Mohawk Industries, Inc.

Good morning. My name is Natalia, and I will be your conference operator today. At this time, I would like to welcome everyone to the Mohawk Industries fourth quarter 2018 earnings conference call. All lines have been placed on mute to prevent any background noise. After these speakers' remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. To withdraw your question, press the pound key. Should anyone need assistance at any time during this conference, please press star, then zero, and an operator will assist you. As a reminder, ladies and gentlemen, this conference is being recorded today, Friday, February the 8th, 2019. Thank you. I would now like to introduce Mr. Frank Boykin. Mr. Boykin, you may begin your conference.

Thank you, Natalia. Good morning, everyone, and welcome to Mohawk Industries' quarterly investor conference calls. Today we'll update you on the company's results for the fourth quarter of 2018 and provide guidance for the first quarter of 2019. 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. You can refer to our form 8K and press release in the investor information section of our website for a reconciliation of any non-GAAP to GAAP amounts. I'll now turn the call over to Jeff Loeberbaum, Mohawk's chairman and chief executive officer. Jeff?

JEFF LOEBERBAUM, Thank you, Frank. After five consecutive years of record earnings, 2018 proved more difficult than we anticipated. With inflation increasing dramatically, luxury vinyl tile impacting other U.S. flooring products, and most of our markets slowing. In this environment, we selectively invested approximately $1.5 billion to enhance our long-term performance, primarily in new product categories and geographies, with greenfield projects and acquisitions, cost savings initiatives, and buying back shares. Our industry has faced periods with volatile costs, and shifts in consumer preferences before, and we have always navigated through them to emerge stronger in a more competitive position. In 2018, inflation in the U.S. was primarily driven by increasing material costs, escalating transportation and energy costs, and constrained chemical supply. The tight U.S. labor market increased employee turnover, which impacted both efficiencies and training costs. Our ability to offset these pressures was hindered by continuous inflation, more competitive imports due to a stronger dollar, and substitution of LVT for other alternatives. In the US, LVT is taking share from other flooring, and it will become a significantly larger part of our portfolio. Our LVT manufacturing and import strategies are progressing, and our margins will improve in the future. In the US and Europe, We are adding more talent to our LVT operations to increase our production efficiency and differentiation in 2019. While we are managing through these conditions, we are enhancing the long-term value of our business. In 2018, we acquired leading flooring companies in Australia, New Zealand, and Brazil. And in Europe, two flooring distributors and a specialized mezzanine company. We entered the European porcelain slab and carpet tile markets. We expanded our higher quality ceramic in Eastern Europe and initiated sheet vinyl production in Russia and quartz countertop manufacturing in the United States. Much of the benefit from these capital investments will be realized in 2020 and beyond as we achieve higher volume, mix, and productivity. Turning to the fourth quarter results, we generated sales of $2.4 billion, up 3% as reported, or 5% on a constant currency. For the period, our adjusted operating income was $241 million, or 10% of sales, with an adjusted EPS of $2.53. As with our full year performance, The period was affected by significant inflation, slowing markets, and LVT impacting sales of other products. Even as we executed price increases in many products, our businesses experienced increased competition and greater pressures on pricing and mix. In the period, inflation continued to be a headwind across most categories as higher materials flowed through our costs. We decreased our manufacturing production in the fourth quarter to adapt to market demand. Our startup costs in the period were higher than we projected, with LVT production improving slower than anticipated. Our new countertop and sheet vinyl plants initiated manufacturing, and our Polish ceramic tile expansion was still starting up. In the period, we purchased about $274 million of Mohawk stock, reducing our share count by $2.3 million, or the equivalent of 3% of our outstanding shares. For more details on our segments, I'll now turn the call over to Chris Welbert.

