莫霍克工業集團 (MHK) 2005 Q2 法說會逐字稿

At this time, I'd like to welcome everyone to the Mohawk Industries second quarter 2005 earnings conference call. [OPERATOR INSTRUCTIONS] Now I will turn the conference over to Mr. Jeff Lorberbaum, Chairman and Chief Executive Officer. Sir, you may begin your conference.

Thank you very much. Welcome to Mohawk's second quarter conference call. With me I have Frank Boykin, our CFO, who will read the Safe Harbor statement.

Certain of the statements made during this conference call, particularly those anticipating future performance, business prospects, earnings and expense estimates, operating strategies, acquisitions, new products, the impact of military conflict, and similar matters constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended. Estimates and forward-looking statements involve a number of risks and uncertainties. These or other assumptions could prove inaccurate and therefore there can be no assurance that the estimates or forward-looking statements will prove to be accurate. For those estimates and forward-looking statements, Mohawk claims the protection of the Safe Harbor for forward-looking statements as contained in the Private Securities Litigation Reform Act of 1995.

Thank you. Mohawk's second quarter net earnings were $93.8 million and diluted earnings per share were $1.39. Both improved 8% above last year. Net sales for the quarter were $1.624 billion, an increase of 9% above 2004. The improvement comes from internal growth, higher selling prices, lower SG&A and growing hard surface sales, which were somewhat offset by higher raw material and energy costs. The second quarter showed continuing strength in the commercial and new construction channels while the retail replacement channel remains below our expectations. Carpet price increases were implemented during the quarter as a result of rising material and energy costs. The raw material costs moderated during the quarter though they may change further as we go forward.

We recently announced the acquisition of Unilin, a leader in high-end laminates in both the U.S. and European market. We expect to close on the acquisition in the fourth quarter of this year. This is the second significant step in broadening our participation in the hard surface flooring market. Unilin has a history of innovation and cutting-edge products, making it a leader in premium laminate. It is the only fully integrated U.S. manufacturer. Unilin's management will remain in place and lead our laminate product efforts. Frank, would you give our financial report, please?

I'd be glad to. Net sales for the quarter came in as Jeff had mentioned at $1.625 billion or a 9% increase over last year's second quarter numbers of 1.486 billion Gross profit as a percent of net sales was 26.6% compared to last years 27.1%. This was impacted by raw material increases and energy cost increases as well as an $11 million LIFO charge for the second quarter.

During the second quarter, SG&A as a percentage of net sales improved to 16.7% from 17% last year and then operating income as a percentage of net sales was down slightly at 9.9%, which compares to 10.1% last year. Interest was reported at $13 million compared to 14 million in the second quarter of last year. Income taxes, the rate was comparable to last year at 36.2%, came in at $53 million and then net earnings came in at $94 million or a 7.6% increase over the $87 million in the second quarter of last year. Earnings per share up at about 8% at $1.39 this year compared to $1.29 last year.

If you look at the two segments for the quarter, Mohawk sales came in at $1.2 billion or a 7% increase over $1.1 billion last year. With operating income for the Mohawk segment as a percent of net sales 8.1% this year, compared to 8.8% last year. Dal-Tile sales very strong this year, first -- second quarter came in at $440 million or a 16% increase over the $380 million last year. And then Dal-Tile's operating income as a percentage of net sales ended the quarter at 15.8%, compared to 14.7% last year. If you look at the year-to-date results, the net sales came in at $3.1 billion or an 8% increase over last year's $2.9 billion. Gross profit as a percent of net sales at 26.2%, compared to 26.7% last year and then SG&A as a percent, again, improved to 17.1% this year compared to 17.4% for the six-month period last year.

Operating income was at 9.1% this year as a percentage of net sales compared to 9.4% last year and the net earnings came in at $164 million or a 7% improvement over the $154 million last year. In earnings per share at $2.42, up 7% from the $2.27 last year. The Mohawk segment net sales for the six months were at $2.3 billion or up to 7% from last year's number. And then the operating income for the six-month period for the Mohawk segment was 7.1% of net sales, compared to 7.9% last year. On the Dal-Tile sales for the six-month period, they were at $842 million, or a 14% improvement over the $740 million number that they reported last year and then operating income as a percentage of net sales was 15.2% this year and 14.2% last year for the six months.

On the balance sheet, receivables ended the quarter at 776 million and that represents about 46.3 days compared to 46 days last year. Inventories were at 1.125 billion this year at the end of the quarter, compared to last year's second quarter of $926 million. That represents -- this year represents the turn of four times, which is an improvement from last -- from the first quarter and then on the accounts payable, we ended up with $758 million in payables and accruals, which represents about 62 days, compared to 65 days last year. And then finally our total debt ended up at $884 million at the end of this year's second quarter compared to 984 million last year which represents a debt-to-cap ratio of about 24%. Turn it back over to you, Jeff.

