莫霍克工業集團 (MHK) 2006 Q2 法說會逐字稿

Good morning. My name is Paige and I will be your conference operator today. At this time, I would like to welcome everyone to the Mohawk second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [OPERATOR INSTRUCTIONS] Thank you.

I will now turn the call over to Mr. Jeff Lorberbaum, Chairman and CEO.

Welcome to the second quarter conference call. Operator, could you check-- ? It sounded like there was someone who could speak during it -- if you'd check while I start? With me I have Frank Boykin, our CFO, who's going to read the Safe Harbor statement.

I would like to remind everyone that our press release and statements we make on 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 filings with the Securities and Exchange Commission.

Thank you, Frank. Mohawk's second quarter GAAP net earnings and earnings per share were $120 million, 22% above last year or $1.76 per share, 21% above last year. Net sales for the quarter were $2.058 billion, and improvement of 27%. The improvement resulted from the Unilin acquisition, hard surface growth, internal growth, price increases and new patent licenses.

Adjusted net earnings for the second quarter were $118 million. The adjusted net earnings exclude stock option expense that was not required in the prior year, increasing net earnings $2.1 million. And they also exclude the portion of a one-time duty refund received from the U.S. customs, decreasing our earnings by $3.9 million.

The Mohawk segment changed it's accounting method for inventory during the period from LIFO to FIFO. The change in FIFO will take out uncertainties from unpredictable earnings charges we have dealt with for the past couple of years. In the second quarter had we continued with LIFO, the LIFO adjustment for the first time would have increased earnings slightly. Frank, you want to give the financial report?

I would be glad to, Jeff. As Jeff mentioned, we have changed our accounting for inventory from LIFO to FIFO. And we have restated all current prior year amount to reflect FIFO accounting. If you look at our sales for the quarter, they were $2.058 billion, up 27% from the previous year. The growth without Unilin would have been 7% over the prior year for the quarter.

Our gross profit came in at $592 million or 28.8% of net sales. That compares to last year's margin of 27%. We benefited this year from an improvement in the mix with the Unilin and Dal-Tile segments growing, which had a higher gross profit margin than the Mohawk segment.

The SG&A came in at $369 million or 17.9% of net sales. That compares to last year's SG&A percent of 16.7%. SG&A is higher this year as a result of option expensing, which we did not have to do last year under GAAP, [sample] investments and an improvement -- or a change in our mix with the Dal-Tile segment growing stronger than the other segment. Dal-Tile generally runs higher SG&A percentages than the rest of our business.

Operating income came in at 10.8%, an improvement over last year's 10.3%. Interest expense was at $44 million -- interest and other expense, compared to $13 million last year. This was -- higher interest expense was due to the Unilin acquisition debt.

Income taxes at $60 million represented a 33.4% tax rate, an improvement from last year's 36.2% tax rate. That was due to the Unilin tax planning that we put in place.

And then net earnings at $120 million. And GAAP earnings per share at $1.76 or 21% over last year. Again, the $1.76 includes $0.06 for U.S. customs refund. Adjusted earnings per share, as Jeff mentioned, for the second quarter were $1.73, which would exclude the $3 million stock option charge and the $6 million duty refund.

If we look at the segment information; the Mohawk sales for the segment came in $1.242 billion or 4.8% over last year. This represents slower residential replacement business offset by price increases. Operating income at $99 million for the Mohawk segment represented 8% of net sales, down slightly from the 8.6% of net sales that we had last year in the operating margin.

If we look at Dal-Tile, the sales for the segment came at $507 million or a 15% growth over the prior year. All products in the Dal-Tile segment experienced positive revenue growth. The operating income for the Dal-Tile segment came in at $74 million or 14.6% of net sales, down from the 15.8% margin of 2005. This margin was -- in 2006 our margins were impacted by the Muskogee ceramic facility start-up cost that negatively impacted margins.

Unilin sales came in at $314 million, with operating income at $60 million or 19% of net sales. Operating income for the corporate and elimination segment came in at about $10 million, up from last year's $5 million. This increase was due to the addition of the Unilin business as well as expensing of stock options and inter-company eliminations.

If we turn to the balance sheet; receivables were $988 million, which reflect a -- 44 days compared to about the same number of days in 2005. Inventories came in at $1.284 billion. We are continuing to improve our turns in inventories with the turns at the end of the second quarter at 4.6 times compared to 4.2 times last year. This inventory number, again remember, is reflecting inventory at FIFO and it would have been $16 million higher, had it not -- last year's inventory would have been $16 million higher had we still been on LIFO.

Fixed assets were $1.905 billion. Capital expenditures during the six months ended in June were $83 million. We have revised our full-year estimates for capital expenditures and reduced it down to $250 million for capital expenditures. Depreciation and amortization came in for the six months at $135 million. Our full-year estimate for depreciation and amortization is $280 million.

