Good day, and welcome to the Mohawk Industries Inc. Fourth Quarter 2022 Earnings Call. Please note this event is being recorded. I would now like to turn the conference over to James Brunk. Please go ahead.

Thank you, Jason. 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 fourth quarter and full year performance and provide guidance for the first quarter of 2023. 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 over the call to Jeff for his opening remarks. Jeff?

Thank you, Jim. For the full year of 2022, Mohawk's net sales were $11.7 billion, up approximately 4.8% as reported or 8.8% on a constant basis. And our adjusted EPS for the year was $12.85. The flooring industry entered 2022 with momentum from strong housing markets supported by record home sales, low interest rates and rising household formations. High home equity levels, shifts to larger homes and the desire to customize living spaces during the pandemic were driving remodeling investments. As the year progressed, the U.S. housing market declined under pressure from rising interest rates and inflation. In Europe, energy and overall inflation escalated and consumers reduced discretionary spending to pay for essentials. In the first half of the year, the company implemented pricing actions and production that offset the inflation we incurred. With reduced home sales and remodeling in the second half of the year, our Flooring volumes decreased. Our pricing did not cover material and energy inflation. Throughout the year, commercial and new construction and remodeling activity outperformed residential. Even with the housing industry slowing during the second half of the year, we concluded 2022 with a strong balance sheet, low net debt leverage of 1.3 times EBITDA and available liquidity of approximately $1.8 billion to manage the current environment and optimize our long-term results. We acquired five bolt-on businesses during the year that extend the scope of our product offering and our distribution. These include sheet vinyl, mezzanine flooring and wood veneer plant in Europe, a nonwoven flooring manufacturer and a flooring accessories company in the U.S. When we complete the integration of these acquisitions, we will expand their sales opportunities, enhance their operations and improve their efficiencies. We've just acquired Elizabeth in Brazil and are awaiting regulatory approval to close Vitromex in Mexico, both of which will almost double our local market positions in ceramic, expand our customer base and product offering and improve our manufacturing capabilities. The teams are preparing to integrate the businesses, which will create significant sales and operational synergies. Turning to the fourth quarter results. Mohawk's net sales were $2.7 billion, down 4% as reported or approximately 1.3% on a constant basis, and our adjusted EPS was $1.32. Our revenues were driven by price increases and strength in the commercial channel. Our sales across all our businesses were slower than we expected in the quarter as residential sales contracted with rising interest rates, declining home sales and lower consumer confidence. As a consequence, our customers lowered their inventory levels and consumers reduced their spending for renovation. Unlike other products, flooring does not require immediate replacement. So purchases can be deferred more than other durable goods. Commercial sales continued stronger than residential in the quarter, benefiting from ongoing remodeling and new construction projects. In the quarter, our Global Ceramic segment outperformed the others due to a higher level of commercial and new construction sales. Our Flooring Rest of the World segment softened as higher inflation and energy costs reduced demand in Europe. Our Flooring North America segment sales declined with lower residential activity and a reduction in customer inventory levels. The combination of weakening sales, plant shutdowns and the consumption of higher-cost inventory decreased the segment's performance for the quarter. In response, we reduced production rates and lowered our inventory, which increased unabsorbed overhead expenses. We curtailed spending across the enterprise, though inflation offset many of our initiatives. In both Flooring North America as well as Flooring Rest of the World, we're taking restructuring actions in specific areas to align our operations with the present market conditions. During the quarter, energy and material costs around the world began to decline, which should positively affect our future results. While we're managing the present economic cycle, we're operating with a long-term perspective and expanding capacities in areas where we have the greatest growth potential when markets rebound. These include LVT, laminate, quartz countertops, porcelain slabs and insulation. We have reduced our planned capital spending until we see greater certainty in our markets around the world. We recently announced an agreement to resolve the securities class action lawsuit filed in January 2020. Though we believe the case is without merit, further litigation would be burdensome and expensive. We reached a settlement of $60 million, a significant portion of which will be covered by insurance and is subject to court approval. We also settled a dispute with the Belgian Tax Authority regarding royalty income. Though we believe our position is correct, we settled the $187 million assessment for EUR3 million. I'll turn the call over to Jim for a review of our fourth quarter financial performance.