Thank you. The Mohawk segment raised prices during the second quarter to offset the rising raw material and energy costs. The price increases continue to lag the cost changes but will not be fully executed until sometime in the third quarter. Some of our raw materials have recently moderated but higher oil prices and possible worldwide demand could influence costs going forward. The level of material pricing for the upcoming quarter could change in any direction. Presently, we're not planning any additional increases in carpet selling prices. The carpet products continue the trends of the first quarter with the commercial and new residential continuing to grow while the retail replacement continues to be soft.

The commercial business is showing improvements in all channels. Our acquisitions of Lees provided a solid carpet tile foundation and is allowing us to increase our participation in this growing area. Carpet tile growth is also having a positive effect on our product mix with a higher average unit price than broad room carpet.

In residential, the new construction business is still running at a strong pace and we believe it should continue for the foreseeable future as our products are purchased at the end of the construction. The retail replacement business has not shown the improvement that we had anticipated. We assume that consumers are postponing some discretionary purchases as a result of economic factors, such as rising oil and gas prices. Sales of our home products are still under pressure as we have exited some marginal products and some customers have reduced their inventory levels. The profitability of these products are in line with the Mohawk segment and we're still investigating other ways to maximize our business. These include increasing prices, changing -- redesigning some products as well as looking at other areas to manufacture product in.

Our new SmartStrand merchandising displays are being installed at retailers across the country. The SmartStrand products are aimed at the mid to high end of the market and have comprehensive merchandising and advertising programs to support them. The new products are being well-accepted by the consumer and have excellent, inherent characteristics for durability, cleaning, and stain resistance. We will be expanding this program in the second half of the year with additional style and price points. Our residential product mix is changing as a result of slower redecorating sale and fiber changes. The consumers who remodeled tend to purchase higher-valued products when redoing their own homes. In addition, more polyester products are being sold as their value increased when compared to nylon and polypropylene alternatives which have escalated in cost at a higher rate.

The expansion of our extrusion and yarn capacity is on schedule to start up the end of this year and should be fully operational in the second quarter of '06. This will add about 50 million pounds to our fiber capacity and give us more flexibility to satisfy requirements for both nylon and polyester fibers. Our hard surface products continue to grow at a faster rate than our overall business. Ceramic, wood and laminate products continue to increase their share of the flooring market. With Unilin, we have an excellent opportunity to grow our share in the laminate as we have with Dal-Tile and ceramic.

The Dal-Tile business continued with excellent sales growth during the period. All products and channels contributed to the improved results. The residential business continues to expand faster than commercial as we invest in additional products and marketing to broaden our participation. Ceramic has a higher share of its sales in the new construction market which is presently stronger than the other channels. Our margins continue to sustain historically high levels due to improved product mix, the efficient operation of our manufacturing and the ability to pass through the energy and distribution costs.

The timing of new ceramic introductions pushed belated marketing costs from the second quarter into later periods. We will go back to more normalized expenditure levels going forward. Our expansion of ceramic capacity continues on track. Our Mexican facility will start up with new capacity the end of this year. It should be fully operational in mid '06. The expansion of our Muskogee facility has just begun with the foundation being poured. It should begin start-up in the third quarter of '06. The equipment will produce glazed tile as well as higher-value tile with the color embedded into the body of the tile. We presently purchase this type from outside sources. When all the capacity is operational, it will add about 20% to our manufacturing base during 2007.

Our stone floor and countertop sales continued to grow. The stone flooring is sold through all of our tile locations and the specialized stone centers, which also have an inventory of stone slabs to satisfy local markets. We have presently about 17 locations doing this and have significant potential to continue expanding these.

Our acquisition of Unilin represents a highly strategic, attractive acquisition for Mohawk that will establish Mohawk as a leader in the laminate flooring, both in the U.S. and Europe. Their strong management team has created unique patented technologies, efficient manufacturing and excellent brands. The opportunity to accelerate our market penetration and leverage Mohawk's distribution and brands is compelling. In addition, their niche strategy and insulated roofing and other wood panel products offer new opportunities to grow our business.

Mohawk's strong balance sheet allowed us the opportunity to acquire Unilin. We're in the process of obtaining regulatory approvals for the United States and Europe. The combined management team is presently developing a long-term strategy to maximize our laminate business. We expect the acquisition to be slightly accretive in 2006.