Finally, long-term debt in total was $3.127 billion. This represent -- is represented by a debt to capitalization ratio of 48%. That's an improvement from the 51% we had at the end of the first quarter. During the quarter we paid down about $160 million of debt before the impact of foreign exchange. If you look on a pro forma basis, how much debt we paid down since the end of the third quarter '05, it's about $450 million. Jeff, I'll turn it back over to you.

Thank you, Frank. I'm pleased with our second quarter performance in light of the economy and industry factors we're facing. During the period, we experienced the same sales trends from earlier periods with the commercial channel continuing at a better pace, the residential construction good but expect softening and the residential replacement remaining weak. We believe the consumer consumption is being affected by higher energy and rising interest costs. Also, geopolitical events are affecting the overall confidence in the economy.

The Mohawk segment grew by 5%, with margins improving from the first to the second quarter. In the second quarter, carpet raw material costs remained relatively flat and our nylon suppliers -- fiber suppliers announced an increase in price for July. In August, we are implementing selling price changes to recover these cost changes. Given the volatility of the oil, it's difficult to predict if more price increases will be required in the future.

Industry sales improved from the first quarter but were still behind last year in units. Sales trends continued for the commercial and residential construction -- new construction channels performing better than the residential replacement channel. The Mohawk segment incurred marketing expenses as a result -- higher marketing expenses as a result of a greater level of product introductions due to raw material supply changes and new laminate introductions. We continue to adjust our product line and assets to reflect the changes in raw material value between nylon staple, nylon filament, polyester and polypropylene products. The first introduction of Mohawk laminate products produced by Unilin is being received favorably. There will be additional products introduced throughout the year.

Our other Mohawk hard surface branded products continue to grow. We have completed the start-up of the major projects during the quarter, including a fiber and yarn manufacturing plant, a carpet padding plant, two distribution centers and the acquisition of a carpet backing plant. We're anticipating the carpet industry demand will remain soft in the third quarter. Our organization is focussed on managing our inventories, enhancing our processes, controlling our costs and improving our marketing.

A new Mohawk advertising campaign was launched during the quarter including TV, print and internet. The theme of the campaign is around the beauty of a Mohawk floor changing the outcome of a fairy tale representing your lifestyle. In addition, the Mohawk website has been revised at Mohawkflooring.com. It is now organized into three parts that define the buying process for the consumer; those are planning and decorating, shopping and buying, and care and maintenance. Included is Dream Vision, in which the consumer can visualize her redecorating and give her other options and helpful ideas. In the future, the consumer will be able to use her own room photos.

Our Dal-Tile segment reported strong results, with a 15% improvement in sales, both from volume and price increases. Residential sales are growing faster than commercial as we continue to expand our residential market share. We seasonally introduced a higher level of new products than the associated merchandising during the period, which increased our SG&A costs. The balance of the year should be more in line with our historical activity.

We opened one new service center in the quarter and plan to open five more in the balance of the year. The first phase of our expansion in Muskogee was started up in the quarter and impacted costs approximately $2 million. The second phase of this expansion will start up in the third quarter. The Mexican expansion that began production the end of last year, is now running at full capacity and will continue to improve its productivity as we go along. Additionally in Mexico, a new mosaic tile production line is scheduled to begin production in the third quarter.

During the period, we received a refund of import duties we paid in the amount of $6 million. The product classification has been in dispute since before we acquired Dal-Tile. We expect significantly more duty refunded but cannot be sure of the timing or the amount, which must be determined by customs. The refund could be in the $30 to $40 million more than we already have and some may not be received until well into next year.

The Unilin segment greatly improved margins from the previous quarter. This margin improvement was done due to positive events which we don't anticipate continuing. These include seasonally higher sales, lower than anticipated costs, timing of market expenses, better product mix and new patent licenses.

The Unilin revenues for the quarter were slightly ahead of last year. Laminate sales in Europe were up while sales to our U.S. distributors were down, as we had anticipated. Our U.S. distributors substantially reduced their inventory since we supply them from the U.S. instead of Europe. Our distributors indicate their sales of Quick-Step laminate to their customers were up from last year. Our U.S. laminate sales should return to a more normal level in the third quarter.

Patent licenses were higher than expected from additional agreements and settlements were a limited portion of the improvement.

Our roofing and board sales were up in Europe. We've increased prices to offset rising raw materials and energy. We anticipate further price increases in this category the end of the third quarter.

We continue to improve future projections for the Unilin business. The revenues and margins are more volatile than our other businesses. We're happy with the higher results in the second period. We believe the margins in the second half will be in the 13.5 to 14.5% range, due to holiday shutdowns in Europe, higher raw materials cost and increased sampling costs.

We continue to believe there's substantial opportunity to grow our laminate business in the United States. National Floor Trims magazine polled retailers who voted Unilin's Quick-Step the number one brand of laminate in the U.S. In addition, Quick-Step was rated highest for quality, design, durability and ease of maintenance in each category.