Thank you, Jeff. Sales for the quarter were just under $2.7 billion, reflecting a 4% decrease as reported and a 1.3% decline on a constant basis. The favorable price/mix was countered by reduced volume and unfavorable foreign exchange. The decline was mainly attributed to weakness in the U.S., where the residential markets slowed more than anticipated. The gross margin, as reported, was 20.9%, and 22.4% when excluding one-time items, compared to 26.8% from the previous year. The year-over-year decrease was largely due to higher inflation of $263 million, mitigated by stronger price/mix of $269 million and productivity of $16 million. The fourth quarter margin was further negatively affected by a weaker volume totaling $95 million, temporary plant shutdowns amounting to $69 million, and foreign exchange headwinds of $12 million. Selling, general and administrative expenses as reported were 18.6% of sales, and when excluding one-time items, they were 17.9%, consistent with the previous year. On a dollar basis, the positive impact of foreign exchange was $12 million and volume was $3 million, partly offset by a $6 million impact from price/mix and $3 million from inflation. The operating margin, as reported, was 2.3% for the quarter. Restructuring and one-time charges totaled $58 million, which included initiatives in Flooring North America and Flooring Rest of the World as well as our disclosed litigation settlements. The restructuring charges combined initiatives announced in Q2 with a new project in Flooring Rest of the World to better align our LVT assets with market conditions. Excluding these charges, the operating margin was 4.5%. The decline in operating income year-over-year was primarily driven by higher inflation of $266 million, offset by price/mix of $263 million, productivity of $15 million, and lower start-up and other items of $8 million, although these were insufficient to counter the weakened volume of $92 million and the increased temporary plant shutdowns of $69 million. Interest expense for the quarter reached $15 million, while other expense reflected a $10 million charge due to unfavorable transactional foreign exchange. In the fourth quarter, our non-GAAP tax rate was 12.6%, down from 18.9% in the previous year. We project the full-year 2023 tax rate to range between 21% and 22%, with some quarterly variations. Earnings per share, as reported, was $0.52 and $1.32 when excluding charges. Moving to the segments, Global Ceramics reported sales of $988 million, representing a 4% increase as reported and a 5% increase on a constant basis. Efforts to drive favorable price/mix across this segment and improved year-over-year volume in the U.S. helped offset declining unit volumes in other regions. Operating income, excluding charges, was $70 million, marking a 16.7% increase compared to the prior year, with an operating margin of 7.1% that improved by 70 basis points due to better price/mix of $111 million, productivity gains of $17 million, and favorable foreign exchange and other items totaling $8 million. This was set against inflation rising by $85 million, lower volume by $28 million, and increased temporary plant shutdowns of $14 million. Flooring North America recorded sales of $946 million, a 6.8% decrease year-over-year, as weaker volumes were only somewhat mitigated by favorable price/mix. The volume reduction was mainly due to declines in residential channels and customers reducing inventory levels amid deferred discretionary spending. On an adjusted basis, operating margin for Flooring North America was roughly breakeven. The decline in profitability compared to last year was driven by weakened volume totaling $32 million, temporary plant shutdowns of $33 million, and the impact of higher-cost inventory and other inflation amountsing to $109 million, partially offset by price/mix of $71 million and productivity of $8 million. We anticipate that many of these challenges will carry over to Q1; however, in Q2, with seasonally stronger sales, reduced costs, and increased production, we expect to see a significant improvement in profitability. Flooring Rest of the World reported sales of $717 million, a 9.9% decrease reported and 2% on a constant basis. While installation products saw strong growth, this was not enough to offset declines in the flooring categories, primarily laminate and LVT, as inflation led consumers to cut back on discretionary spending and customers lowered inventory levels. The operating margin, excluding charges, was 7.7% for the quarter, and operating income was down compared to the previous year due to the decrease in volumes of $32 million, temporary plant shutdowns totaling $22 million that resulted in lower productivity of $10 million, and inflation increases of $79 million, which were only partially offset by price/mix actions of $81 million for the quarter. With business concentrated in residential channels, we foresee that several of these issues will affect Q1, but results should improve throughout the year as lower energy and material costs are expected to encourage higher consumer spending. The Corporate and elimination segment reported a loss of $6 million in Q4 and $37 million for the full year. On the balance sheet front, the company generated free cash flow of $91 million in the fourth quarter and over $165 million in the second half of 2022. Receivables at the end of the quarter were $1.9 billion, with days sales outstanding at 60 days, compared to 56 days the prior year, influenced by customer and channel mix. Inventories stood at just under $2.8 billion, representing a 17% increase year-over-year, although it declined by 4% compared to the third quarter. The year-over-year rise in inventory was mainly due to a surge in inflation, while the sequential decline reflects production levels being adjusted to align with demand. Inventory days ended at 138 days for the current year versus 131 days in the third quarter. Property, plant, and equipment totaled just below $4.7 billion, with capital expenditures for the quarter at $151 million compared to depreciation and amortization at $159 million. For the full year, capital expenditures amounted to $581 million and depreciation and amortization totaled $595 million. Our current outlook for 2023 projects capital expenditures to be around $560 million and depreciation and amortization at $592 million, but adjustments will be made as the situation evolves. The company continues to maintain a robust balance sheet with gross debt at $2.8 billion and leverage at 1.3 times adjusted EBITDA, providing us the flexibility to navigate through the challenging environment. I will now hand it over to Chris.