Thank you, Jeff. For the quarter, our global ceramic segment sales increased about 5% as reported, or 7% on a constant currency basis to $861 million, with headwinds from inflation, pricing pressures, and lower growth in some of our markets. Adjusted operating income for the segment was approximately $87 million, or 10% of sales. In North America, our ceramic business increased sequentially, but remained challenged due to import pressures and transportation expenses. To improve our margins, we have increased prices on our products to recover inflation and higher freight costs. We are increasing sales of high-end products made in our new Tennessee plant with technical collections for commercial and color-bodied porcelain with greater slip resistance and durability for residentials. For the premium consumer, we're also introducing luxury wall tile collections with handmade looks as well as porcelain floor tile with rectified edges and polished effects. Sales of our large porcelain slabs and countertops are expanding as they gain market acceptance. Our new quartz countertop plant is manufacturing basic products as we ramp up production and optimize our processes and formulations. We have initiated sales of our patented perennial ceramic roofing with some of the largest distributors in the country. This new product makes premium slate-type roofs accessible to the broader market. This year, we will also introduce luxury vinyl tile by Dow Tile, a new ceramic technology that will make the tile installation faster and easier. Across North America, we are taking many actions to lower our costs, including consolidating regional service centers and reducing headcount. We are improving our service by increasing our regional inventory levels and lowering our transportation costs by shipping truckloads and redistributing them locally instead of making multiple higher-cost stops. We are improving efficiencies of our manufacturing operations and installing an energy generation system in Tennessee to lower costs. In Mexico, our new production lines in Salamanca are operating well, and we are focused on improving our mix and margins. We are expanding our customer base and product offering with our Dowgress large sizes, which replicate porcelain at lower price points. We have announced price increases in Mexico to cover inflation and shipping costs. In November, we finalized the purchase of Iliani in Brazil. Iliani is an industry leader with the best brand and a premium position in one of the world's largest ceramic markets. The Brazilian market is strengthening, and both our sales and margins are expanding. We have ordered the first phase of new equipment to enhance Illiani's operations and margins following the strategy we used to dramatically improve Marazzi's profitability. We are formulating strategies to optimize our combined Brazil and Mexico sales in Central and South America. In Europe, conditions softened as we went through the period, with the Italian economy deteriorating the most due to the political uncertainties. Our exports outside Europe, which are focused on commercial projects, also slowed. Given these conditions, we experienced greater pressure on margins as competition increased. We reduced production rates in the fourth quarter and are continuing to do so in the first period. We are increasing our commercial sales force to boost sales of our premium technical ceramic. In retail, we are expanding our high-end collections and unique thin wall tile products. We are gaining traction with our large porcelain slabs, which can be used for floors, walls, and countertops. With the expansion of our European ceramic footprint, we are increasing the specialization of our plants in Italy, Spain, Poland, and Bulgaria to improve our competitive advantages. For example, we are moving production of our outdoor products to Poland, where we've added new lines dedicated to this category. We have increased the production and size capabilities at our Bulgarian plant to enhance our sales in lower price points across Europe. In Western Europe, we are creating a separate sales force specifically for these lower-priced collections. We anticipate introducing a patented easy installation tile in Europe later this year. With these actions, we expect to increase the utilization of our European assets as we move through the year. The Russian ceramic market has grown as the economy improved. During the period, our sales and profitability increased substantially, although the weaker ruble significantly reduced our translated results. To overcome inflationary pressures, we enhanced our mix and expanded our volume. We've installed two new production lines this year, which will enable us to grow both our porcelain floor and wall tile business. We are launching production of porcelain slabs, which are used for floors, walls, countertops, and commercial exteriors. In 2019, we will commence production of sanitary ware to make us a more complete provider of premium bathroom products. To highlight our offering and enhance our brand, we are expanding the number of large company-owned flagship stores in major metropolitan areas. In the fourth quarter, our Flooring North America segment sales were approximately $974 million, decreasing about 3% with an adjusted margin of 9%, including startup costs of $7 million. The segment sales slowed as we went through the period due to softer existing and new home sales, weaker remodeling and inventory reductions by customers in some channels. During the period, we initiated further price increases to recover higher material and freight costs. Additionally, we launched numerous initiatives to enhance efficiency, reduce material costs, and improve processes. In the U.S. market, LVT sales continue to increase, impacting the purchase of other flooring. In November, we announced Paul DeCock's appointment as president of the Flooring North America segment to enhance our results. He has changed the management structure to improve our marketing, operations, and innovation in each flooring product. Paul has two decades of experience in the industry and joined Mohawk in 2005 with the Uniland acquisition. Paul previously led the flooring business for our Flooring Rest of the World segment. Early in his Mohawk career, he led our U.S. hard surface business. In the period, carpet was impacted by the high-cost materials and hard surface alternatives. We have increased carpet prices to better align with our cost. In our premium SmartStrand collections, we introduced our new ColorMax technology, which blends colorations with greater clarity and deeper saturation. ColorMax was selected by retailers as the most innovative new product at the recent flooring trade show. We also updated our entry-level SmartStrand collections to enhance their sales. We expanded our patented Aero Unified soft flooring offering to strengthen our increasing distribution. We've increased our proprietary continuum polyester offering with higher style products at all price points. We have completed most of our regional markets and our residential customers remain cautiously optimistic about prospects for 2019. We continue to enhance our commercial sales organization with increased segmentation by channel and greater focus on specification of large projects. Across all products, many initiatives are being executed to enhance efficiency, material cost, quality, and service. We have reinvigorated the premium laminate category through the new investments we made to produce visuals that exceed real wood with previously unachievable water resistance and durability. Would sales remain under pressure as we provide other alternatives with superior value propositions? Both our residential and commercial LVT sales grew substantially during the period as we implemented our sourcing and manufacturing strategy. We were offering a premium Pergo LVT collection, which before introducing has great consumer brand recognition than any other LVT product in the market. Though we had anticipated even more improvement, the speed of our LBT production increased about 20% over the prior period. We are adding more engineering resources to further increase productivity, formulations, and yields. Long term, we are confident that our investment in this technology will provide us with competitive advantages when it is operating at expected levels. Our flooring rest of world segment delivered fourth quarter sales of $614 million, an increase of 12% as reported, or 16% on a constant currency basis, with acquisitions enhancing our results. Adjusted margins for the segment was 13% of sales, including startup cost of $18 million. As we progressed through the period, we experienced softening market conditions in both Europe and Australia. LVT sales continued their strong growth, and we significantly outperformed the laminate market with our premium collections. We've initiated laminate price increases to recover rising cost and currency changes. Our investments to expand laminate production in Europe and Russia have increased our market share by delivering differentiated visuals and waterproof features. The new lines also supported margin expansion with improved mix and greater efficiencies. The expanded production is enabling us to increase our sales in Russia, which has been constrained by capacity limitations. Our LVT sales continue to grow dramatically as our production rates increase. Some of our LVT introductions were postponed until later this period as we overcame technical problems that increased our costs during the fourth quarter. We have seen about 15% speed improvements in LVT over the last quarter as our processes have been refined. and we anticipate continued improvement in the year ahead. The improved performance of the new line will allow us to add unique visuals and performance features to our collections. In Europe, we are gaining share in sheet vinyl by launching new products to expand sales on the continent as our new plant in Russia has begun to satisfy its local market. Our Russian sheet vinyl facility is operating as planned and is producing goods to satisfy commitments to major customers. As we refine the plant's processes and cost, we will expand our customer base with innovative products. Our European carpet tile plant continues to progress as we broaden our product offering and customer base. We are expanding our commercial sales force and increasing the specification of our products. We have integrated Godfrey Hearst into the MOOC structure. Presently, the Australian housing market is slowing and we are adapting to the changing conditions. We are investing in new assets to expand Godfrey Hurt's commercial carpet and leveraging Mohawk's resources to enhance product and material strategies. We anticipate bringing greater value to the market with more innovative products and a comprehensive offering of hard surface products distributed under our brands. The volume and profitability of our insulation business is improving significantly. Our polyurethane insulation is taking share from other products as it did prior to prices rising from material constraints. Since the supply of raw materials has recovered, our service levels have improved and pricing has become more competitive with other alternatives. Our board sales and margins for the year were the highest in a decade. The investments we've made have improved our offering and productivity. With a softening economy in the fourth period, we experienced sales and margin pressures. We have implemented initiatives to increase sales and focus on value-added products. We're expanding the mezzanine flooring business we acquired last year as we leverage our existing manufacturing and sales organization. Now I'll pass the call to Frank, who will review our fourth quarter financial performance.