The U.S. International Trade Commission ruled favorably on most of our claims for infringement from the designated offshore producers. The defendants have now applied to a review of the decision, which will take some time.

Our Company also received a favorable ruling from the U.S. Supreme Court, which vacated the lower court's ruling on the pending class action suit related to suppressing wages by hiring illegal aliens. The Supreme Court ruled on another case which should have a positive bearing on our own. We expect the court to take three to six months to reconsider the case. We remain confident in our position and believe the allegations are unfounded.

We are managing our balance sheet, with debt-to-capitalization ratio improving to 48% after paying down $160 million of debt during the quarter. Since September, we paid $450 million of debt.

Mohawk has many initiatives to improve inventory turns and working capital management as we go forward. We expect the Mohawk segment to realize benefit from the earlier price increases and the capital investments, offset by continued weakness in the residential carpet business and rising material costs. Sales and marketing investments by Dal-Tile should support continued growth and market share.

Unilin results will be more normalized in the third quarter as they move into the European vacation period when maintenance is performed. Unilin will also be impacted by additional sampling expenses that were deferred the second half.

After considering these factors, the third quarter earnings forecast is from $1.76 to $1.78. This guidance does not include any further refunds from the U.S. customs.

There continues to be uncertainty in consumer demand, oil prices, interest rates and the flooring industry. Most economists are predicting slower GDP growth in the second half. We will continue to manage our business through this environment as we have done in the past. Through this uncertainty, we are approaching the end of the year with caution.

Frank just told me -- I think I misread the earnings estimate future, it should be $1.76 to $1.85, as it says in the press release. With that, I'll be glad to take questions.

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

Hi, guys. This is actually Ray Huang on for Mike. Just had a couple of questions. First of all, Unilin margins -- I think you talked about getting some positive product mix this quarter. I thought you guys were shipping more towards like a lower price point. Just wonder if you could expand on that? Is that baked into your second half guidance?

Long term, we expect the average product mix to decline as we've broadened the mix into lower price points. But in the quarter, we actually had a positive impact based on product mix.

Can you give like a time horizon for the longer term impact for the negative mix?

We think going forward in the second half of the year, margins going to be 13.5 to 14.5%.

Okay. Also, for the Dal-Tile segment, I wonder if you could break out the percentage? How much was pricing, how much was unit volume?

I don't have that with me at this minute. Most are volume.

Finally, you could expand on the typical time frame for the lag for the price increases and how it takes to flow through -- it varies by segment?

The price increase we're talking about -- the big one we're talking about is the -- in the carpet division. If we go back to the last one, it was started in late November, I believe, and it took until sometime through the second quarter to get it executed. So it takes a significant time to move it through the various channels.

Okay, thanks a lot.

You're welcome.

Your next question comes from the line of Eric Bosshard with Cleveland Research Company.

Good morning.

Good morning.

Hey -- a couple of questions. First of all, can you give us a sense on the capacity additions additions you've made in the business? I know that CapEx was up last year and this year, it sounds like you're moderating the number a bit. Can you just give us a sense how much capacity you're adding and in what businesses? And then attach to that -- just talk a little bit about how quickly you think you will optimize utilization of that capacity when considering your outlook for demand.

We have a lot of projects going, so I'm just going to go at high levels. The extrusion and yarn expansion added, I believe, about 10% to our total capacity. And it's presently running at capacity.

The ceramic expansions, which were made up of a lot of different pieces, some in Mexico and some in the United States, equated to approximately a 20% capacity increase in the ceramic production capacity. That capacity takes anywhere from -- close to six to 12 months to start up in various stages. As I said, the one that was completed in Mexico the end of the year is not operating full. What happens is it starts up in stages. And we don't start it all up the first day. What else can I tell you?

How were you with ceramic capacity -- you said that with extrusion yarn you were at capacity, it sounds like you have 10% more in ceramic. Were you at capacity and this now will give you that 20% more?

We have always purchased product from outside sources in the ceramic business -- from around the world. That capacity typically ranges in the 30 to 35% of the total capacity. Our business has been growing 15% a year. So what's happening is, the capacity -- as we come on, we slow down some of the outside purchases to balance it out at points in time. But basically, it's taking care of the increased sales that we've been having. Our expectation is to be running it at full capacity when it's available.

Okay. And then within the extrusion in yarn, you also commented on some additional backing capacity, how do you think about filling up the utilization of that? I guess, how do you combine that with your outlook for where carpet demand is likely to go over the next 12 to 24 months?

Again, within our fiber production, we also buy pounds from outside suppliers so we can continue running ours and reduce the amount of outside purchases. Is what we've done historically.

His question was the backing. The backing capacity, Eric, we just backwards integrate it. We were buying -- we were purchasing product from these vendors and now we're making it ourself.

We plan on making 100% of our production. And we do have some excess capacity, but it was planned to have some excess to take care of the peak parts of the year.