Thank you, Jim. The Global Ceramic segment increased sales and earnings with a higher mix of new residential construction and commercial sales than our overall business. Residential ceramic sales in all geographies are slowing and operating margins are contracting due to lower volumes and manufacturing shutdowns. The cost of energy and transportation are declining, which will benefit our margins as these costs flow through our inventory. In the U.S., ceramic sales and volume both increased as we benefited from our premium product offering, price increases and growing countertop business. Our collections with larger sizes and unique finishes, combined with specialized structures and shapes, are enhancing our sales and mix. We're increasing our sales efforts in growing categories, including health care, hospitality and fitness as well as multifamily and build-for-rent homes. Cost inflation increased as higher energy and transportation expenses from prior periods were incurred. We are optimizing material supply chains and reengineering formulations to improve our costs. We reduced our inventories during the quarter by lowering production and enhancing our import strategies. We are reducing discretionary spending and limiting capital investments. To support additional growth in our quartz countertop sales, we are adding manufacturing capacity by the end of this year. Our countertop mix continues to improve as we expand our premium collections featuring our advanced painting technology. Our Ceramic business in Europe remains under pressure with slowing demand, customer inventory reductions and inflation. Our costs in the quarter were impacted by peak energy prices in the third quarter and reductions in plant volumes from temporary shutdowns. We are receiving energy subsidies in Italy, but we remain disadvantaged to some competitors who have long-term energy contracts. Natural gas prices have declined substantially, though disruptions could impact future costs. As ceramic sales slow, the market is becoming more competitive. We are introducing new technologies to enhance surface textures, expand design capabilities and improve our costs. We are completing the expansion of our large porcelain slabs to support continued growth and enhance our styling. We have successfully reformulated our body composition to use alternative materials. Sales in both Mexico and Brazil decelerated in the quarter as inflation and increasing interest rates reduced residential demand. We anticipate continued near-term weakness and have reduced production levels in both countries. To cover inflation, we are managing mix and pricing. Natural gas prices in the regions are declining in line with the worldwide market and will lower costs as they flow through inventory. We have completed the acquisition of Elizabeth in Brazil and are awaiting regulatory approval to close Vitromex in Mexico. These acquisitions will position us as a top producer in two of the world's largest ceramic markets. We anticipate significant synergies in all aspects of the businesses, which will enhance our sales and margins. We should be well-positioned to leverage our combined strengths when the markets emerge from this downturn. During the fourth quarter, our Flooring Rest of World segment was impacted by high inflation in energy prices and consumers reducing investments in home improvement. This caused a decline in residential sales, which comprise a majority of the segment's business. As consumer spending slowed, our customers further reduced their inventory levels, which lowered market demand even more. In response, we implemented temporary plant shutdowns and reduced our inventory levels, compressing our margins. Natural gas prices in Europe peaked at an unprecedented level in the third quarter, raising our material and production costs. Our pricing and mix did not fully cover inflation, which remains a headwind. We remain focused on optimizing volume with selective promotions as well as controlling costs until the business improves. To enhance our competitive position, we are increasing our supply chain from outside the European Union. We have initiated additional restructuring actions to align with current conditions. Since the beginning of 2023, gas prices have declined substantially and material costs should follow. Assuming this trend holds, Europe should see lower overall inflation with higher wages, and consumer spending should increase. During the quarter, all of our European Flooring categories experienced significant volume declines with many residential remodeling projects being postponed as inflation eroded consumer discretionary spending. Our product mix was impacted as homeowners purchased lower-priced flooring to maintain their budgets. We are launching new product collections and expanding promotional activities to improve our sales. Higher-cost inventory will compress our margins until it flows through our costs. Our sheet vinyl sales outperformed our other flooring categories as consumers chose lower-priced alternatives. We are improving the small polish sheet vinyl plant we acquired in the third quarter by increasing its output, reducing its cost and expanding its distribution. We are expanding our rigid LVT offering as it takes some share from flexible. We are increasing our existing operations and improving our formulation to lower our costs. We're adding new rigid production that makes smaller runs with additional patented features. We will phase out of the residential flexible LVT products and will close the supporting production. The cost of this new restructuring initiative is approximately $45 million with a cash cost of approximately $7.5 million, resulting in annualized cost savings of $15 million and significantly increased sales. Our Insulation business is growing as conserving energy has become a higher priority and building requirements have increased. We selectively increased pricing to cover higher material costs and we lowered production in the fourth quarter to reduce inventory levels. We are growing our sales and distribution in the U.K. as we startup our new insulation plan. Our Panels business has faced the same pressures as our other categories with softening demand and rising material prices. During the quarter, our customers continued to reduce their inventory levels, further impacting our sales. Anticipating higher winter wood and energy costs, we maintained our inventory levels going into the first quarter. Our investments in green energy have benefited our performance by reducing our reliance on higher-cost gas and electricity. The integration of our recent mezzanine acquisition in Germany is progressing as planned. We are defining best practices and utilizing our own manufacturing to replace source boards. Our business in Australia and New Zealand are slowing with the local economies as inflation and mortgage rates are impacting foreign sales. We are taking actions to align our cost and inventory levels with the expected volume decline. We have announced additional price increases and are initiating selective promotions to maximize our sales. We are updating our product offering and enhancing our merchandising to capture greater market share. As in other categories, commercial sales are stronger than residential and we are increasing our participation in specified projects. For the quarter, Flooring North America sales decreased faster than anticipated, primarily due to declines in residential channels, rug and customer inventory reductions. With inflation and interest rates at high levels, many consumers deferred discretionary spending or traded down to lower-cost products. Earnings in the segment were compressed due to lower sales, consumption of higher-cost materials, reduced inventory levels and temporary plant shutdowns. Our hard surface products outperformed soft and the commercial sector remains stronger than residential, with hospitality showing the most growth. In response to slower market conditions, we are completing our restructuring actions, deferring capital projects and reducing discretionary spending. During 2022, we reduced our costs through process enhancements and the rationalization of less efficient facilities while absorbing historically high inflation. We continue to adjust our strategies to manage the near-term market conditions; reductions in energy and materials should become a tailwind in the second quarter. Our commercial business remains solid as remodeling and new construction projects continue. We maintained strong margins in the quarter with pricing and mix offsetting inflation. Our flexible LVT products are a preferred alternative that provides versatile styling with easy installation. The combination of our carpet tile and LVT collections enables the customization of commercial spaces with unique designs. Our integration of a small flooring accessories acquisition is proceeding well. The company produces rubber baseboards and stair treads used in commercial installations and broadens our current flooring accessory business. In the fourth quarter, sales of residential soft services declined more than other categories; sales weakened as retailers reduced inventory with declining consumer sentiment and home sales. The multifamily channel was the strongest performer, and we are realigning resources focused more on this sector. As demand dropped in the quarter, we increased temporary shutdowns, which resulted in higher, unabsorbed costs. We have significantly lowered inventories in the fourth quarter and are reducing costs by eliminating less efficient manufacturing, enhancing productivity and adjusting production to demand. Participation in our recent flooring roadshows was at a record level, with leading retailers expressing optimism about the year ahead. Our rug sales were lower as national retailers continued to adjust inventories with reduced consumer spending. We are restructuring our rug operations to lower costs and align production with demand. The integration of our nonwoven rug and carpet acquisition is progressing well and provides new opportunities with our existing customers. Our resilient sales grew in the quarter as we leveraged our WetProtect and antimicrobial technologies to differentiate our collections. We offset inflation through pricing and mix, though increased plant shutdowns resulted in higher unabsorbed costs and lower margins. We are introducing new collections to expand our offering while eliminating less productive SKUs. Our sheet vinyl sales were higher as consumers pursued budget-friendly flooring options and the multifamily channel strengthened. The first phase of our new West Coast LVT plant is operating at expected levels. We are preparing new technologies that will improve our cost and add differentiated features. We will install additional production lines and train personnel throughout this year. Our Premium Laminate sales were impacted by slowing retail traffic and customer inventory adjustment. Our laminate is gaining acceptance as an alternative waterproof product in all channels. During the quarter, we offset inflation through pricing and mix, though our margins were impacted by lower absorption from temporary shutdowns as we reduced our inventory. We are beginning to see reductions in material inflation, which should help us recover our costs. Our new manufacturing line, which began last year, is operating at planned levels and will deliver our next generation of laminate features. With its industry-leading design and performance, our laminate business is in an excellent position to capitalize on the growing waterproof flooring category. Now I'll return the call to Jeff for his closing remarks.