I'm proud to announce that Mohawk won two awards at NeoCon, which is the National Commercial Show for innovation with our Karastan and Lees products. In addition, Floor Covering News presented Mohawk awards for carpet manufacturer of the year and overall floor covering manufacturer of the year. A strong housing market and declining unemployment continue to support the overall economy. Our business in new residential construction and the commercial market has continued to show strength. Other economic factors such as high oil and gasoline prices seem to have affected the retail replacement business. Future raw materials and energy prices are not predictable and may affect our industry. After considering all of these factors, the third quarter earnings forecast is from $1.71 to $1.80 earnings per share.

Many people believe that oil prices should be stabilizing for the first time in a couple of years. Improving consumer confidence and job growth should have a positive effect on flooring purchases by the consumer and should improve the carpet industry sales. We continue to invest in broadening our participation in ceramic, stone, and the laminate business. We're well positioned in the floor covering industry to take advantage of all growth opportunity. With that, we will be glad to take questions.

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Michael Rehaut.

Yes, hi, good morning.

Good morning, Mike.

Just a couple of questions if I may. First on the sale side, I was wondering if you could give us perhaps a little bit more detail if possible on the Mohawk segment sales with regards to, if you look at the segment overall growing at 7%, perhaps -- did commercial and residential new construction -- are you talking about like a 10%-plus growth rate? And for the residential replacement, when you say soft, are you talking about maybe is it -- we're talking about a negative percent? Or low single-digit or?

The commercial business is improving, both of them have rising average costs in the businesses. We're guessing -- we don't have industry numbers, but we are guessing that it will be similar to the past with the average price going up about 5%, plus or minus a little bit. We then also have a product mix change that's going on that could be almost equal to that, in addition to the pricing changes going on in the marketplace, as people substitute less expensive products for various segments. In addition to mix change, also have the impact of the new construction business taking a larger part of it. What else can I tell you? The specific growth rates of the different pieces, we don't give out as a general piece. The industry numbers aren't available at this moment so I don't know what those are.

I mean for the residential replacement, perhaps could you give us an idea what percent -- what that represents as a percent of your overall business and you don't have to give that if you don't -- if it's not possible -- the exact growth rate, but are we talking about in negative territory here in terms of the sales were down year-over-year?

The residential redecorating business of our total carpeting business would exceed 60% of the total. With Mohawk's mix, I would think that our mix versus our top competitors is a higher percentage of residential replacement to the whole total mix than most of our major competitors. The builder and residential numbers, they're estimates and the reason is that -- if you look at it by product, the products overlap both sides, so, there's not a -- an easy break looking at it from a specific product standpoint. And if you look at it by customer, we have customers that are in both categories so you just start making guesses internally of how much they are and I'm not prepared to give you those guesses because I'm not sure how valid they are.

Okay. And -- and just one last question. On the margin side, you mentioned that -- you started to -- you've started to see some cost increases moderating. If costs were to stabilize from here on out, at what point might you expect, given the price increases that you've been able to implement so far, your operating margins on the Mohawk side turning back in positive territory year-over-year.

That's a good one. There's a lot of fluctuation going on in the marketplace today. There's a change between the different channels. There's a change between different products, moving from one product type to another. There is a declining mix change as people substitute lower products. And -- as well as the raw material costs, you've started with the assumption that they've stayed the same. As we backward integrate more and more, our costs become more volatile and the pricing, in many categories, actually change month-to-month and they go up and down from month-to-month. And it's difficult to predict what's going to happen in the marketplace long-term. We've built into these things a lot of assumptions to our estimate over the next quarter. It's our best guess at what's going to happen in the short-term. Our goal is to continue to increase the margin long-term, but given all the changes in the marketplace and what's going on, I have a difficult time projecting when and how much.

Your next question comes from the line of David MacGregor of Longbow Research.

Good morning, Jeff, good morning, Frank.

Good morning, David.

Just on Unilin, are you able to talk yet about synergies? I know you've said they're limited in '06, but beyond that can you give us more color than you did on the announcement call?

As we said there, the big synergies are in the increase in market share and being able to sell more products and the U.S. marketplace is the largest single opportunity in the business. And that will continue to be the biggest opportunity in the business besides growing the businesses that they have. The last two years we've said they were in double-digit growth. This year they're in the mid-single digits in the first half of the year. We expect it to improve in the second half of the year going forward. And our teams are just getting ready to talk about and getting together. As you know, we've been two different businesses. We're just having the first initial meetings, as a matter of fact, this week talking about some direction of what to go with the different brands and product strategies so we're just in the first stages of getting people at different levels, organizations, just talking to each other.

Your next question comes from the line of Margaret Whelan of UBS.