Great. And then secondly, if you could help us in terms of modeling the second half, as far as growth goes. I know you commented that in this quarter, it sounded like residential new construction still had a good quarter. I understand carpet is the last thing to go in a finished house. How should we be thinking about the revenue growth of the Company in the second half of the year, relative to what you reported for the second quarter across the business?

We have not given specific divisional amounts. What we give is the earnings per share estimate. What we can tell you is that we don't see anything that leads us to believe that the residential business is going to improve, given all the political circumstances and the information we're all seeing on television -- it surprises me that anybody's buying anything. Our guess about the future and what the consumer is going to do is no better than yours. If you'll take the model the number we gave back to you, you'll get in the ballpark.

Okay. And then lastly, in terms of margins in the Mohawk segment -- I know you commented that the November price increase just got through, but I know that you're dealing with higher material costs, as we speak. Should the margins in that segment improve, hold stable or contract from this point?

I think what we said -- I said earlier was that we're thinking the margins could improve from the things that are in place presently going forward. And those will help us overcome, in the short term, some of the negatives in the pricing -- in the cost.

Thank you very much.

Your next question comes from the line of John Baugh with Stifel Nicolaus.

Morning, congratulations.

Good morning, John, thank you.

Jeff, feel like I got sandbagged pretty good on the Unilin margin, which is good on the upside. You were estimating 14.5% I believe for that division for Q2 or thereabouts and you came in at 19%. Is it just that volatile? Did a whole bunch of stars line up? You want us to believe we're going all the way back down to 13% or 14% right away. Which I know with Europe shutting down, that might be the case. Just trying to get a sense of where you think that margin is say, beyond the holiday shutdowns? And help us understand why your guidance on that margin was so far off on what they reported? Obviously, it was good news but it was still a big difference.

What we had said prior was we expected it to be somewhere in the 13.5 to 14.5% range, improving over time. And that's the same guidance we have now. What happened during the period is our manufacturing costs were lower we had anticipated due to some of the wood prices, due to some of the -- wood was drier than we had anticipated so it lowered some of our costs. The product mix was better than we had anticipated. We're not assuming that the product mix is going to stay better than it is. That seasonality you have during the quarter -- the shipments tend to go up a little bit in front of the next quarter. We will have during the third quarter the raw -- the plant shutting down. We had some patent licenses, as well as some patent settlements, which we didn't anticipate. So all the stars aligning. And we don't anticipate that going on in a continuing basis. If it does, we will be quite happy with the results.

Are those patent license fees one time, Jeff, or do they continue with their contract on out?

They could be both. Some do, some don't. What happens is there could be some settlements that are one time and then there are also some ongoing pieces. We build all those into our future estimates.

On Dal-Tile, you -- clearly the commercial business is good. And clearly you're taking share by introducing new products in the residential market. But the -- residential new construction has seemingly been going up 5, 10% a year for -- I don't know how many years in a row. It looks like it goes negative 5 to 10%, maybe for a couple years. How does that -- in combination with how big Dal-Tile Del tile is getting now -- how should we think about revenue growth there, which has been in the 15% area, if we get that kind of scenario? Does it moderate to ten, single digits, stay closer to 12 to 14%? Any kind of ballpark?

What we've tried to communicate is that we have put a lot of investments in our business in the last few years. Those investments, we believe, will allow us to grow in excess of what the market does. What's happened now is -- the last year or so, the market's probably grown in the 8% range, could be more or less. We've grown in the 14 to 15% range. If the market slows down, it could impact both the amount we grow above it and the market. It's anybody's guess what those will be. But we believe, like you, that it'll trend down with those pieces but will still exceed the market.

Okay, thank you.

You're welcome.

[OPERATOR INSTRUCTIONS] Your next question comes from the line of Laura Champine with Morgan Keegan.

Good morning. In that $1.76 to $1.85, do you have anything in the duties that you expect to receive in the number?

We do not.

Not.Then a follow-up that's, unfortunately, not related. In the Mohawk business, you got price increases coming. Would you expect the top line growth to accelerate in the back half of the year because of those additional price increases? Or is that going to be more than offset, in your view, by continued declines on the unit side?

It's anybody's guess because we're having a difficult time out guessing what the consumer is going to do. We've given you the estimate for the third quarter and we're just assuming, given all the economic data, that it's going to soften further as we go through the year.

Can you comment on whether or not the Q3 guidance contemplates growth accelerations? You must have a -- some top line estimate for Mohawk built into that? Does it -- ?

We think, Laura, that the replacement business is going to remain soft and the commercial business will continue to grow. And that there will be a slowdown at some point in the builder business force.

Okay, thank you.

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

Good morning. It's actually [Susan] for Margaret.

Hello, Susan.

Can you talk a little bit about -- I know that you're dedicated to paying down the debt but given the kind of pressure that the stock's been under lately, is there a level where you would consider coming back in and reinstating some share repurchases?