Thank you, Chris. Net sales for the quarter were $2,449,000,000 and grew 3% as reported with the legacy business up almost 1% on a constant exchange rate basis. Flooring Rest of World had the strongest growth with LVT and laminate products performing well both in Rest of World and in our North American segment. Just as a heads up, in 2019, the first quarter we'll have one additional day and then we'll have one less day in the fourth quarter of 2019. Gross margin as reported was 26.4% or 27.1% excluding charges and was down from 32.3% last year. Inflation of $61 million, lower productivity of 24 million, higher startup of 17, plant shutdowns of 15 million, and unfavorable foreign exchange of 13 million, offset increased volume of 18 million, and price mix of 9 million. SG&A, as reported, was 17.7%. or excluding charges 17.3% compared to 17.1 last year. We had unusual charges of 27 million that primarily were related to the Godfrey Hearst and Ileani acquisitions and plant consolidation in North America. Our operating margin excluding charges was 9.8% down from 15.1% last year. Inflation headwinds of $62 million along with the impact of increased startup of 18 million, shutdown of 15 million, and lower productivity of 23 million, offset $9 million of improvement in price mix. We also had a $7 million headwind from FX. EBITDA was $381 million in the fourth quarter and $1.7 billion for the full year. Our interest expense for the quarter was $14 million, which compares to $7 million last year, and the increase was related to early extinguishment of high-cost Illiani debt. Our income tax rate improved to 19.2% from 27.2% last year due to the 2017 Tax Reform Act. We estimate a first quarter rate of approximately 22.5% to 23.5% and a full year rate of 22 to 23% for 2019. Earnings per share excluding charges were $2.53, which was a decrease of 26% compared to last year. Turning to the segments, our global ceramic segment had sales of $861 million. Fourth quarter sales increased 5% as reported, with our legacy business up 2% on a constant exchange rate basis. Our Russian business reported the highest growth, and North America improved sequentially on a year-over-year basis in the quarter. Operating income excluding charges was $87 million, with a margin of 10.1%, down from 14% last year. Inflation of $30 million, declining price mix of $6 million, and increased shutdown cost of $8 million, offset incremental productivity of $13 million and stronger overall volume. In the Flooring North America segment, sales of $974 million decreased year-over-year by 3%. We had improvement in price mix of $26 million, which was offset by volume weakness and soft-surface product lines. Our operating income, excluding charges in this segment, was $86 million, with a margin of 8.9 percent compared to 16.7 percent last year. Improvement in price mix of $20 million was offset by inflation of $36 million, unfavorable productivity of $37 million, and $7 million of production shutdowns, as well as startup of $7 million. We also had $17 million of lower volume. In the Flooring Rest of the World segment, Sales were $614 million and increased 12%, as reported, with our legacy sales growing 3% on a constant exchange rate basis. LVT had the strongest growth in this category. Operating income excluding charges was $78 million, with a margin of 12.8% compared to 15.8% last year. Productivity and lower material costs were offset by $5 million of foreign exchange and another $5 million of lower price mix, as well as higher startup of $13 million. In the corporate and elimination segments, we had an operating loss of $11 million, and in 2019, we are estimating a loss ranging between $35 and $40 million. Jumping to the balance sheet, Receivables ended the quarter at $1,606,000,000 with our days sales outstanding at 60 days in the quarter compared to 59 days a year ago. Inventories ended the quarter at $2,288,000,000 with inventory days at 128. Our inventory was up $340,000,000 from the fourth quarter of last year with 70% of the increase from new businesses and acquisitions and 30 percent of the increase from Chinese pre-buy and inflation. We lowered our legacy manufactured inventory in most categories as we ran production below sales during the quarter. Our fixed assets for the quarter ended up at $4.7 billion and included capital expenditures of $151 million with depreciation and amortization of $139 million. For the full year, capital expenditures were $794 million, with depreciation and amortization of $522 million. We are estimating CapEx for 2019 to be approximately $550 to $580 million, with depreciation and amortization estimated at $560 million. Looking at long-term debt, our balance sheet and cash flow remain strong, Total debt was $3.3 billion at the end of the quarter, with leverage at 1.8 times debt to EBITDA. Jeff, I'll turn it back over to you.

Thank you, Frank. As we enter 2019, many macroeconomic conditions around the world could impact our results. Economies have been slowing in most of our markets, oil volatility is making our costs unpredictable, and the housing markets in many regions are under pressure. Though our outlook is cautious because of these issues, we expect our results to improve through the year. In the first quarter, we're reducing production rates due to softer environment in most of our markets. Higher priced materials will flow through before we realize the benefits from recent changes. The dollar strengthens relative to last year and will have a significant negative impact on the first period. We continue to introduce innovative new collections, implement price increases, and improve manufacturing processes. Taking all of this into account, our EPS guidance for the first quarter of 2019 is $2.02 to $2.12, excluding any one-time charges. Our major product and geographic expansions are at various stages of ramping up. As we progress through the year, these investments will increase our sales and margins. Price increases will benefit our results. Our startup costs will decline. and production levels will increase. We will realize the potential of these projects in 2020 and beyond as volume and efficiencies increase. Today, the business is strong with substantial resources, a broader product portfolio, and a more diverse geographic footprint. We have a strong balance sheet, extensive liquidity, and historically low debt leverage. In the short term, we are taking the appropriate steps to manage through these market uncertainties, and we're confident our investments and acquisitions will significantly enhance our long-term business. We'll now be glad to take your questions.