Thank you, Chris. The flooring industry is slowing due to higher interest rates, sustained inflation and low consumer confidence. The visibility of the depth and duration of this cycle is limited, and conditions differ across the world. Mohawk has a strong record of managing these downturns by proactively executing the necessary actions. We're adjusting our business for the current conditions by reducing production levels, inventory, cost structures and capital expenditures. We're implementing restructuring actions in both Flooring North America and Flooring Rest of the World to streamline operations, reduce SG&A and rationalize higher-cost assets. In the first quarter, we anticipate more pressure on pricing and mix due to the low industry volumes. Our inventory costs remain elevated in most products due to the higher material and energy that we incurred in earlier periods. Additionally, we will not raise production as normal in the first quarter to prepare for future demand, increasing our unabsorbed costs. Our cost of energy has fallen and should benefit our global margins as our inventory turns. Our second quarter results should show sequentially stronger improvement with seasonally higher sales, increased production, and lower material costs. Significantly lower costs of energy in Europe should enhance consumer spending, discretionary purchases and flooring demand. We're refocusing our sales teams on the channels that are performing the best in the current environment. We're introducing new innovative collections and merchandising, as well as targeted promotions to improve sales. Given these factors, we anticipate our first quarter EPS to be between $1.24 and $1.34, excluding restructuring and other charges. Around the world, the long-term demand for housing will require significant investments in new construction and remodeling. Mohawk is uniquely positioned with a comprehensive array of innovative products, industry-leading distribution and strength in all sales channels. We're implementing structural changes to navigate the industry's challenges while optimizing our future results. We anticipate coming out of this downturn in a stronger position as we benefit from our bolt-on acquisitions, enhanced market positions in Brazil and Mexico, and strategic expansion of our high-growth product categories. Our balance sheet is well positioned to manage the current cycle and to drive future growth and profitability. We'll now be glad to take your questions.

Our first question comes from Phil Ng from Jefferies. Please go ahead.

Jeff, a quick question. In terms of your price/cost despite demand being weaker last year, you managed price/cost really well, but you did highlight you're seeing a little more competition on pricing. But raws are falling as well and kind of flowed through a little more in Q2. So how should we think about that price/cost equation looking in the current backdrop in 2023 and how that progresses through the year? Any pockets where we're seeing a little more pricing competition in particular you want to flag?

So the energy and material costs are moving. The low amount of volume we're seeing across the world is causing additional promotions and pieces. So far, it's been controlled across most of the marketplaces, and so we think that's going to continue. In our first quarter, we said we expect more pressure on pricing and mix at the lowest part of the year. We think that we're going to see some balancing of the cost and pricing better in the second quarter as the costs flow through inventory. We'll have to see how the rest of the year goes. We're going to have to continue to manage it and change as required.

And Phil, from a year-over-year perspective, we would expect that you still have the higher-cost inventory layers that are going to come off in the first quarter. With that renewed pressure on price and mix, I would expect the gap between price/mix and inflation to be greater in the first quarter than the fourth quarter, and that was included in our guidance.

Got you. So it feels like your margins are going to bottom out in Q1 and get progressively better throughout the year. That's really good color. And then help us think through productivity. You talked about you're rolling out some restructuring efforts in North America and the Rest of World. But demand is a little weaker and you're seeing more start-up costs with new capacity coming on. So give us a little color how to think about productivity for this year? And then how is the acceptance of some of these new capacity that's coming on? I think you're bringing on laminate, you've got some LVT coming on as well. How's the product acceptance so far?