At some point, I mean, we will be more aggressive in share repurchases and acquisitions. We haven't defined the point. I think earlier we said we've been comfortable at having our debt in the mid 30s to mid 40s range, historically. As we get down in those ranges, we'll consider different directions.

With things starting to flow a bit, has there been any change in the acquisition pipeline?

As you can tell from the conversation, we have not been aggressively looking at acquisitions lately. I guess we -- we're quite pleased with the rate that we've been paying down our debt.

That's about it.

Okay, thank you.

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

Morning, guys, how are you?

Morning, Carl.

Frank, do you have a target to debt to cap by the end of the year? How much debt you think you'd like to pay down by 12/31?

We're hoping to get our debt to cap down over the course of the next 18 months, I'd say, to the -- I'd say low 40s, high 30s range.

Year end '07 by -- high 30s, low 40s. And then, just looking at turns and then also the accounts receivable, if you're looking out the next 12 months or so, how -- what specific initiatives are you undertaking to continue to improve turns and what's led to the improvement? And then what do you think you can do to get collections up, get that AR turned down a little bit?

To start out this year -- in the last couple of years with the rising raw materials, we systemically let our inventories get -- go higher because you're buying at lower prices in a rising marketplace. We went into this year and we changed our bonus program to actually have a component of the bonus program based on inventory improvement. And we have no question that our people are reacting to that and are increasing the turns in inventory. At the same time, we're reviewing all our inventory levels, we're looking at cycle times and processes to see how we can improve them. We're reviewing the product line and SKU requirement, and a combination of all those various initiatives are enabling us to provide a high level of service and lower inventories.

And in the accounts receivable side, Jeff?

A lot of that's just driven by market.

Yes.

We've got to be competitive.

Wherever the market is, we've got to be competitive.

Your sense is, 44 is kind of the number, as you look forward, that's about -- ?

I think it's seasonal. So you have to look past the quarter, but yes.

Okay, I'm looking out with you.Thanks, guys. Appreciate it.

Welcome.

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

I had a question on the U.S. laminate business at Unilin. What kind of capacity are you running at the new facility at North Carolina?

I don't know the answer to that. We did not run the plant full this quarter with the lower pieces of the -- as they were declining their inventories. It also has to do with how much we make in Europe versus here. We're still making some in Europe and sending it here. We're anticipating to run it near capacity in the going forward basis.

And for a custom -- as you make this transition from U.S. -- from European production to U.S., what were the old lead times a distributor could have expected Quick-Step? And what would be the new lead times?

Depends on where you live, but it could be easily eight to 12 weeks.

From Europe, correct?

From Europe.

And from the U.S., what, a week maybe?

A week? Yes. It could be less.

Okay. That's it.Thank you.

You're welcome.

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

Good morning, guys. I'm trying to understand the -- in the Unilin business, first of all -- what was the impact of currency on the quarter?

I mean, if you look at it -- we don't have prior numbers in there, so there's no prior year comparisons. I'm not sure how your question is -- what your question is.

The Euro moved about 7, 8% favorable to the dollar in the quarter. I'm just trying to understand how that translates.

On the quarter for Unilin for foreign exchange is not really that significant, if you just look at their P&L on a stand alone basis.

Can you remind us, again, what percentage of the revenues are in the U.S. versus in Europe?

About a third in the U.S.

Okay. Still the 7% move in the Euro was not that significant?

No.

Can you remind us as well what percentage of revenues are laminate flooring versus the HDF and the other building products?

We break it into laminate and HDF -- laminate HDF and the patent as one business and the others separate. And it's two-thirds, one-third? Of the total.

Yes, about one-third of it is not laminate --

Two-thirds is non-laminate flooring related -- all the board and the patents, all laminate. What I'm asking is, one of your bigger competitors in laminate last night released results and in doing so, indicated that they were seeing weaker laminate markets in both United States and Europe, including lower laminate prices in both U.S. and Europe. I'm just trying to reconcile their experience with yours. I'm wondering if the bulk of the strength in the quarter came from sort of the nonlaminate flooring portion of that business?

What we said was that the laminate in the United States was down significantly because of the change in our inventories at our customers. Our best guess, which is just input we're getting from them, is that they've told us that their sales of our products have increased during the period. But we don't have their books so we can't see it. European business has also increased during the period.

So your direct shipments to your distributors in Europe was up in the quarter?

Correct. But in the U.S., they were down substantially.

Correct. I understand that. Finally, Jeff, in your prepared remarks, you made reference to the fact that certain expenses were being deferred to the second half in the Unilin business. Can you just expand on that for me?

It's really just some marketing expenses that we would have -- in our estimates, we had planned to get some more products in the place sooner during the quarter and some of them didn't reach the market as we anticipated.

Can you quantify that for us?

I don't have a number here to give you.

Maybe I can follow-up with you afterwards?

You can give me a call.

Thanks very much, guys.

Your next question comes from the line of Sam Darkatsh with Raymond James.