Ladies and gentlemen, at this time, if you would like to ask a question, please press star, then the number one on your telephone keypad. Management requests that you limit your questions to one primary and one follow-up. If you have additional questions, you may re-enter the queue by again pressing star 1 on your telephone keypad. And your first question comes from the line of Michael Wood with Numera Instanet.

Hi, good morning. Thanks for taking my question. I was hoping you could shed some light on general industry dynamics in the U.S. ceramics market with the 10% EBIT margins you reported, which are going lower in the first part of 19. I guess even if we say you're tracking above that because of the investment headwinds and destocking that are hurting results temporarily, where do you think the competitors are from a profitability standpoint and where that marginal production cost is? I'm trying to understand that given your scale advantages, at what point do you start to see the competitors alleviate some pressure that you're seeing on the price-cost side?

The competitors, we believe, are already reducing their production rate significantly in the U.S. market. However, about 50% or more of the U.S. capacity is satisfied by worldwide supply base and is imported. At the same time, you have the 10% increase in tariffs from China, which is the biggest supplier of imports to the country. So you have a lot of dynamics going on. We are raising our prices as we speak to recover some of the freight and margin loss we've occurred so far.

Okay. And then a follow-up. You talked about the deteriorating, slowing sales in many markets. Can you just give us an update on what markets you've seen stabilize since at the start of this year and what markets are continuing to slow down?

So we see in Europe, the market's slowing across. We have a large part of our sales are in Italy, which is going into a recession. We have the Russian market is improving in Russia. The Mexican market decreased in 2018. It was running at double digits in our category in 2018. 2017 and 2018, it was running negative. We think a lot of it was caused by the interactions between the U.S. and them, but we see it improving. And the U.S., your guess on what's going to happen with the economy and housing is as good as mine this year, is it?

Okay, thank you. Good luck.

Your next question is from the line of Steven Kim with Evacor ISI.

Thanks very much, guys. First question is about your LVT production and how or whether your plans have evolved since you started building the two major lines a couple of years ago, the two new lines. For instance, I'm wondering, is your intention to focus the new Dalton line on high-end rigid LVT and source the rest, whereas maybe previously you intended to produce both high- and low-end rigid, or maybe you're planning to do more flexible LVT on that line for the time being, or is it basically just that your plan is essentially unchanged, just merely delayed? So whatever you can share about your thinking and how it may have evolved would be great. And as for the rigid product you're currently making, where is this product being sold today?

see if I can answer all those. So in the United States, our strategy hasn't changed. The new line is focused on making rigid products, and it will primarily make mid to higher-end rigid products because we think we can utilize the full capacity doing that. We changed the thing that, given that it was taking us longer than we hoped and the market was growing faster, we changed the strategy in the middle of last year And we began importing more products so that we could satisfy larger parts of the marketplace. And going into this year, we've raised our inventory substantially in LVT going into the year to support it. And then we've also announced that we said we're introducing a new Pergo brand in that, which today has a higher consumer market. brand than any other thing in the category. We haven't sold the first piece of it yet, and we're also going to put LVT in the Dow Tile product offering this year.

Okay, got it. That's helpful. Okay, so then my second question relates to inventory. I think you mentioned that you're sort of building the stuff that you're making in LVT, the new LVT lines is going into inventory right now. I assume that means that you're going to be looking to launch this Pergo product, I guess probably in the home centers, I'm guessing, and maybe other places too, in one queue, I'm guessing. So could we actually see inventory dollars down as soon as 2Q this year? And I mean on a year-over-year basis, inventory and dollars down? Or are we going to have to wait until later this year?

First is that I assume you know that the Chinese have a down period in the first of the year, so you have to pre-buy ahead of it. The second is we are expecting our sales to go up, so we're building inventories for those product categories before we have any sales. and you have to build enough so you can satisfy the customers. Third is the inventory is also going into all these new businesses we keep talking about. When you start them up, you put in all the raw materials, the inventories, and you're building new products before the sales in those too. So the inventories are all there. Frank, you want to touch a little bit on where the inventory distribution is at this minute? The inventory growth distribution?

Oh, yeah, yeah, yeah. Like I said in my comments, about 70% of the $340 million of growth is in new businesses and acquisitions and the balance either in Chinese pre-buy or inflation. I think another point to make there is that we've worked real hard to – take our inventory, manufactured inventory levels down by production levels down below the sales levels. And I think we've done a pretty good job of keeping the manufactured inventories down in most categories.

The growth in all these different businesses, you have to put the inventories ahead. So I don't expect the inventory turns to be where we'd like them going into the second quarter because it's going to take a while to get all these business is up even though the inventory is there to support much higher sales.

Okay. So inventory probably won't be down year over year until maybe the back half of the year is kind of what I'm hearing. Is that fair?

Yeah, the turns. It'll be the turns rather than the inventory.

Okay. So the turns will be up, got it, in the back half. All right. Thanks very much, guys.

Your next question is from the line of Matt Bowley with Barclays.

Hi. Thank you for taking my questions. Jeff, could you elaborate on the comment you made there around improving results through the year during 2019? Is that a revenue growth or a margin comment? Are you anticipating, I guess, the margin declines to lessen? You know, just how exactly should we model improving results after the first quarter? Thank you.