The productivity piece is driven by multiple factors as we slowdown. Some of it we isolate; some of the costs we isolate into temporary shutdowns, but we don't capture them all. The productivity ends up being a catch-all for all of those things that change as they go through. We think due to the volume differences between last year and this year, the productivity is going to be less in almost all the businesses. If you remember last year, we were coming out of COVID in the first half; we were building inventories and running most of the businesses at very high levels. This year, we're going to be running at much lower levels, and that's what's going to show up in the productivity decrease as we go through. I think your other question was around the new investments. The new investments are all in areas that are growing and where we've had capacity limitations, and we think they're preparing this for a growth cycle as we go to the other end. We're adding laminate, which has been a growing category, and it’s expanding because it is becoming more accepted as a waterproof option, which is a technology we've brought in as an alternative to LVT and it's actually more resistant to scratches and more durable. We're increasing our quartz countertop business, which our lines have been running full. We've been supplementing with imported products to support greater sales, and that should be starting up at the end of this year. The investments in LVT in the western part of the country should support broader U.S.-based production and should give us advantages by having both East Coast and West Coast production. We are out of production in our ceramic slab businesses, which is based in Europe. It's a growing category taking the high-end marketplace as another alternative. And we've just started up a new insulation plant in Europe, putting us in a region that we haven't been in.

Just a point of clarification on that productivity comment, Jeff. You said it's a catch-all, less productivity versus last year, but on a year-over-year basis, is that still a good guide or you would expect it to be a negative headwind on a year-over-year basis?

On a year-over-year basis, when we get outside the first quarter, it should become more of a positive. Again, what you have is when you're running the facilities, even if it's not a complete shutdown, if you're running slower, you do have inefficiencies in both labor and material that are going to come through the productivity line.

Okay. Super. Thanks a lot for the color.

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

Thank you. Good morning.

Good morning, Susan.

My first question is, can you help us think about the sequential lift that you expect for the second quarter relative to what we normally see in sort of historical years? Should it be bigger than what we've otherwise seen, given some of the factors that you outlined? And then how do we think about the cadence through the year? Is it reasonable to think that first quarter should be the low point?

So going into the first quarter, residential sales are slowing and customers are minimizing their inventories. So we're expecting them to keep their inventories low at this point. We are using high-cost inventory levels in the first quarter. Production volumes are lower than last year when the business benefited from a rebound we just talked about. There's more pressure on pricing and mix due to the industry volume and competition trying to utilize facilities as we are. We see inflation impacting our labor costs around the world as we start raising the labor rates, and we're actually putting some more investments in new products to reposition some of the pieces to optimize our volume this year. With this, we're anticipating improving conditions as we go into the second quarter with lower costs. To remind you, normally, margins expand as we go into the second quarter. We think that will expand a little more this year because of seasonally stronger volume and mix. In both our Flooring Rest of the World and North American segments, we're expecting the margins to improve as the cost and pricing better align from this inventory flow-through.

Okay. That's very helpful color, Jeff. And then my second question is how do you think about the longer-term trajectory for your Flooring North America margins? You obviously made up a lot of ground in the last couple of years relative to where we were before the pandemic. How much of that do you think you can hold on to as things normalize? And how should we be thinking about what that new rate of profitability could look like?

Currently, we are facing peak costs that we weren't able to cover. These costs peaked in the third quarter and are still affecting our inventory. Pricing never adjusted to these costs as inventory levels decreased, which has affected our margins. Going forward, we expect costs and prices to align more closely, which should help improve margins. Over time, we anticipate that margins will continue to rise. However, in this current environment, there is pressure on all aspects. We need to navigate through this year, but significant improvement is expected as we move into next year.

Just to remind you, this cycle is a little bit different. It's not typical like other cycles. Employment remains strong, with wages increasing. Housing remains in short supply, and low mortgages will limit people's movement as much, aging homes, and higher home values should support future remodeling and strengthen the rebound or the pent-up demand. Commercial projects continue to be initiated; that's holding at this point. And inflation is slowing, and interest rates may actually be near peak.

Is it reasonable to assume that you can sustainably operate at a higher level than in 2019, while still possibly being below the peaks seen in earlier years?

I don't have the numbers in my head to compare them like you're asking. I think that in this year, what you have is all the lack of visibility, and we don't exactly know what the volumes are going to be and the competition is going to be. So we'll have to adjust as we go forward.

Our next question comes from Eric Bosshard from Cleveland Research Company. Please go ahead.

Thank you. I have a couple of questions. First, you mentioned the pressure on price/mix, which still seems to be ahead of costs as it was in Q4. Jeff, in previous cycles, it appears there is some pressure for a quarter or two before it improves. How should we view the behavior of price/mix during this phase of the cycle, not just in Q1 but throughout 2023?

Price/mix, first of all, you have a channel change as you go through. As you go through the cycles, the highest-margin businesses we have, with the retail replacement and remodeling businesses, tend to slow down first. So those margins slow down, and that impacts the mix as we go through. So that's affecting one part of it. The margins have been affected by these lower throughput through the plants as our costs increase, and then we have to make conscious decisions over what we do with the infrastructure and how far you cut it back in order to ensure that you're able to operate as the business improves on the other side. So we're managing those and keeping changing the strategy based on what the volume levels do. The other thing, I guess, going on this year, is you have recently, all the channel inventories were taken down. We think they should be bottomed out about now. We think the energy and inflation in Europe is going to be a big change in it as it flows through the economy over there. We see residential remodeling and home sales improving as we go through the year. With that, we expect the mix to improve as the other categories improve.

The favorable price/mix, which was approximately $270 million in the quarter, may not need to decrease significantly in 2023. The question is whether there will be a shift or change that causes this number to decrease or contract from its current level, or if it will remain stable.

You are going to see some trade down. Again, it depends if you're looking sequentially versus year-over-year. But in the first quarter year-over-year, you do have still favorable price/mix from all the pricing that was initiated in Q2, Q3, and Q4 of last year. Then you are going to get to a point where you start overlapping the initiatives from 2022. The point is, and especially in the first quarter with the lower volumes and until that starts to pick up, you're going to continue to see pricing pressure in the marketplace.