Good morning, Jeff, how are you?

Excellent. How are you, Sam?

I'm doing fine. Thank you. Couple quick questions, if I could. The LIFO to FIFO switch -- I'm not sure who I should direct this question to. From 30,000 feet it seems curious because I wouldn't imagine that you would think that anything has structurally changed in the industry with respect to the future direction of input costs. Can you help us understand why that decision was made? Is it solely because of forecasting? I'm just curious as to why that decision might have been made.

First is that the rest of the business was on LIFO -- on FIFO. We had part of the business on LIFO and part of the business on FIFO. Second is, we believe it's our goal to maximize our shareholders value in the business and we believe the market had a difficult time understanding that the inventory costs -- and that they were non-cash charges and we don't believe that the marketplace gave us full credit for being on LIFO. We felt it was the advantage of our business and shareholders to change it.

Are you switching your tax books from LIFO to FIFO, also?

Correct.

You are? So you're saying that you're going to be potentially increasing your cash outlay, in terms of taxes, to rectify a non-cash misunderstanding by the marketplace?

Tax impact is minimized. We have some other strategies that we're putting in place. And this whole thing will take place over several years.

But to answer your question -- as you stated, there will be slightly higher taxes going forward to get rid of this -- this LIFO piece.

Got you. Last question, if I might. Is there a way you could help us -- to help quantify the patent royalty payment in Unilin? Or if you'd rather not for competitive reasons -- I'm just trying to understand what the normal seasonality of margins might be, second quarter versus first quarter or second quarter versus third quarter. Because looking at the year ago results, it would be hard for us to ascertain that.

We have contracts with various companies. We add them as they come about. We believe it is detrimental to the business, because if we announced them, you would be able to figure out which people were paying what amounts if you were close to the industry. And we think that would not be good for our business. We're not prepared to give those data out.

Is the accounting for that additive both to revenues and operating profits? Or is it just operating profits? How would you account for those payments?

It would go through revenues and operating costs.

But there's also significant legal fees to go along with these things. We are in courts around the world. We are in suits around the world. And we have a lot of costs in order to maintain the value of those patents.

Would that be the biggest piece of the change in operating margins in Unilin -- would it have been from the patent royalty payments?

The settlements were a very limited part of the change.

Thank you, gentlemen.

Your next question comes from the line of Fritz von Carp with Sage Asset Management.

I think my question has been asked and answered. Thank you.

Your next question comes from the line of [Joe McFadden] with Aberdeen Asset Management.

My questions have also been asked and answered, thanks.

Your next question comes from the line of Errol Rudman with Rudman Capital Management.

Good morning.

Good morning to you. My question was asked but it wasn't answered. So can I ask a -- ?

Sometimes we choose not to answer questions.

John Baugh asked a question of why the drop in the estimate for the margins of Unilin. And I didn't understand your answer. And I think there have been some subsequent questions where you -- about licensing and so on. Is there a general focus -- or maybe you could repeat your answer so that I could understand?

Let me try and I'll let you ask more questions. First is, there were some unusual events, different than we had anticipated, which includes lower manufacturing costs in some of our plants, some lower raw material prices than we had anticipated, along with -- we used wood, and to pay upon the wood we get, it could cost more or less to process the wood. Second is that, we had anticipated the product mix being in one place and we got a higher level of better value products than we had anticipated. That we got in -- we believe that the business in Europe was a little better than we had anticipated. And the combination of all those things, along with some new patent settlements and licenses that we signed, helped improve the margins in the second quarter. In addition, those same things that all went right in the second quarter, we would like them to continue happening on a continuous basis, but we're not anticipating that occurring.

In the third quarter, you have the vacations in Europe, which then create plant shutdowns and large amounts of maintenance that aren't in other quarters -- affects the third quarter, specifically. Was there anything else I can help you with?

Should we expect, going forward -- on the same topic -- that the margin variability quarter-to-quarter would continue to show the pattern that it did from the first to the second quarter?

We are still developing better systems to forecast forward. This business was run as a privately-held business. And they did no forward forecasting at all prior to our ownership. So within the business, we are developing better systems. They continue to improve over time. But they are still limited and we have limited historical basis to do these on and the people are being trained. So one is, we will get better at it. And we have given a range that says, over the next two quarters -- through the rest of the year, we expect to be in the 3.5 to 14.5%. I would be delighted if I was surprised and they were more.

Thank you very much. I appreciate your going over that material with me.

Your next question comes from the line of Steve Fockens with Lehman Brothers.

Good morning, guys. Could you remind us -- on your expectations for Unilin sales growth U.S., Europe and the total business over the next couple of years?

What we said back a few quarters was that we had expected the European business to grow between 2 and 4% as a business. And that we had expected the U.S. business, when we got in place all of the structures -- we thought that the laminate business was going to grow -- the industry was going to grow in the double-digits and that we thought we could grow faster than the industry.