To start out with, the outlook, you know, which we said is cautious because of the economies and the housing, which we're having difficulty projecting what's going to happen this year. But we do expect improvements in the business as we go through with expansion of the sales and the margins as we go through the year.

Okay, understood. And then secondly, does the first quarter guidance anticipate any effect from the tariffs? I'm assuming you wouldn't necessarily see an immediate impact, but I guess beyond the first quarter, obviously as you're sourcing from China, how should we think about what the margin impact would look like or what you're planning around that? Thank you.

I don't have any idea whether the additional tariffs will go in or not go in. We don't know. We haven't built anything into our plans, but we'll have to adjust if they go in how we operate and how it impacts the marketplaces.

Okay, thanks for the detail.

Your next question is from the line of John Lovello with Bank of America.

Hey, guys. Thank you for taking my question. The first question, just following up on Matt's question maybe, it looks like the first quarter implied operating margin could kind of be in the 8.5% to 9% range, and realizing that could be just conservatism on your part. But the comments about things getting better or improving, I mean, should we be thinking about improvement just sequentially, or should we be thinking about that on a year-over-year basis in terms of operating margin?

We were talking about the year-over-year margin percentage improving sequentially.

Got it.

Okay. Third quarter, fourth quarter.

Yep. Okay. Got it. All right. That's helpful. And then, you know, if we think about – some of the headcount and consolidation that you guys had, headcount reduction, I should say, and consolidation of the service centers that you guys talked about. I mean, clearly makes a lot of sense from a cost perspective. Is there any risk, though, that, you know, of negative impact to your operations, or was this really just kind of redundant capacity?

What we did is, in some of the major markets, we had multiple stores in every corner of the metropolitan areas, and we've developed ways of getting the product to those customers with less service center footprints in the area.

Yeah, and we don't really see a risk to that because we analyze each market by market and where we took the reductions, we should be fine.

Okay, thanks, guys.

Our next question is from the line of Mike Dahl with RBC Capital Markets.

Good morning, thanks for taking my questions. The first question, I wanted to go back to the discussion around inventory and not withstanding the uncertainty about whether or not tariffs go into effect at 25% in March, just focused specifically at what's played out over the last couple of months. You mentioned the Chinese pre-buy, part of that is around the Lunar New Year, part presumably for you guys and also maybe your competitors is related to also getting that in out of the tariffs. Can you just discuss what you're seeing in terms of both competitor inventory levels and channel inventory levels from your customers in LVT?

I can't speak for my competitors because I have no idea, but we are raising the inventories or all the reasons you just went through. In some cases, we're buying it ahead because of the pricing. In some cases, we're buying it ahead because of the increases. And in some cases, we're buying it ahead to expand our business and footprint and brands we're selling under in each cases. So it's all of the above. I would imagine the rest of the world's doing the same thing.

And so do you see any potential channel issues in terms of too much inventory in the retail channel as you head into the spring?

I mean, I can see what on the ceramic side we tend to build up in preparation for that Chinese shutdown. But then as you go through the quarter, obviously your inventory goes down because you're not buying more from the Chinese. why they're shut down.

The imports in ceramic, which we can see, always go up dramatically the first of the year as people are putting in new products, changing out old ones and building up the inventories. And so what happens is the imports decline as you go through the year, and they make adjustments in the second half coming out of it. So you typically go in with a more optimistic view, and you adjust in the second half of the year, and you can see it in the import data.

Got it, okay. And then my second question, Jeff, I was hoping you could give us a little more color around Paul's appointment in North America and just what specifically he's already changed out and if there's anything more radical in nature that he's considering as far as strategy there.

I guess a little background on Paul. Paul's been in the industry his whole life. He joined our business when we acquired Unilin in 2005. At that point, he came to the United States and he ran our United States hard surface business for a number of years. And then he went back and he's been running the rest of the world's segments flooring business since. Since he got here, he's announced changes in the management structure where we've had a more focused approach on each product category And with that, we expect to have greater efficiencies and execution in each category. At the same time, we're going to enhance the sales synergies across the total segment as we go through. And a majority of those things needed to be done have already been announced and executed.

Okay, great. Thank you.

Your next question is from the line of Catherine Thompson with the Thompson Research Group.

Hi, thank you for taking my questions today. The first is really more for LVT production, more specifically in the U.S., but secondarily in Europe. As you think about tackling the new ceramic or stone-type LVT product, is this a type of product that you would attempt to manufacture domestically, or is it still a type of product that you would prefer to import? And just really broadly speaking, stepping back and looking at the forest for the trees, how do you intend to tackle the fast-growing different types of products coming out of LBT, either manufacturing or more import? Thank you.

There are two types of stone products. One stone product is just changing the stone ceramic looks, is just changing the visuals on the various types that are here. which we have been doing the other, and then there's a new product type that has a different core with it that's being made in China, and we have not entered that one yet.

Okay. Is it your intention to get into that product this year?

Our strategy is to... have both a source strategy and a manufactured strategy. And if the business believes they're better off or they need something that's sourced, we won't hesitate to do it.

Okay, great. My second question just is on flooring North America. You gave some great detail and prepared commentary on some puts and takes on the margins. But as we've had really two consecutive quarters with pretty steep declines year over year, help us understand what things are more easily addressable and fixable, and what ones will take a little bit longer to rectify. So really kind of more, you know, inflation things that can catch up, but others that are trickier, like manufacturing. Thank you.