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

I'll ask a multipart question but keep it to one. Following up on some prior questions, natural gas has been a significant obstacle for ceramics throughout 2022 and has recently dropped sharply in both the U.S. and Europe. I understand you have some high-cost inventory to manage and that you were partially hedged in Europe in the fourth quarter. Can you help us understand the potential cost advantages as we progress through the year? Do you primarily address these cost advantages through pricing to boost demand, or are there offsets that would allow you to maintain pricing and recover that price cost?

Well, let's talk about the cost first. So as we get to the back half of the year, our costs should be more in line with our competitors. We should be pretty much equal.

The European comment.

Yes. We believe there will be pressure on volume in the market. However, as energy costs decrease and wages increase, we anticipate that demand in Europe could rise in the future. It all depends on how these factors play out.

And then around the world, the energy prices are continuing to come down everywhere, and it will impact the cost. We're going to have to see what happens with the competitive environment, given the slowing conditions around the world.

Our next question comes from Mike Dahl from RBC Capital Markets. Please go ahead.

Good morning. Thanks for taking my questions. Sorry to beat the dead horse here on the price/cost stuff, but I'll ask one more. On the pricing side, I guess, correct me if I'm wrong, but some of the pricing last year, we were under the assumption, it was almost kind of surcharge pricing that layered in pretty quickly in relation to some of the energy cost increases on both product and maybe on some of the logistics also. So I guess the question is, to what extent is it more kind of quantitative or mathematic in terms of how much pricing comes off as some of those costs come down, and maybe those surcharges roll off?

You are right that we had temporary surcharges in various markets on different products, affecting both product costs and freight. Most of those surcharges have now been eliminated. The main factor behind the cost increases has been price increases in the marketplace, and we will need to manage these in relation to competition to remain competitive as the market changes.

So a couple of things to note there. In the second half of the year, we generated a little over $165 million coming into 2022. Obviously, we were behind on inventory, so we had to kind of build up inventory. For 2023, our visibility is limited. We do expect cash flow to improve, but it's worthy to note that we're investing in growth categories and acquisitions to try to improve the long-term results.

Our next question comes from Stephen Kim from Evercore ISI. Please go ahead.

Yes. Thanks very much for all the info. I'm going to sort of follow up on that last question there regarding inventory. With respect to the plant shutdowns and your planned inventory reduction, I understand that market forces are driving some of this. But it also seems like there's a bit of an opportunistic aspect, perhaps, where you're shifting the timing of your annual production into periods with lower commodity cost. So in other words, what I'm curious about is if commodity costs were not declining as they are, would you still take the same amount of shutdowns? Or are you planning to take a little bit more than you would otherwise do because of the trajectory of commodity costs? And then finally, can we get some guidance about where your inventories and dollars could go over the next couple of quarters?

In the fourth quarter, we decided to reduce inventories in some areas because of our outlook on commodity prices. We lowered them even though our customers were also reducing theirs, which negatively impacted our margins for the quarter. In certain European markets, we opted not to reduce inventories at that time, unaware of a potential spike in energy costs, and kept some inventories higher expecting costs to rise in the first quarter, which ultimately did not occur. If we had known the outcome, we likely would have acted sooner to reduce those inventories. We continuously make these decisions based on our perspective of future business dynamics.

The goal is to try to keep the inventory levels and production very close to demand. So that was one of the principles behind not building the inventory as we normally do in Q1.

Okay. So that's a year-end comment. In terms of the trajectory here over the next couple of quarters, though, can you give us an idea of what we might expect, Jim?

So there is a general expectation to have free cash flow that is improved over the prior year and what you typically see, quarter-over-quarter free cash flow generation will be heavily predicated on working capital needs, particularly inventory and payables as well.

Second question relates to mix; not price per se, but mix. You've mentioned that you've seen trade down across your categories, reflecting pressure that the average consumer is feeling with their rising household expenses. And so basically, the consumer's P&L, if you will, is driving negative mix. But on the other hand, certainly in the U.S., but in many other markets, I think you've seen homeowners' balance sheet strengthen dramatically due to much higher home equity levels. And so my question is, do you expect this to show up eventually in favorable mix as folks tap into that home equity? And are you positioning your product assortments in any way to be able to capitalize on an eventual move to higher-end products or a richer mix, which is different from what you're seeing like right now?

Yes, to your question, it's really a question of timing. At this point, we see we're towards the front end of it. It started with the housing slowing down in the third quarter. So we're seeing at the front end so we would be doing all that later in the year.

We're working on new collections in LVT and ceramic that feature larger sizes and specialized shapes, which are improving our product mix. We're also implementing similar initiatives in LVT, aiming to enhance our mix further.

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

Thank you. Question, you talked about this a little bit earlier, but just some more clarification. This sequential rise into the second quarter, is that going to be felt in all three segments? And which one would you say would feel at the most?

The two ones that will feel at the most, as we said before, will be Flooring North America and Flooring Rest of the World as their costs better aligned with the pieces as you go through. The Ceramic business has held up better because of the different mix it has. So it won't have the same change in the other as the other two. So we think those two will be much more than the other ones for those reasons.

Will it be the return to normal production that poses the biggest risk, or are there other factors that could lead to a sequential change?

Well, I'd say it's a combination, really. And so you have seasonally higher demand, so that's going to help me on the volume. My production increases. So then my plants just by the nature of it are going to run better. So I don't have that unabsorbed expenses shutdowns. And then the last one would be the costs to kind of align. So inflation is not as impactful, is the hope as you go through Q2.

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

Hi, everyone. This is Andrew stepping in for Mike. I wanted to ask about your multiyear acquisition strategy. What opportunities are you seeing in terms of products or regions?