Good morning, Margaret.

Good morning, how is everyone?

Perfect.

A couple of things, would you give us an idea of the trends in the quarter? April, May, June, both on the residential and the commercial side. Just trying to get a sense for if it's possible to quantify the higher oil prices and the impact on consumer spending or the seasonality of your business.

I'm not sure how -- you want me to breakdown what--?

Just--?

I'm not sure what you would like from me.

I'd like to get an idea of April, May, June, the trends in the quarter, versus last year, on the consumer end and the commercial side. Did they improve sequentially? Was April the peak and then declined? Or was there any real difference?

I think toward the end of the period we are seeing some improvement in the retail business. I've given up taking short moments and projecting them forward.

Yes..

But there does seem to be some improvement. It may be related to the -- to the consumer confidence going up, possibly, but I mean I'm not willing to take a momentary change and move it forward.

Yes.

The commercial business continues to remain fairly strong as we go through. I think as we look forward, last year, the industry started picking -- the commercial business started picking up in the second half.

Yes.

So, the comparisons get more difficult in the second half.

Yes..

And what we would suspect is that the business maintains this level and the rates have increased slow because we're going up against higher last-year comps, with the expectation now. I'd like to be pleasantly surprised.

So, the trend you saw toward the end of the period, has that continued into July?

The business in the commercial continues to be fairly stable.

Yes.

As we go forward, but again, the comps, we're assuming the percent increase will slow down.

Okay. And the other question I had for you is Dal-Tile has just -- it's exceeded your own and everyone's estimates and expectations really since the deal and the margin for the second quarter was an all-time high. Where do you think it actually peaks at sustainably? Is it around 16%? Or is there more opportunity there?

Boy, that's an interesting question. Let's talk about what's been going on. What we've been getting is we have improved the product mix by selling higher value tiles.

Yes.

We have increased our market share by putting out more samples and more salespeople and more distribution points, which have all helped favorably. The -- we've gotten through the Muskogee start-up and so it's operating efficiently, which is helping with it. Then within the quarter, we introduced fewer products into the marketplace in the second quarter than we have historically and those introductions, just because of timing, have gotten pushed out, so, that had a positive effect on the SG&A costs in the second quarter, which it won't go on an ongoing basis.

Yes.

On the other side looking forward, we have multiple plants starting up as we speak and those start-ups also cost money in different pieces, but they're going to pay dividends long-term.

Yes.

As we do. So, I mean we're not projecting on our own numbers a straight-up margin improvement.

Okay. But you could definitely hold this level?

Well, again, the SG&A costs in the quarter were less than they normally are. So, those will impact the margins on a going-forward basis versus the second quarter.

How do you -- how do you think about -- you mentioned in your prepared comments that you're bringing in -- or products that you have been importing, like some of the color tile, you're going to make it locally now. So, what are the actual savings on that, that you've realized by making it rather than buying it from someone else and then importing it? In basis points. Or do you have a sense for that?

What happens is some of it is a swap from imports to not. Others of it -- but what's happened in the last part is our business has grown, as much as the capacity has grown.

Yes..

So it hasn't offset the purchases. We continue to purchase products from both suppliers at rates that are similar except the growth we've done through the internal piece.

Yes..

Now, the other thing that's happened is that -- and what the Muskogee plant was, was that was the first step in -- there's still a large portion of the high-end ceramic tile being manufactured in Europe.

Yes.

And it's the higher end product and it has more value and more margin and so that plant, we went after manufacturing that and the expansion of that plant will allow us to make even more higher-value products, which is really helping the mix.

Yes.

In it. So, it's really -- at this point it hasn't been a swap, it's been a change in our average mix of what we're selling.

Okay. And so a lot of the synergies that you've realized with Dal-Tile, hopefully, will be able to do the same at Unilin. And the only question I have is have you thought any more about how you're going to finance that? And what's your capacity for more issuing equity versus debt?

We have given it thought. We're not ready to announce it yet.

Okay.

We have had initial meetings with both of the rating agencies.

Yes.

And we are in the process of discussions of going through what different options there are and how it would affect our ratings.

Okay.

And we're in the middle of the process.

Okay. Thank you very much.

You're welcome.

The next question comes from the line of John Baugh of Legg Mason.

She almost got your name close.

That's close enough. Congratulations.

Good morning, John.

Two questions. First, will LIFO disappear or be a lot less given the fact we didn't have further raw materials in Q2? Any way to predict that, Frank?

Well, you know, it depends on what's going to happen with inflation.

Are you sure you understand what happened in Q2?

Your question one more time then.