I mean, there's some... Going forward, there are different issues. So the issues you have with the overall... economies and pieces which we can't control, which we're not sure exactly how they're going to evolve and we're going to have to react to. You have issues in each category, like ceramic, where the stronger dollar has reduced the pricing in the marketplace. The tariffs are raising the prices of the stuff coming out of China. And at the same time, our freight costs have been going up here, which we've absorbed last year. we announced an increase at the end of the fourth quarter to try to recover some of the margins as well as the freight costs to get them back. In each of the different product categories and markets, there's different dynamics in each. You have on top of that, all of these new investments we have are underutilizing the fixed costs because when we go into the new businesses, it takes time to ramp them up which is why we said that a large part of these new profitability will be in 2020 and beyond, because even if we start them up and get them there, we have to get the customers to buy enough to hit the profitability that we expect. So it will improve through the year, but until you hit these rates of utilization that we need in each one, you won't be to the potential of what they can have.

All right. Thank you very much.

Your next question is from the line of Susan McCleary with Credit Suisse.

Thank you. Good morning. My first question is just it seems like you did make some significant progress in the quarter in terms of price mix despite some of the macro weakness that we saw. Can you talk to a little more color around that, how sustainable it is, and Really how we should be thinking about it trending as we move through this year?

I guess a few things. One is in our carpet business with raw materials, we would expect that as the inventories flow through, that it will help the margins, which should be about the second quarter. We should start seeing that. However, I can say that the oil prices, the predictions by people who know more than I do, range from about $50 a barrel to $90. And so I have no way of predicting what they're going to be and will have to react as they go through, is it. The same thing you hear as we talked about in the introductory things about introducing a lot of higher value products in each category, about try to driving the premium products. And the question is going to be as we go through the thing, we think we'll help the mix. The question is going to be how the economies and volumes are going to be as we progress through the year. And, you know, we're sure we'll improve it if we don't have any negative things we're not anticipating show up.

Okay. And then my second question is just, as we do think about your sourced as well as manufacturing strategy, can you talk a little bit to the margin differentials with those products and how we should be thinking about the implications of that on the business?

The margin differential in the short term will probably be similar. In the longer term, we would expect the margins in our manufactured to be higher.

Okay. So we should be expecting that to come through more in 2020 then?

Yes.

Okay. All right. Thank you.

Our next question is from the line of John Vaught with Stifel.

Thank you. Good morning. I had two things quickly. You gave us some color around production of LVT both in Europe and the U.S. Was that a rigid comment only, or is that all LVT, and is there any distinction between the growth rates of the two?

I think you asked a production question and a growth question, I think. Let's start with the production piece. The production, the new lines... will actually make either. In the United States, we're primarily focused on, well, not primarily, we're focused on rigid because there's enough volume to use it. In Europe, which hasn't moved as fast, we're actually producing significant amounts of flexible because the marketplace isn't moving as fast to rigid as it is here. That was the second part.

So, Jeff, you're... Your production comment in the U.S. about 20% sequential from third quarter was rigid? That was rigid. Okay. Thank you. And then secondly, the home centers are changing out their floors a little bit on what they're offering. Could you discuss how that impacted you, say, last year and how you anticipate it? impacting you this year with any focus on timing this year?

John, are you talking about a particular category?

Well, we know they're de-emphasizing carpet and hard surface emphasis, and I'm just curious as to what you're seeing, how that's impacting your business.

Listen, they're trying to participate in all the flooring categories like everybody else. At the same time, they see the trend in LVT-like products increasing, so they're giving them more space and reducing some of the space in the other ones while they still try to optimize the other product categories. And I would say that's probably similar for the entire marketplace.

I know they're also relying on our domestic expertise on the ceramic side, and we're doing quite a bit of work with the home centers.

Great. Thank you. Good luck. Thank you.

Your next question is from the line of Phil Ng with Jefferies.

Hey, guys. You know, rest of the world foreign was a bright spot for you guys last year, but you're seeing market conditions slow down a bit in Australia and Europe. How should we think about growth in that market in 19 and margins step back a little bit? What drove that?

Well, particularly on the Godfrey Hearst, we've integrated Godfrey Hearst into our organization. The Australian housing market has weakened as we expected and we're responding. We're expanding our commercial carpet tile in that market. We're sharing best practices with the United States and we're closing inefficient assets. We're also bringing innovative products to the market and expanding our hard surface offering in that market.

The other sales in Europe, the sales are moderating as the economies are. And we still have the highest growth in LVT and laminate. We're increasing prices in laminate to offset inflation over there. We're increasing our LVT sales with our expanding production. We have more sheet vinyl capacity in Europe because going forward we won't need it to supply the Russian marketplace as we go through, and we've increased the capacity in high-end laminate in both countries to allow us to expand those as we get through. A lot of it's going to depend on how the economies evolve over there, and we're expecting them to be a little slower this year.

Got slower growth, but you're still expecting growth at this point. Is that fair?

Yes. It depends on which products, markets, and pieces as you go through. Okay. I mean, they can all be different.

Got it. And just given all the moving pieces you've called out with raw mats, ramping up new capacity, Jeff, I think on the last call you mentioned that flat organic EBITDA growth was probably not a bad way to think about 19. There's obviously been some puts and takes. Is that still a real estate goal, or there could be some downside risk to that target at this point?

It depends where the economies go and what's happening. I would say there's some downside risk to that given what we see in the housing markets and the general economies.

Okay. All right. Thanks a lot. Appreciate the call.

Your next question is from the line of Michael Rehaut with the J.P. Morgan.

Hi. This is actually Maggie Welborn on for Mike. I was wondering if you could talk a little bit about sales mix by of a channel and product, um, within your segments during the fourth quarter. And, uh, specifically, did you see any shifts from the third quarter and how do you expect it to play out, um, in the first quarter of 2019?

I guess the biggest shift we saw was, you know, from the housing into the housing sales slowing down and new and existing home sales in the U S marketplace. Um, as it slowed down, we felt the impact of it. Um, Other things would be in Italy. They went into a recession, so we saw the same thing. We saw compression of the sales, and then as things slow down, you tend to see more price competition. On the other hand, in the United States market, in some of our categories, as we raise prices, we saw some of the retailers trading consumers down to try to offset the higher prices in Italy. retail so that also created a mixed change but I mean all the markets are unique and different.