We are in the process of finalizing two ceramic acquisitions in Brazil and Mexico. We believe these acquisitions are strong opportunities because we already have a presence in both markets, and they will position us among the top players in each. Both markets are significant for ceramics, and merging these two businesses will allow us to offer a complete range of products. The companies we are acquiring focus on different aspects of the business, and our existing offerings are typically at the higher end of the market. These acquisitions will help us capture the full spectrum of opportunities available. We expect these two businesses to be beneficial once they are integrated. Typically, in the current environment, there aren't many acquisitions because of low margins; companies that are not in distress are generally reluctant to sell due to their margins and market conditions. Therefore, I wouldn't anticipate many acquisitions until we see an improvement in multiples and margin expansion.

Our next question comes from John Lovallo from UBS. Please go ahead.

Hey, guys. Thank you for putting me in here. The first question is on cash flow conversion this year, given similar CapEx levels and entering the year at sort of higher working capital levels. How are you guys thinking about free cash flow conversion?

So a couple of things to note there. In the second half of the year, we generated a little over $165 million coming into 2022. Obviously, we're behind on inventory so we had to kind of build up inventory. So for 2023, our visibility is limited. We do expect cash flow to improve, but it's worthy to note that we're investing in growth categories and acquisitions to try to improve the long-term results.

Got you. Okay. And then the second question is, it sounds like the commercial business has held up really well. Are you seeing any signs of slowing in that business?

You start with the ABI Index, which I'm sure we're all monitoring; it has been below 50 for several months. This suggests that there will be fewer projects initiated. Most of these projects typically take at least a year, with some extending up to three years, so it takes time to see their progress and understand the situation. Certain categories in commercial are performing better than others; for instance, hotels did not invest during that entire period. However, there are still ongoing investments in hotels for updates and maintenance, and they are currently performing the best. Ultimately, it all depends on the economy, but there is a long timeline involved.

Got it. Thank you, guys.

Next question comes from Rafe Jadrosich from Bank of America. Please go ahead.

Hi, there. It's Rafe at BofA. Thanks for taking my question. I just wanted to follow up on a comment you made earlier in terms of the Europe natural gas input. I think you said that you saw costs would be more in line with competitors by year-end. I thought while raw material costs were going up, your competitors were hedged, so they had lower input costs. I would have thought as the kind of gas prices come down, and they're hedged, you would actually have sort of a benefit there, lower gas prices. Is there a window where your input costs will be lower because they're hedged and they don't get the benefit from the falling raw material cost?

First is that the comment was around our European ceramic business, not all our businesses. And so in European ceramic, the cost of gas prior to this was about 15% of the manufacturing cost. It peaked at somewhere over 40%. We've said going into this thing that we have not hedged gas prices historically. It has given us an advantage by not doing it. But as you went through these things as gas prices went up by 8 times to 10 times over there, we're competing against people that had hedged it at much lower prices. The comments were around this year as the gas prices have dropped substantially that we believe by the fall flowing through inventory, we should be on a competitive level with those companies that had hedged before this whole thing started.

Got it. So because they're still hedged, will they have higher gas prices at the end of the year?

I think where they are hedged will be more like what the market will be, is the way to look at that.

We think their average hedging price will be similar because we're assuming that they hedged more. If you have a hedging policy, we're assuming that their average hedge prices will be similar to where our purchase prices will be.

That's very helpful. And then just in terms of the planned CapEx, can you just break out how much of it is maintenance versus growth? Then within that growth component, like how much is flooring categories versus some of the other growing lines like countertops? Thank you.

The growth investments, I would say, are between $200 million and $250 million, depending on timing. Most of that would be in the Flooring area. Maintenance CapEx is approximately $250 million. And the balance is on cost reductions, product innovation, and acquisitions.

Our next question comes from Adam Baumgarten from Zelman. Please go ahead.

Hey, everybody. I have a question about first quarter EPS. Since it appears to be in line with the fourth quarter, should we also expect similar performance at the segment level?

Could you please clarify your question a bit more?

You said your EPS guidance is really the same in Q1 versus what you put up in Q4. So just from a segment fundamentals and performance, should that look similar as well?

So I would say Flooring North America, given the market conditions and such, remains slow, and we anticipate more pressure on pricing and mix with the higher-cost inventory still being used. Production levels will still be low, and labor inflation will increase. But given this, I still expect margins in Q1 should be slightly better and then strengthen in Q2 when the costs align and volume seasonally increases.

Got it. Thanks. And then just on the LVT piece, shutting down or exiting the business out of Europe, do you foresee a similar move in North America at some point? And also just on the European exit in flexible, are you able to repurpose that capacity for the rigid manufacturing?

Yes. To address that specific question, in Europe, we are transitioning from our residential flexible products to rigid ones. We will continue to manufacture flexible products for the commercial sector. In the U.S., we will not pursue that change since we have a significantly larger commercial presence that utilizes our flexible LVT.

Our next question comes from Laura Champine from Loop Capital. Please go ahead.

Good morning. Thanks for taking my question. In Flooring North America, are you holding share versus your competition?

We think that the carpet industry, we are in line with the industry.

Got it. Is the issue that carpet is losing market share compared to other flooring categories? If that is the case, is it simply due to the shift towards Commercial, or are there other factors involved?

I think it's a few different pieces. One is you're comparing to the fourth quarter, the prior year where we had really significant pent-up demand, that the inventories were low, and all the plants were running as much as we could get labor and material to run, and you're comparing that now to an environment, and our customers' inventories were low and they were actually trying to build their inventories, which continued into the first half of the year. So you're comparing that to an environment where the opposite is occurring. Our customers are lowering inventories, the environment is slower. And so that's exacerbating the decrease, but it is still losing share to hard surface as it has been.

