Interface Is Still A Risky Investment - But Conditions Could Improve From Here

The situation still looks very cloudy for Interface (TILE). The recent run-up in its share price could just be attributed to a broad-based bullish sentiment by market participants, expecting conditions returning to normal once a vaccine gets a handle on the COVID pandemic. For Interface, that would mean more workers returning to the office and therefore the opportunity for remodels and renovations.

From a fundamental basis, by reading the last 10-Q, cost-cutting measures have at least stopped the company from showing red ink on the income statement, adjusting for non-cash charges. The company reported $15.9 million in operating income in its third quarter but still shows an operating income loss of $60.2 million for the 9-month period mostly related to goodwill and asset impairment charges. On the other hand, cash flow from operations in the 9-month period ended October 4th was $97 million with collections of accounts receivable and inventory reductions the biggest contributors to cash flows.

Interface's balance sheet is not in great condition as the company has a debt-to-equity ratio of almost 2.5x. That said, management is looking to raise $300 million of Senior Notes with a maturity date of 2028 to pay down a portion of its revolving credit facility and term loans, which coupled with the $378 million in available liquidity at quarter-end should provide them with a nice buffer to wait out the effects of the pandemic.

We are still bullish on Interface just on the merits of valuation. The company has seen its forward earnings multiple expand to 8x compared to the 5x when we first wrote about the company. That said, its current multiple remains depressed (and rightly so) as risks and uncertainties remain high. For context, the company has traded between 15x and 30x earnings in the past 10 years.

In good times, Interface can achieve returns on equity in the high double digits. In the last 5 years, the company has grown earnings per share at a compounded rate of 17%. Although we can't expect those types of growth rates in the near future, at 8x earnings the market might be pricing Interface as a no-growth company in perpetuity. An investment in Interface is only for highly speculative accounts and investors should position size accordingly.

Sequential improvement

Interface reported third-quarter sales of $279 million, down 20% on a year-over-year basis, and slightly ahead of the consensus by $6 million.

Sales by region still look very depressed with orders down 25% in the Americas, 16% in EMEA, and 15% in APAC. Consolidated orders were down 21% compared to the prior year, however, on a sequential basis, orders improved by 11% from the second quarter. Management believes this sequential improvement in orders is potentially signaling stabilization in demand.

The company also saw sequential improvement across all products and modest improvement trends in Europe, especially within its Nora Rubber business in Germany, which the company acquired in mid-2018. Nora is a global leader in performance flooring and a worldwide leader in the rubber flooring category. Management also commented on its Chinese market returning to growth as more people went back to the office. Positive trends in both Europe and Asia should help offset a depressed North American market. After all, EMEA and APAC regions account for approximately 45% of total sales.

Considering the 20% drop in sales and carpet tile production down 31% year-over-year, Interface managed to maintain healthy gross margins of 37% during the quarter, down approximately 270 basis points from the prior-year period, highlighting the 70% variable cost structure of the business lessening the impact of decremental margins.

When asked during the conference call about the possibility of taking out production capacity for its carpet tile business given the current production rates and stronger demand for LVT and rubber flooring, management was adamant in keeping things where they stand right now, especially in Asia where the company wants to capture Chinese market share. The decision to keep production capacity might signal confidence in a market recovery. If the market rebounds, then higher volumes would absorb more fixed costs and thus increase profit margins. It is a good lever to have.

What's next

Interface operations might take a few more quarters to rebound due to its heavy exposure to the corporate office and commercial market, with renovations and remodels making up 80% within the commercial sector. That said, the company has taken initiative to expand its market beyond the corporate office with the introduction of LVT and rubber flooring. During the quarter, management saw pockets of strength within the healthcare, education, and hospitality markets, where hotels and schools took advantage of low foot traffic to do renovations and remodeling, helping them to offset their lack of participation in the residential market, which has experienced a mini-boom. The company believes the corporate office market will recover in the back half of 2021:

We anticipate demand to pick up in the coming quarters, and we believe there will be a recovering office market in the second half of 2021. According to our recent Gensler study, 44% of employees prefer to be back in the office full time, while 44% prefer a hybrid office home arrangement. This bodes well for the comeback of the office market. - Q3 call

The company is also capitalizing on other opportunities, such as entering the $2 billion U.S dealer market with value-engineered products through an increased sales force; and by rolling out its first carbon-negative carpet tile in the U.S and with an expected global launch in 2021. With this new product, Interface is going after the environmentally-conscious business that has set carbon reduction targets.

The Bottom Line

We can observe the market pessimism towards Interface by comparing its stock performance to a close peer such as Mohawk Industries (MHK). Year-to-date, shares in Interface are still down approximately 44% compared to Mohawk's almost flat performance, even if the latter has been accused of serious accounting fraud.

The risks are high. There is no doubt about that. If the corporate office market never recovers and the work-from-home trend becomes a permanent situation, then Interface's business model would have been seriously disrupted. Add to that the hefty outstanding debt on the balance sheet and things could get ugly very quickly. With its shares highly depressed, it seems the worst-case scenario is been projected by the market.

We find comfort in knowing that management is highly committed to paying down its debt as its number #1 priority. Next year, the company just plans to spend approximately $30 million in maintenance CAPEX, freeing up more capital for debt amortization and bringing the company closer to its 2x leverage target, compared to a current 2.9x net leverage ratio.

The investment idea remains highly speculative. But at 8x forward earnings, we believe there could be an upside opportunity if conditions start to improve from here. By showing "better-than-feared" results, Interface could see its earnings multiple re-rated higher. We remain bullish.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.