Okay, thank you. And then just another question. You talked about increasing prices. I was just wondering what is your level of confidence and your ability to realize the better pricing in the first quarter and into 2019?

Again, it's a lot by product, by country. The carpet industry, along with ourselves, increased prices, and they seem to be holding through the marketplace as we speak. We've announced an increase in ceramic, which was helped by the increases in the tariffs and the large amounts coming in there. So we're expecting to be able to get those through as we go through. You go through different markets today. And ceramic in Mexico, we've raised the prices, and we're expecting those to hold. We were very aggressive in Mexico in the lower price points the last year because of the new capacity we put in and pushing it through the marketplace. On the other extreme, you have Italy, where the volume's going down in the whole industry, where there was new capacity put in the marketplace over the last year or so, and the margins are being compressed and we're projecting the margins to be lower next year and i mean um i don't know in russia we're increasing prices in the russian market and expanding it the russian market has been a growth area for us um and we see it continuing for this year also um okay thank you

Your next question is from the line of Stephen East with Wells Fargo.

Thank you, and good morning. First, you've talked about curtailing production in the fourth quarter and the first quarter. As you look at your business now, do you expect you'll be curtailing production beyond the first quarter? And if so, how long do you all think it lasts, at least what you're seeing right now?

We believe we'll be increasing the production rates to match sales going through the year, we've been producing under the sales rate in many of the product categories. So the production rate should go up and help us.

Gotcha. Okay. And then, you know, I guess two things. On the LVT, how long do you think you all are at, you know, normal capacity utilization rates for A-grade type product? Is this a 19 event that you think you can get to, or does that also stretch out into 20? And then just quickly on your guidance for the first quarter, if you wouldn't mind just rank ordering, you know, what are the biggest issues in your guidance that you gave?

Let's see. The LVT, we think that by the end of the year, we should be operating the new lines at similar productivities and speeds as our older lines, having worked through the technical challenges of it. So we think going into 2020, we'll have the lines operating at the productivity levels we expect. And then I forgot the second part of the question.

Steven, you were asking about the risk in the first quarter guidance. Is that what you meant?

No, just if you wouldn't mind, Frank, just rank ordering the issues in your guidance that's down. you know, year over year a bit more than fourth quarter, just trying to understand if you would rank order what the biggest drivers of that decline was.

In the first quarter, it would be the economy slowing in most markets. It would be housing under pressure in some regions. It would be the lower production rates due to the softer environment. And it would be the higher price materials flowing through as some of the Sales levels were softer in the fourth quarter. It takes a little longer for the inventories to flow through.

Okay. Gotcha. All right. Thank you.

Your next question is from the line of Justin Spear with Zellman and Associates.

Thank you. First question for me is just the capacity utilization in these new plants. You mentioned the 20% production speed. Where is it today, and what is fully optimized in your definitions?

The plants are running five days a week. They're running at much lower speeds than we anticipate them getting to by the end of the year. There are more interruptions from software, hardware, technical things that are being solved one after the other. There is training going on with each one. So we would expect that the production rates would increase. The downtime would decrease dramatically. Then you start working on things like the raw material inputs and how you reduce those. And you start working on other things of how to improve the product offering with more technical innovations. You know, all have to happen as we go through the year. We think when we get to the end of the year and go into 20, we'll be in a good position.

If we were to pull back and look, you have a lot coming at you. You've got raw materials coming at you. You've got macro issues. You've got LVT outgrowth issues. If you could help us unpack how much of the revenue and profit in terms of margin drag from inefficiencies that are being expressed in 18 and potentially 19, and where, when you get those optimized, how much margin improvement you could potentially enjoy as you get those up. Help us unpack that, because I think we can look at the raw materials and say that was a bad guy in 18. The other moving piece is how much is just from being suboptimized.

There's multiple parts. So one part is the startup cost. So the startup costs were about $80 million in 17, and we said the startup costs in 18 will be $35 to $40 million in the startup costs. Now, besides that, you have to get the productivity and the volume up. And the volume, when you get up to 80%, 85%, the costs start dropping dramatically and the profits go up dramatically. And then the second part is, as you start filling them up, you start selling more higher value products and lower value products. And depending upon the marketplace and what it is, the mix can be a big improvement as you go through once these things stabilize. So, I mean, we're at all different places. You know, this new plant making countertops in Tennessee I mean, it's operating one shift now, is it? One shift as we train the people and go forward. It's operating with very basic products, and that's totally different than it's going to be next year as we get through. So that's extreme on one side. In the sheet vinyl plant in Russia, it's operating on two shifts, is it? we're having to go find new customers who never bought sheet vinyl from us. And we were doing that. So the question in that one's more about the ramp up of it and how fast we can get customers to move versus technical problems and getting it started up for instance. And each one of these is unique and different, but it's balancing, you know, when you go into new things, the good news is, You're going into new products or new geographies, which is a big upside, but everybody doesn't wake up the next day and say they'll buy everything you can make when you haven't been in the markets before. So there's a lot of things that have to get laid out, which is why you really have to think of it in long-term pieces as they ramp up. When they get ramped up and running full, they'll all be running at the average of our margins for all of our businesses. If that's the potential, now the question is, is it going to happen in six months or two years in each one? I can't tell you.