So on a blended basis, that's kind of upper single digit kind of view?

Correct.

Okay, thanks. And then secondly, can you remind us how much, if any, cash came with the Unilin acquisition that may have helped towards debt paydown over the last few quarters, if any?

I think it may have been -- I don't have the number in front of me, you can call back to confirm it -- I think it was in the $150, $160 range -- maybe around there.

Okay, great. Thanks very much.

You're welcome.

Your next question comes from the line of [Bob Thompson] with [Advanta].

Hi, guys, most of my questions have been answered. I just had a couple small ones. It looks like your CapEx has been a little bit lower than projected. Do you anticipate that moving up in the second half of the year? I'm glad that it was lower. Do you have an estimate on CapEx for the second half of the year?

What we started with as a plan this year that we said that we thought we would spend about $300 million. We've lowered the plan to about $250 million. And we spent in the first half about $90 -- $83, $84. -- $83. So some of these plant and pieces -- some of the expenditures don't come in until after you started them up and proven the equipment. We don't pay for it all up front. We'll have some higher expenses on the stuff that have as well as other pieces going in.

Thank you. Do you -- have you put any natural gas hedges in place? I know most of them had rolled out for '06.

Yes. We have a policy that says we're not trying to beat the market. Our plans with natural gas are to buy six to 12 months of hedges to have a portion of the business hedged at all points. Last year, as the gas went through the roof, we quit the policy because we thought it was a momentary blip. This year we have been buying those and the hedges, as you would imagine, are above market today. I think we have around 70% hedged of the total. What else can I tell you? The future hedges are -- still anticipating higher gas prices, which you can see in the market.

And lastly, you have $300 million due in '07. Do you have a plan at -- in terms of refinancing that or just trying to pay it off as part of the debt reduction plan?

I think it's going to roll into our revolver. We're evaluating it. But right now, it's probably roll into our revolver and we'll just pay it off over time as we generate cash.

Okay, great.Thank you.

Your next question comes from the line of [Robert Tracy] with [Kinikos].

For your -- for Unilin and Dal-Tile and Mohawk, could you break out the percentage of revenues for residential demand versus commercial demand?

We don't give out specific channels of information. In general, what we say is that our total demand of residential and commercial is typical of the marketplace; which says that the new construction business is somewhere in the 15 to 20% range. The commercial business is around 25%. And the balance is residential remodeling. And it differs from business to business within each business. We have a difficult time getting specific answers because many of our customers claim both categories and many of the products go in both categories. So they become rough estimates we make -- but they're guesses at best.

If you look at the laminate business, that's primarily going to be residential.

The laminate is almost all residential.

And then on the Dal-Tile, I'd say it's more heavily weighted towards commercial than the carpet side would be -- towards commercial, in general.

I'm sorry, you said 15% new construction, is that what you said?

-- residential construction.

15% new residential construction, 25% commercial and the balance is replacement?

If you take an average over the entire business.

Over the whole business. But when it comes to Dal-Tile, it's more commercial versus residential. And then laminate is primarily residential?

Laminate is almost all residential. Dal-Tile would be higher commercial.

Okay, thank you very much.

You're welcome.

Your next question comes from the line of Alex Mitchell with Scopus Asset Management.

This is Bob Goldberg sitting in for Alex. Good morning. A couple of questions on Unilin. Can you give us an idea of what you're seeing in the market, in terms of price trends in the U.S.? I know we've seen erosion over a multi-year period. Are we continuing to see a slow rate erosion? Or how does that figure into your guidance for the 13.5 to 14.5% margin?

We believe that the industry on a going forward basis will have a declining average selling price by the total market. And that has been the way it has been. You're in a relatively new industry. The industry is only since the early '90s. As it matures, there's improvement in processes and products. As those things pass through the marketplace you get better values. The industry has been in that mode for some period of time and we don't see it changing in the near term.

Our business with the Unilin -- they spend a tremendous amount of time creating product differentiation and added value to their products. So we're able to achieve higher average selling prices than the average of the marketplace.

So in your guidance, do you -- you're assuming that the erosion in Europe realization is less than the market? Is that what you are saying?

That the market's average selling price is below our average selling price.

I was wondering, though, in terms of the erosion, though. Do you see less erosion or is it just that you are starting from a higher base?

If you look over a longer period of time -- the Unilin business has participated in the medium to high end part of the marketplace and participated in very little of the medium to lower end. Mohawk's strategy, which we have said, is to participate in a larger share of the market so that we can have a broader business than they have had historically. And in doing so, we have said that that would reduce the average selling price because instead of walking away from some of the product categories like they have done, we're going to participate in those.

Okay. I hear what you're saying. Second question on the Mohawk segment. Just wondering -- the assumption that's embedded in your guidance for the third quarter. Because on a FIFO basis, I imagine you won't be seeing the cost increases as quickly as you would have under LIFO. Are you assuming that you are able to hold margins to the third quarter? Or margins actually expand as you implement price increases? I was just wondering the thought process there, in terms of -- what happens to margins in the Mohawk division in the third quarter compared to the second quarter?

