Mohawk's Magical Disappearing Reserves
Mohawk Industries’ (MHK) 12 cps 2Q EPS beat is overshadowed by key reserve declines
When evaluating a company’s earnings quality, one of the key red flags we look for is a reserve account that is moving out of step with revenue and/or the reserve’s related asset. However, as is the case with anything in earnings quality analysis, the mere presence of a red flag does not automatically indicate there is anything material going on. Analysts must dig further by looking at long-term trends and trying to determine what is driving the change before concluding that the reserve is being manipulated to benefit earnings.
In some cases, the reserve lagging may be reasonable. For example, most companies rightfully beefed up their allowances for bad debts as a percentage of their gross receivables during 2020 as the pandemic increased the likelihood that their customers would run into problems paying them back. In the last few quarters, these companies have begun to provide for bad debts on new receivables at pre-pandemic levels which has led to their reserve percentages trending down to a more historical norm. An analyst looking at a company’s reserve percentage over just the last two years might see the year-over-year decline in the reserve percentage and incorrectly conclude that the company was managing earnings. Therefore, it is necessary to take the time to look “behind the numbers” to see the movement in a longer-term context and to think intuitively about what might be driving the trend. This demonstrates once again why static ratio analysis can be very dangerous. It is also valuable to consider all such movements over time as a change in one accrual once or twice may be more innocent than when you see multiple accounts moving simultaneously in the company's favor.
Despite many red flags resulting in a false alarm, some companies we follow regularly post unusual declines in reserves that seem to defy explanation. One such company is Mohawk Industries (MHK), the maker of flooring products including tile, wood, laminate, and LVT. While MHK topped analysts' estimates by 12 cps in the second quarter, we will see that earnings appear to have received substantial and unsustainable benefits from reserve cuts over the last few quarters which make the beat much less impressive.
Warranty Reserves Plummet Despite Rising Revenue
MHK offers warranties on the products it sells. No company can produce goods that never fail 100% of the time. It is reasonable to expect a certain percentage of the flooring MHK sells today to eventually result in a customer demanding reimbursement under the warranty. Therefore. MHK estimates this future cost based on past experience and credits a reserve account for a like amount. Here is the company’s disclosure regarding the accounting policy for warranties from its 2021 10-K:
“The Company warrants certain qualitative attributes of its flooring products. The Company has recorded a provision for estimated warranty and related costs, based on historical experience and periodically adjusts these provisions to reflect actual experience.”
We don’t know what the actual provision expense is every quarter, but the company does disclose the total reserve amount in its footnotes. Logically, we would expect the reserve account to track fairly closely to the company’s revenue. The following table shows the calculation of the reserve as a percentage of revenue for the last sixteen quarters:
We see that in the early stages of the pandemic in the 3/20 and 6/20 quarters, MHK’s revenue dropped while its warranty reserve balance increased. This drove the warranty reserve percentage to as high as 2.6% which is well above its more normal level of 1.9%. We are uncertain as to what would prompt the company to do this although, given our cynical side, we can’t help but wonder if since earnings were going to be bad anyway, the company saw a chance to build up reserves then and take them down later when it needed a few cents of earnings in the future.
By the first half of 2021, the reserve percentage had returned to the historically normal 1.9% level. However, since the second half of 2021, the reserve continued downward despite strong revenue growth. In the latest quarter, despite revenue rising by $200 million over last year’s second quarter, the warranty reserve fell by almost $14 million. The decline in the warranty reserve has been spread over multiple quarters and we are not implying that the full brunt of the benefit hit in the second quarter. However, what investors should take away from the table above is that the company’s warranty reserves look unsustainably low compared to historical experience which may very well require an increase to the reserve in the quarters ahead. When this occurs, not only will the tailwind to past quarters disappear, but future quarters will experience a headwind. As we said above, we don’t know what the warranty provision expense was in the quarter, but we can estimate that it would take a charge of about 22 cps to put the reserve back at the more normal 1.9% level, and 35 cps to put it back at last year’s mid 2% level. That’s a sizeable headwind.
Allowance for Discounts, Claims, and Doubtful Accounts Is Falling
MHK records its allowance for doubtful accounts, claims, and discounts in the footnotes of its SEC filings as a single contra account netted against receivables. Unlike the warranty reserve, we understand the clear connection between the pandemic and an increase in bad debt reserves. Most companies we follow understandably shored up their bad debt reserves to account for the increase in uncertainty of collections brought on by Covid-related shutdowns. As conditions returned to normal, their reserve levels began to return to their pre-pandemic norms. Their recent quarters have received a boost from lower year-over-year reserve expenses and likely write-backs of previously written down receivables as amounts that had been written off ended up being collected. In most cases, this was not manipulation of the reserve, but rather a natural reflection of the business environment. Sure, the benefits to earnings were real, but importantly, analysts' models which drive EPS targets likely took them into account.
However, MHK’s reserves for discounts, claims, and doubtful accounts has fallen well below its historical norm. The following table shows the allowance as a percentage of gross receivables for the last sixteen quarters:
Going back this far gives a clear view of how the company increased the allowance during Covid. Before that point, the company’s allowance percentage seldom fell below 4%. During the pandemic, this rose to well above 5%. In 2021, the allowance began to trend down which was not unexpected. However, despite an increase in receivables and sales, this account has steadily declined in the last four quarters which has driven the reserve percentage down well below its pre-pandemic norm. It is logical to assume that the company has enjoyed lower expenses as it let the allowance wear down. It is also logical to assume that Wall Street models have not incorporated this benefit which takes the shine off MHK’s recent earnings beats.
As with the warranty reserve discussed above, we don’t know what the provision expense is, so we can’t calculate the exact impact on earnings in each quarter. However, the reserve percentage can’t continue to fall and at some point, the company will have to begin rebuilding it. We estimate that it would take an approximate 18-cps charge to return the allowance to a pre-pandemic mid-4% range.
Amortization Percentage of Capitalized Contract Costs Is Falling
MHK capitalizes costs to obtain contracts and amortizes them over time when the amortization period is over one year. These costs include setting up displays in customers’ stores. The company does not give any color on how long the average amortization period is. However, we regularly track the amortization expense as a percentage of the average outstanding capitalized balance over time as shown in the following table:
Capitalized costs increased during the pandemic-driven demand for home-improvement materials and have fallen off since then. As a result, we are not surprised to see a decline in the absolute amount of amortization expense. However, what is surprising is the expense is falling noticeably as a percentage of the average outstanding balances. It appears that the more recently placed store fixtures are being amortized over a longer time frame than the older ones that are becoming fully amortized. This does not seem like a sustainable trend. We estimate that if the amortization percentage had remained at the year-ago level of 26%, it would have taken about 1.8 cps off of EPS in the second quarter.
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