In view of the LVT kind of stopping and starting, is there any change in the economics of that business relative to maybe six or 12 months ago? You mentioned you think the margins will be better internal produced versus sourced, but do you – in a no-tariff scenario, are the fully landed economics still superior or at least as good as Chinese imports? That's our plan. And lastly, the productivity initiatives, the mix-up and other productivity initiatives you mentioned, how should we think about the incremental contributions from those across your business in 2019? Well,

You have to separate out the new projects from the existing ones. In the existing ones, it's going to be more determined about the economies and the competition and what it takes to run the assets in the marketplace. And we will have to adjust as they are. If the markets are good, the mix will be better. If the markets are bad, we'll sell more commodity stuff and the mix will go down. So it depends on how the whole markets evolve over time in each product in each country.

I'm going to sneak one more in. LVT is a percentage of revenues. Where is that in terms of the flooring rest of the world and flooring North America?

Well, LVT, once we have all the plants up and running and fully optimized, we'll have manufactured sales in excess of a billion dollars. In addition to that, we will continue our sourcing strategy like Jeff mentioned earlier.

Thank you, guys.

Your next question is from the line of Keith Hughes with the SunTrust.

Thank you. Frank, in the prepared comments, in flooring North America, did you say productivity was negative 37 million? Is that correct? I did. In this second quarter row, it's been a pretty notable negative number. Can you just describe exactly what's going on there that caused that?

Yeah, it was impacted this quarter, again, by lower manufacturing levels, high employee costs, and then ramping up of the new capital projects that we've got going on. It's going to continue, Keith, to lag. Productivity will continue to lag in the first quarter with inefficiencies and higher costs. But we are expecting to see improvements as we move through the year in there.

Okay. Definitionally, in some of the other segments, you've called out the lower production or lower production volumes as a separate item, but it's lumped into this number here. Is that correct in Florida and North America?

No. Lower volume, the margins associated with the standard margins associated with lower margin volumes are included in the volume number. But to the extent you've got higher unabsorbed overhead, for example, that's going to show up in productivity.

Okay, so you talk about some shutdown numbers. That's something different, is that correct? Correct. Okay, is that just plant closures, or what is that number defined as?

Well, like in ceramic, for example, there's not plant closures, but you may have lines down.

Okay, all right. Thank you very much.

Okay.

Your next question is from the line of David McGregor with Longbow Research.

Good morning, everyone. Can you just talk about order patterns you may be seeing in commercial non-res markets?

Well, at least on the ceramic side, we've seen the commercial business slowly improve.

We're seeing so far in the first quarter, it seems like it's strengthening a little bit for us. And all the different markets, we'll have to see how it works.

Is that really with respect to North America or is it? That's a North American comment. Right. And is there anything you can say about the European non-res commercial?

I think we've seen it, at least in Italy in ceramic, it's slowed a little bit, the commercial has. Okay.

Okay. And then what were the most important takeaways for you from the International Surface event trade show?

Which trade show? One more time.

Vegas, the International Surface event trade show.

What we heard from customers is that they are, let's say, cautiously optimistic, really depending on what we see from the housing market.

All right, thanks very much.

Your final question comes from the line of Lee Molle with SunTrust.

Yeah, thanks for getting me in. Just regarding the share repurchases, it's not real big for you guys considering your cash flows, but the $200 million roughly remaining, should we just expect that to be deployed as quickly as possible considering where your stock price is?

We'll continue purchasing it over time. And depending upon the market and what's going on, we'll act different.

Fair. And then so one follow-up, just thinking about balancing the repurchases and your leverage, I guess how, do you have a max target for your leverage or how high would you be willing to take your leverage?

Related to the stock purchase, we have approval from the board to buy $500 million is the approval at this point. So to do different, we would have to go back to the board and get a different piece. The leverage in the – our total leverage, I mean, in our history of the not-too-distant past, we've been comfortable going over three times, but we want to maintain our ratings with a rating agency so we can continue to borrow money. So under the right circumstances and being able to pull the leverage down, we would leverage the company up some more.

Fair. Thanks, guys.

And we do have an additional question from the line of Christopher Van Dirk with ValueSquare. Christopher, your line is open.

Hi, good morning. Thank you very much for taking my question. I would like to hear whether you could break out carpet in the U.S., Hi. Can you hear me?

Okay, great.

My question would be regarding carpet. Could you break that out, how much there is and how big that is in the U.S.? And then also, where do you see the carpet market going in the long term? Because carpet and rugs are somewhat of a declining market, so I was wondering how Mohawk is positioning itself in that market on the longer term and how you see that evolve in the long term. Thank you.

The carpet category is approximately one-third of our total business. Global business. Global business. And it's been declining over time. If you go back a while, it was 100% of our business. It's now a third as we expand into other categories. We would expect... that the other categories would grow faster over time and it would continue to decrease as a proportion of the total.

Do you expect any further investments or will it really decline or do you expect to just go along?

The investments will be in line with what we think we need to be competitive, bring new products to the marketplace, and increase our efficiencies. But I would expect the investments in it to be lower than the other categories.

Thank you. And on ceramics, I heard rumors that there are closures in the doll pile stores. Could you elaborate a bit on that one? Because I'm always a bit surprised that – that I heard rumors that the ceramics market is suffering from the LVT. I thought the ceramics would be quite resilient to the entrance of LVT.

LVT has increased at a rate that's so high that it's impacted the sales of every product category in the flooring industry. So they've all been lowered and LVT is taking you know, 100% of the flooring increase of the entire category is it. On our stores, what we said was we've reduced the number of stores in markets where we had a number of stores and we could maintain the business with lower costs by redistributing the same business to fewer entities. And it's enabled us to reduce our SG&A costs.

I would add that on the LVT, so far it's been primarily, as it relates to ceramic, a U.S. phenomenon. In our countries like Mexico, Brazil, Russia, where labor is a lot less expensive, we haven't seen that.

And there are no further questions. I will turn the call back over to Mr. Loperbaum for any closing remarks.

Thank you for joining us. We think we're in a good position for the future. Have a good day.

This concludes today's earnings conference call. You may now disconnect.