Well, yes, obviously you had the raw material increase here at the beginning of the quarter and then we didn't have anything beyond that. So the question was, essentially, if that's the case in Q3 and we don't have further increases, will the LIFO impact mitigate or go away altogether or is it still be a big number?

Again, just to make sure, it was about 5 million in the first quarter, 11 million in the second quarter. And in the third quarter, it's totally dependent upon what's going to happen with inflation in raw materials. And so, inflation goes up, we will have more LIFO charges.

If it doesn't go up from Q2 levels, would we not have a material LIFO charge?

Yes, that's true. Just one thing to keep in mind, what -- what governs the inflation number that we use are some published governmental indexes -- indices that are out there.

They're not actually our purchase prices. They're government indexes. So we don't have any idea of what's going to happen with the government indexes.

Interesting. Okay. The other question was on the home product. Are you talking area rugs where you're seeing weakness? Is it throws? What have you eliminated and what are the, say prospects for that business for the second half of the year?

We have various pieces of the business. We have been sourcing product, which last quarter we said that we have analyzed some of the sourcing pieces and we were not making the returns that we wanted. So, we have actually exited some marginal products there. As the industry and raw material prices have come up, certain products we have not been able to get the margins that we require. We have reduced the -- we have actually gotten out of some product categories that haven't met our expectations. We're in the process and have been of increasing prices on products in the marketplace, at various ones. We are putting new introductions in the marketplace to take the place of some lower margin products. We're redesigning products to make new versions that are less expensive to meet price points our customers are looking at. We are going through the manufacturing and administrative process of looking at how to improve the cost structures of it. And so we're re-analyzing it, like everything else, there is a lot of pressure on all the pieces.

But is it safe to assume, Jeff, that at least the second half, that that's going to be a drag year-over-year, in other words, is it going to take some time to implement all of that stuff?

Yes, what's happened is that we would expect that the margins in that part of the business would be lower than the prior year.

Okay. And obviously the sales would be impacted by dropping some product, as well.

As well as some of our large customers look like that their sales didn't meet their expectations and some of the large customers are still pushing inventories down from where they were.

And last thing again on this, is it inclusive of area rugs or exclusive or across all products or what?

It would be inclusive.

Okay, thank you much.

Your next question comes from the line of Laura Champine of Morgan Keegan.

Good morning, Laura.

Good morning.

She got your name right!

Pretty close. Can you give us the unit growth in carpet for both of your segments just so we can get a sense of what impact pricing and mix had during the quarter?

Unit growth of the segments?

That's right. Unit growth in the segments.

You got that?

I think if you look at the -- on the residential side, the price increases were about 10% versus 5% offsetting mix.

Okay.

I think that they're going to be -- our best guess is the industry is going to be flat to up a little bit, maybe. I don't know. But most of the increase is going to be in pricing.

Okay.

This is our best guess, but we don't have any data to substantiate that.

In the Mohawk segment, were your units or your yards sold? Or were they up or down?

They didn't change a lot.

Okay. And do you know how much pricing you're getting -- Frank, I would take it that your 10% residential price increase and 5% mix offset, I'm guessing that applied to Mohawk. Is that right? Or is that for the whole company?

That's for the Mohawk people.

Mohawk.

Okay. And for Dal-Tile, can you say what kind of price mix effect you had during the quarter?

I would guess the pricing is probably about the same thing, about 5%. It would be different -- a large part of it is included in -- we sell a lot of those products with the distribution costs included with the oil and gas for the trucking, those are sold to FOP and in many cases to the customer. So, you have to build in the pricing of the trucking costs into the cost of the product, which is a little different than the carpet value. Does that make sense?

Kind of. So, does that mean that if I count that expense, as well, then prices were probably up to Dal-Tile's customers about 5% year-over-year? Is that the right way to look at it?

Yes.

Okay. And -- and secondly, you mentioned that Unilin was growing mid-single digits in the first half. The industry -- I guess the industry growth numbers we're all looking for for laminates are around 15% on a year-over-year basis, is that -- was that mid-single digit growth in the first half equal to the industry or is Unilin actually giving up a little share?

That is a conglomeration of Unilin's entire business, both in Europe and the U.S. And the 15% number you're referring to tends to be a U.S. number.

Right. Right.

But they're not comparable.

So, is it fair to say that in each region Unilin is holding its share?

We believe so.

Okay. And then just one last one. The inventory is up 21% year-over-year, more than sales were up. How much of that is just that your cost of inventories is increasing and how much is a -- is an inventory build for whatever reason?

Yes, I think it's comparable to what we had talked to you guys about last time.

A large part of it is in--.

The hard surface area.