Our next question comes from Kathryn Thompson from Thompson Research Group. Please go ahead.

Hey. Good afternoon. It's actually Brian Biros on for Kathryn. Thank you for taking my questions. It seems like after Q1, maybe starting in Q2 or even midyear, things are expected to ramp up from the current low levels going on now. What indicators do you guys look at to understand when and how much to ramp up production? There's obviously just seasonality lift. But beyond that, is it strictly just orders coming in? Or are there other metrics you look at to kind of get a sense of how do we get ahead of this retail customer, the new residential activity that picks up to be ready for the ramp-up and not just reacting to it?

We adjust our actions based on how much capacity we have. In a slow market, we have surplus capacity that allows us to respond rather than predict demand. Earlier, we mentioned that we typically build inventory in the first quarter to prepare for higher demand later in the year. However, this year we're not following that same approach due to our available capacity.

Okay. That's helpful. And second question, I guess, is given the restructuring plans you guys have, adjustments of product, operating lines, plants, is there a way to think about kind of the new Mohawk capacity going forward here, a lot of moving pieces, especially since you're also adding some products as well. But is there just a way to understand what the company is able to serve going forward now versus what it was previously? Maybe something like we took out 5% of capacity or across our footprint. Just any color on that kind of dynamic would be helpful.

We have reduced some of our less efficient carpet plants and are adjusting the rug business to match lower volumes. We mentioned that we are decreasing capacity in flexible manufacturing in Europe. The increases, on the other hand, are found in our main growth categories, which I can repeat if needed or you may already have that information.

Our next question comes from Matthew Bouley from Barclays. Please go ahead.

Good afternoon, everyone. Thanks for taking the questions. Another one on the Q1 earnings guide, just to make sure we got all this right. It sounds like you're speaking to some additional kind of headwinds that might be worse sequentially. Price/cost, I heard you mentioned, obviously, reducing production and all that. You're guiding to earnings flat sequentially, roughly, and historically, Q1 is below that of Q4. So I'm just curious what else we're missing there? What might be a little bit better than you typically see seasonally? Thank you.

I don't think that we're anticipating Q1 being significantly better. We are trying to manage our inventories tighter, given that our future view is weaker, and that we don't want to build inventory. We think that the commodity prices and energy prices will stay low. So we're not trying to build the inventories in the first quarter.

When considering sequentially, the two benefits are the lower costs from Q4 to Q1 and fewer shutdowns during the same period. However, these advantages are somewhat balanced out by the price mix, which is leading to relatively stable performance from quarter to quarter.

Okay. That makes a lot of sense. That's very helpful there. And then secondly, back on the pricing environment in European Ceramic. And just any thoughts kind of if you kind of educate us historically, how does the market kind of typically react there to reductions in input costs and you mentioned the competitive environment? Just I know it's prognostication, but any thoughts from you guys on how you think the competitive environment will evolve given the reduction in costs there? Thank you.

Our business is facing challenges due to slow demand, reductions in customer inventory, and inflation. This quarter's results were affected by energy prices from the third quarter and temporary shutdowns. The market continues to receive support from energy subsidies. We are currently at a disadvantage because of hedging, particularly in the first part of the year. As the year progresses, we hope that energy costs will decrease and consumers will experience improved conditions with rising wages and falling energy costs. However, I believe the competitive landscape in Italy will remain challenging in the short term.

Some of you don't keep up with Europe; there were people that their energy costs were more than their mortgages. I mean, it's a huge drag on the economy.

Yes. Got it. All right. Thanks, everyone.

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

Good morning, everyone. Jeff, just a question on the commercial business here. How are you thinking about your competitive position in North American commercial flooring? And do you see sustainably better flooring fundamentals in this category and therefore, you invest more aggressively to gain share? Or do you attribute the relative strength you're seeing in commercial to just timing and the typical lag of the categories to start showing behind changes in residential and therefore, you kind of go forward with what you have? Just curious on how you're thinking longer term about capital allocation in the commercial flooring.

We have been enhancing our commercial business by providing both products and capacity to meet the demand we anticipate, without any restrictions. Typically, during these cycles, commercial is the last segment to decline. However, this current situation is quite unusual because, unlike past cycles where all categories deteriorated, hospitality is currently performing very well while other sectors are struggling. The airline industry is also thriving. This is an unusual environment we haven't experienced before. We'll have to see how everything unfolds, but we are committed to investing in the commercial business. We have solid partnerships, a wide range of products, and we plan to maintain this investment.

Okay. If I could just ask a follow-up, really, just trying to calibrate here. Within your first quarter guidance, what do you assume for U.S. residential for industry unit growth?

It depends if you're looking year-over-year or sequentially. So sequentially, we would expect the volume to improve generically across the business from a sales volume perspective, but certainly, year-over-year, it's going to be under pressure.

It will be significantly below last year.

Right. Yes, I think you discussed that previously on the call. I'm just trying to get some sense of what maybe quantitatively you're looking for, so we can calibrate against the guidance.

I don't really have a good number to give you just on specific on residential units.

This concludes our question-and-answer session. I would like to turn the conference back over to Jeff Lorberbaum for any closing remarks.

Thank you very much for joining us. We are in a strong position to manage through this period. It's going to be slower for the near term, and we're continuing to invest to optimize the long-term results, and we think we're in a very good position to improve our business as we come out. Thank you very much.