products in terms of pressure, downward pressure?

I'm not sure there's that much difference between the categories at this point. The carpet industry slowed down more. So it's probably got more impact.

The next question comes from Truman Patterson with Wolfe Research. Please go ahead.

Good morning everyone. Thank you for taking my question. I would like to get an update on the competitive dynamics for your European ceramic business, especially in light of the Ukrainian mining shutdown. Have your competitors been able to introduce reformulated products and secure access to clay? Additionally, have you been able to reformulate your product as well?

Truman, we've reformulated our body composition with alternative materials. The majority of the products will change over in the third quarter and the balance will be changed as we get into the end of the year. We're not exactly sure where the rest of the group is, but we've made a lot of progress in changing our material.

Okay. Perfect. And then as you guys mentioned, the commercial data points that we track have been really strong still. It sounds like retail in the US has been soft. But could you break out in North America and maybe what your commercial sales were up year-over-year and how it compares to the US residential or R&R retail sales during the quarter?

We don't break it down at that detailed level. The commercial construction remodeling, as you said, is strengthening across all channels. It's led by government, workplace and healthcare channels. We've seen the hospitality and retail increase, and it hasn't recovered as much. So it's got a lot more to go versus the other channels. We're seeing projects that were delayed being reinstated. And I think we said this earlier, the hard surface businesses continue to grow faster than the carpet tile business. In our business, the commercial has a higher margin than our residential business. So it's improving our mix. And then within the commercial business, as these larger projects go on, they tend to use higher value products, which improves our mix part of it.

And I would say the concentration is higher in US ceramic than is in Flooring North America as a percentage of the sales.

Okay. Thanks guys. And good luck on the coming quarter.

Thank you.

The next question comes from Adam Baumgarten with Zelman. Please go ahead.

Good morning, everyone. I apologize if I missed this, but could you provide more details about the temporary shutdowns in the Rest of World segment that you mentioned, and which specific products were affected?

Well, in the quarter, as we saw demand lessen and the environment becomes more unpredictable. We did pull back on some production to keep inventory aligned.

Was that in specific product categories out there, or is it across the board?

I believe it was more related to the flooring category. However, it’s important to note that vacations are approaching, which usually leads us to build inventories during that time. This year, we are planning for more downtime compared to last year when we aimed to minimize downtime to increase inventories. During the vacation period, we will have more downtime.

Okay. Got it. And then just maybe if you can give us an update on the European ceramic natural gas headwinds that you saw in the quarter. And what you're building in for 3Q?

Historically, energy costs account for about 10% to 15% of our ceramic expenses, but in Europe, that figure has risen to 35% to 40%. Recently, gas prices have surged again, and we will need to observe how the market develops. In this challenging environment, we are concentrating on the premium segment, where energy costs represent a smaller portion. We have launched more differentiated products, and I anticipate a slight decline in our share in the lower-end market.

Okay. Thanks a lot.

On the other thing, if the gas prices stay where they are, that will have a bigger impact in the fourth quarter as the inventory flows through.

Okay. Thanks. That's helpful.

The next question comes from Matthew Bouley with Barclays. Please go ahead.

Hey. Good afternoon. Thank you for taking the questions. I wanted to ask about North American, I guess, competition versus imports specifically. Now that ocean shipping might be loosening a little bit. Clearly, the US dollar is getting stronger. What's sort of your sense for the competitive landscape evolving there versus imports and pricing power versus importers? Thank you.

Well, in the quarter, import pricing increased given energy and transportation costs. Ocean freight availability is improving, but the cost is still elevated. Our domestic manufacturing is well positioned with the premium collections and our commercial demand is improving. We've seen the freight decline a little bit, but it's still elevated.

Okay. Got it. And then secondly, apologies if I missed this, but just the free cash flow result in the quarter. You mentioned building inventory and the inflation around that. But just sort of speak to the outlook on working capital and ability to sort of generate additional free cash flow as we move through the year? Thank you.

The balance sheet remains very strong with liquidity at $1 billion and leverage finishing the quarter at roughly 1.1 times. Cash flow was approximately flat for the quarter, affected by rising inflation and increased sales, along with investments in our capital projects. As the year progresses, we expect to achieve strong positive cash flow, with inventory rising primarily due to inflation, enhanced service, and some investments in future projects that will benefit our results going forward. Additionally, we've committed to two acquisitions totaling around $440 million, and the full year capital expenditures are now estimated at about $785 million.

All right. Thanks very much.

The next question comes from John Lovallo with UBS. Please go ahead.

Hey, guys. Thank you for fitting me in here. Maybe just two quick ones on my end. The first one is when do you anticipate hitting the full run rate of that $35 million to $40 million in targeted savings? And how should we think about the cadence of the cash restructuring costs?

So as we said, we're completing the plans on that. You should see most of the cost hit between Q3 and Q4 with limited savings at the end of the year, and then it will ramp up to the full amount during 2023.

Okay. That's helpful. And then did you guys repurchase any stock in the quarter? And would you anticipate the buybacks kind of ramping up here given where the valuation is?

We purchased very little in the quarter with the announcement that we made of the two acquisitions for over $400 million. But based on the strength of the balance sheet that I talked about previously, additional acquisitions and stock buybacks will continue to be opportunities as we go through Q3 and the end of the year.

Okay. Thank you.

Since there are no more questions, I would like to turn the conference over to Mr. Lorberbaum for closing remarks.

Again, thank you for joining us today. We're confident about our future, and we're taking actions to improve our results. Have a good day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.