Is hard surface inventories going up. It's in raw materials increasing. And I don't know the actual units of all the different pieces sitting here, if you want to know the truth.

Okay. Thanks a lot.

The next question comes from the line of Rick Morgan of Iron Horse Capital.

Good morning.

Good morning, Rick. I just had a couple of questions regarding your comment on the Unilin accretion. Does the accretion assume any equities issued or is it just based on temporary financing at the time that deal closes?

It's our best guess at what we think will probably occur.

Permanent, yes.

Okay.

Permanent basis.

Okay. Does that assume--.

Since it's not finalized, that's why we're being -- we can't give you exact numbers yet.

Sure. Does that assume any level of synergies for next year?

Very minimal.

Okay. And then the last one -- is it accretive to your GAAP earnings or cash earnings or both?

Both.

Okay. Great. Thank you.

The next question comes from the line of Rosemary Secsion of BNP Paribas.

Good morning.

Good morning.

Good morning.

Just a couple more questions, I don't mean to -- if this has been asked a different way. But I'm looking at broadloom carpet, you price it at your residential business, in terms of pricing and growth being about stable, but I'm sort of looking at it from the broadloom carpet overall, commercial and residential. Can you give me a sense for what volume did in the quarter for those two pieces -- kind of in that -- looking at it that way? So, in other words, combining both commercial and residential, for broadloom carpet?

We've had a policy not to break out specific product categories. I mean we could sit here and keep breaking it out forever in 100 different ways and historically we give the segment information and don't break out the various pieces within it. If you look at our major competitors, none of them give out that information and we're not sure how it's going to detrimentally affect us, giving them more information about our business.

Okay. Understood. But on the price increase side of the -- when we're talking about price increases and you've talked about how, who knows what happens with oil pricing going forward, but as that changes, if the price of oil were to come down, I guess that's a huge question, but if raw material prices were to come down, would you have to pass on, or would you choose to pass on some of those declines -- onto your customers in order to change this mix effect?

Historically, when raw materials go up, our margins tend to get squeezed and historically when margins fall, our margins tend to increase because the same thing happens. Going up, we don't pass them through as fast and going down, we don't pass them out as fast. And typically in a falling market, we do slightly better.

So, do you -- I mean -- so, but you're basically telling us that the demand was impacted, you think, on the consumer side by the price increases because people--.

I don't know why -- I'm not going to predict the consumers actions. I have to say the consumers in the retail stores, we've talked to a tremendous amount of retailers. We get general information from them and they have said that the traffic is slower in the stores. The exact reasons for it, we're just making guesses.

Right. But you did sense some trading down of people deciding to substitute lower-priced carpets for the higher-priced carpet. No?

Yes, but two things. One is there's a -- as the new construction business does better, it is at a lower average mix. So, that changes the mix and then the second is that we've said all along is that our retailers try to maintain price points. As they try to maintain price points, they buy less expensive items. And the two things combined is lowering the mix.

I see. Okay. Thank you very much.

You're welcome.

The next question comes from the line of David MacGregor of Longbow Research.

Hi there. Sorry, I was bumped off before. Just on the discussion -- further the markets question on the marketing cost, can you just quantify the extent to which the Dal-Tile margins in Q2 benefited from reduced marketing costs?

We don't have that information right here with us right now, David, the exact number.

Is it -- can you try for an approximation?

It would be half a percent or less.

Half a percent?

Is the number -- but remember now, there are seasonal changes, if you go back and look. You have to look at the normal seasonal changes in the cost, too.

Yes. Okay.

Okay?

The second question I had was just getting back to the whole notion of the residential customer starting to react to what's been a pretty amazing sequence of price increases over the last 18 months. And I'm just -- if we could explore for a moment, the scenario whereby your costs don't continue to come down, but, in fact, would maybe begin moving higher again. Is it your sense that at that point you'd be pretty much limited in terms of what you're able to pass through? Or how would that scenario play out?

Well, we can only go back about the past two or three years. As the prices have gone up, that the raw materials make up such a large portion of the business, that the industry has pushed those through to the consumer.

Right.

Now, it's been a very difficult process, it's uncomfortable, nobody likes it, but the industry has continued doing that.

Right.

I don't see anything at the moment that would change why the industry would react.

I guess it's more just an issue of elasticity, whereby after this sequence of price increases, your retail partners are beginning to tell you the volume is suffering.

The question is do we want to work on lower margins to try to maintain share? I don't think that it is the pricing that's creating the problem. They talk about less traffic in the stores to choose products.

Right.

And then this product mix thing, we've actually -- this product mix change that we keep talking about we've probably reduced the cost increases by about half over the past few years with the decreasing product mix.

Yes.

So, both things have been offsetting it. I think that my position at this moment would be that the industry would try to push them through in order to maintain the profitability of the businesses.

Okay, Frank, just one last question while I've got you. Have you talked at all about the stepped-up amortization of the intangibles on--?

We have not, other than there will be one.

Okay, thanks, gentlemen.

The next question comes from the line of Keith Hughes of Robinson Humphrey.

Thank you. My question was on your specified commercial business. It's been good, I guess in the industry for a while now. Are we starting to get to the point where there's enough business out there that you're realizing some better margins on the overall business? And in the discounting of price fights on the business is a little less pervasive than it was say a couple of years ago during the downturn?

On the commercial business?

Right, specified commercial.

I would think that -- I mean the competition is always aggressive.

I understand, but has the landscape changed at all in the last year or so?

I think that the -- a piece that you haven't asked is also that in that commercial-specified business, you tend to look at jobs further out and so the ability to pass through the increases takes a little longer. As you priced the job, in some cases you have to live with how you priced it, even as raw materials go up.

Right.

So, that's still in place and still having an effect. As with everything else, we need prices to stabilize, would be the biggest positive we could have. But in the competition piece, I can't say that I see competition being easier or more difficult. I think it's a normalized competition in the marketplace.

Okay. And just as a follow-up to the last question. The softness in residential replacement has been with us for four, five, six months, depending on how you count it. Nobody I guess really knows why, but do you really think that's a function of the price increases the industry has been pushing through? On broadloom? Or is it other macro factors are the biggest driver? Just your gut feel.

My gut feel is other macro factors, but I don't have any evidence.

All right, okay, thank you.

Your next question comes from the line of Carl Reichardt of Wachovia Securities.

Good morning, guys, how are you?

Hi, Carl.

Two questions, once Muskogee's capacity additions finished, Mexico is done, what percentage of tiles, say end of 2006, would you be making overall, percentage of total production?

Now you have to make a couple of assumptions. The first assumption is how much are we going to be able to grow the business.

Sure.

If you take it and say it's over a new capacity coming in this year, next year and the next year, you have about three years. So, if you say over the three years that we increase 1/3 of the 20%, would be 7% a year, if we increase slightly more than -- more than that or less than that our purchases outside will -- assuming we can grow 7% a year, the purchases outside will remain stable. And what will happen is that will take care of the growth. The growth is slightly less, we will internalize it more and if it grows more, we will buy some more outside.

Got you. And what then would that number be in terms of make versus buy assuming that those assumptions hold through, at that 7% growth rate.

I think around 30%.

30%. Okay.

Give or take. For ceramic, maybe a little more or less.

Great. And then my second question, just on Unilin, if we assume this longer-term 15% growth rate for laminate and overall just U.S. floorings growing at -- total U.S. floorings growing at less than that, at 5% or whatever we want to assume, you had said earlier, I think, Jeff, that you expected more of the share gain to come out of wood and other hard surface. What would you think would be the overall impact on the other types of flooring in terms of their share, consider carpet will continue to lose share gradually over time. Is it wood that gets the most impacted still?

Let's go backward. I think last year it grew 25%. So, I mean it's not a new occurrence. The year before, it grew some number, also high. So, this has been -- it's not something that's just occurring, it's an ongoing process that's been occurring and that occurrence, what's happened is the pieces that have been growing have been laminate and ceramic and wood at the expense of vinyl and carpet and market share. So, a higher percentage of the market share is going into -- of the units growth are going into these other areas.

Okay. And then -- but looking at -- let's assume Unilin continues -- or not Unilin but laminates continue to grow at a rate of 15%, I think Laura mentioned that, as kind of the broader rate. Does that your view, mean that wood flows or vinyl flows continues to flow? We continue to see the same trend, hard versus soft? Or there will be some, let's call it cannibalization between hard surface sectors?

If you looked historically, what's happened is out of the 5%, you had vinyl that was about flat. You had carpet that was growing at 2, 3%. And then you had the ceramic business has been growing and wood, boy, they moved around in the last few years, let's call it 7, 8% is it. Then you had laminate much higher, but laminate has been at -- , laminate is still at the lowest volume -- the lowest percent of the industry as it only has about $1 billion worth of the $20 billion worth of sales.

Right.

So the other pieces are -- ceramic and wood are more than twice its share. So, it's still starting from a relatively low base. So over time, it may grow to be an equal with the others.

Okay, I got you. All right. Thank you, Jeff.

Your next question comes from the line of Jay McCandless of Avondale Partners.

Hi, this is Jay McCandless on for Barbara Allen. I wanted to ask you all one more time on the retail replacement issue. Do you think the slowness is a reduction in people just stopping, doing things to their house? Or I mean is the cycle slowing down? Or is it more of the mix shift that you're talking about?

This is just general discussion, we talked to our customers. They talk about less customers coming into the retail stores.

Okay.

So, the question is, why they left them there, are they just postponing what they've done or are they changing habit? And I don't have the answer.

What do the retailers think?

I'm not sure I have a good, broad perspective to give you an answer that I would stand behind.

Okay. And then I was going to ask you, too, the strength that you're seeing in ceramics is just being taken away from carpet, from vinyl. And that's what the retailers are seeing, also?

Part of the ceramic piece, too, I think that we're growing our share in the marketplace.

Yes.

So, I'm not sure that our -- our success is representative of the whole industry.

Okay. Great. Thank you.

The next question comes from the line of Alex Mitchell of Scopist.

Hi, good morning.

Good morning.

I'm not sure if this was answered--.

Could you speak a little louder?

I'm not sure if this was answered immediately before, but what is the growth rate of laminate in the U.S.?

About 23, 24% last year.

Okay.

In dollars.

Okay. And just on Unilin, what is your outlook for the margins at Unilin? You already have a pretty good margin.

The long-term outlook?

Yes.

The long-term outlook is that as we broaden their position in the marketplace, that we'll end up competing in more areas than they have been. They've been competing in trying to maximize their margins and it has put them in a niche market position, so, as we broaden it, we would expect the average margins to go down as the business level expanded into other categories that they don't participate in. In the area that they participate in, we would expect to keep high margins in those categories.

So, it's not quite the -- your -- like your experience with Dal-Tile? Your increasing margins there.

No, but the margins are starting out twice as high.

Right, exactly.

Is it. And they have a more -- Dal-Tile had a broader approach to the market, where they've had a more niche approach to the market. But the two things are actually different now. We think there's opportunities to increase both the high-end of the marketplace and the rest of the market participation.

Okay. And that was my next question, is how is laminate sold in the U.S. right now? Is it sold in price? Is it sold by brand?

All of the above. The U.S. basically has a higher average price than the European markets. Historically the U.S. has focused on trading the customer up and doing higher value sales to the customer through the distribution channel. It is moving downward in average price more like the Europe end market, as we speak and the trend's been happening for a few years. We assume that over time it will more represent the marketplace similar to Europe.

Okay. Thank you very much.

Your next question comes from the line of Arnold Brief of Goldsmith and Harris.

Two questions, one, would it be fair to say that the growth of laminates, tiles, wood, et cetera, stimulates sales of your rug business and your rug business has higher margins than your carpet business?

The potential option is that -- is there are -- the rug business is still a small part of the total, as it -- the same thing has been happening in rugs though over the last 10 years, is the average selling prices have come down in rugs, making them more available to people in the mass and the units have gone up but as we've talked to in the laminates, as the prices have come down, there has been margin -- not margin, there's been a mix change in the business, as you saw a higher proportion of lower cost products through the marketplace.

But would it be fair to say that the growth of the hard flooring surfaces stimulates sales of rugs?

That's reasonable.

And again, regardless of the trend, the margins on rugs are still higher than carpet?

It's a reasonable assumption.

Okay. Second question is on a longer term basis, you look at the amount of business that you source outside as opposed to manufacturing yourself. What seems to be the difference in the margins of self-manufacturing versus sourcing? And where do you think you will be three, four, five years from now on a longer term basis? Do you want to increase the amount that you self-manufacture?

We think that we're comfortable with a percentage of it being purchased from outside that we think that it brings us some value because we use it for three basic pieces. We use it for high-end niche products, with our low volume differentiated. We use it for some commodities where people want to just run equipment. And we use it to balance out our production capacities with markets so that we don't have to have excess capacity to hit peaks and valleys of the marketplace. And so we're comfortable that we want to maintain a portion of it. We talked about 25, 30% today, I mean it could range from, heck at 20 to 35% would be comfortable.

What's the difference in margins between self-manufacturing and outside sourcing?

That's all over the place. Depending upon if you're buying a commodity product or a high-value, unique one. You can't make a -- it depends on the product and the category. We can -- if you go in the high-end stuff, there's a dramatic difference between what you can buy. If you go in the lower end stuff, some people are just trying to run capacity and there would be very minimal differences.

Okay. Thank you.

Sir, there are no further questions at this time. I would like to turn the conference back over to Mr. Lorberbaum.

Thank you very much. We appreciate you being here. Look forward to a good business. Have a good day.

Ladies and gentlemen, that concludes today's conference call. You may now disconnect.