LIFO -- in both cases, the flow through of the costs were the same. The difference was that we had a -- after we flowed through the cost, in addition to that, there was an extraneous charge that was based on a third-party index that said the inflation was X amount and then we reduced the inventory by that inflation amount to get it to LIFO. And that became a non-cash charge to the business. And the difference between where we were and where we are now is there will be no charge and we won't have to be guessing at what it is when we have no idea how it's going to come out.

I see. Okay, so that would imply then that -- well, I don't want to put words in your mouth. So costs will be going up in the third quarter and then the price will come behind the cost increase?

The lag between the --

You'll be working to -- embedded in your guidance is the assumption that you'll be working to catch up on margin. Is that right?

Correct.

Great. Thank you very much.

Your next question comes from the line of Eric Elbell with Fenimore Asset Management.

Good morning, gentlemen. I know it's kind of hard for you guys to see all the way through the end market, as you just mentioned -- on of your answers a little bit ago -- but you said in your release, for the Mohawk segment, that units were down. Can you provide any sense of how far down they were?

And then if you can, to the extent you can, look through -- or estimate the different end markets; commercial, residential, new and residential replacement, what the price and volume mix was in each of those three? Thank you.

I can help you a little bit -- the industry numbers, which are gathered, showed the first quarter being down in units about 4% and up in dollars about 5%. The second quarter numbers showed the unit declining -- slowing to 2% down in units with approximately a 4% increase in dollars. I don't have the numbers broken down into each channel and category.

Okay. Thank you.

Your next question comes from the line of [Mike Betts] with Eagle Capital.

Hi, thank you for taking my call. I have a couple quick questions. I'm wondering first, whether the tightness in the rebond market is affecting Mohawk at all?

Our padding business is reasonably good at this point. The tightness has raised the prices in the marketplace. And the -- raising prices is helping us.

So everybody else is paying more and you're able to charge a lower price?

We're --

You're able to charge the same price but get more margin?

We are following the market prices in the market, which are going up. And we have -- some of the competitors used a significant portion of their own internally generated waste. That is how they built their business. Our business has been built on purchasing waste. So we're in the same position that we've been in historically.

Okay. You said in the Mohawk division that there was a number -- it sounded like a bit of start-up costs for new operations in this second quarter. Is there any way you can quantify that?

I think for the total start-up cost for all the various pieces together was probably in the $3 or $4 million range for all the different pieces that we have in the second quarter. In the third quarter, we'll have some start-ups with the Muskogee second phase and we'll have the Mexican mosaic starting up, which will probably be $1 to $2 million between those.

Okay. And the -- Frank said earlier that the depreciation for the year would run about $280 million?

Correct.

Do you have that broken down by division, possibly?

I do not.

Okay. That's not something you can provide?

I think what we've provided is the depreciation and amortization for Unilin because that's news. Running about $120, maybe in that range, if you include the amortization that we have from the acquisition in accounting.

Okay. And the $250 CapEx for this year -- is that a good number to use going forward, at this point?

It's a good number for this year.

For this year. But, I mean --

Next year, we haven't put together the capital plan yet. A lot of it's dependant upon what the economy does and the business does. And we're a few months away from concluding that

Thank you very much. That's all I have.

Thank you.

Your next question comes from the line of Douglas Pratt with Mesa Capital.

Thanks very much. Hi, just to beat that dead horse a little bit in terms of the royalty payment -- hello?

We're listening. Hello? Hello? Operator?

Mr. Pratt's line is still open.

Hello?

We're still here.

Hello? Just a follow-up with the question on the royalty payment. You said that came into the revenue line. And I gather you're not going to tell us how much that was. If we make some inferences, we can come up with -- it looks like your growth was about 4% -- I'm sorry, 2 to 3%, if you adjust that relative to the pro-forma for last year -- in other words, with Unilin in both last year and this year. Which is a deceleration for that division from the first quarter.

I'm not sure how you did that because there are no numbers out there except for a ten-month period ending October and a two-month period ending December.

There's also a three-month period for the first quarter, which you released in your first quarter Q. As I said, we've got to do some extrapolation in there. I'd just like your comment in terms of -- are you seeing on a pro forma, apples-to-apples basis -- are you seeing revenue increase, perhaps, above 5% -- or below 5%? And if we adjust for that, earnings look like they were -- I think between that and the customs payment was probably somewhere around $0.14 to $0.15 for this quarter, making it more like $1 -- call it $1.60, versus a pro-forma of about $1.58 last year. So I guess what I'm getting at -- it seems like growth is deaccelerating more than the printed number indicates. So I'd like your response to that. Thank you.

I'll try to answer it. First is in our adjusted number, we took out the duty already. We didn't want to overstate it, either. In our announcement we have extracted that for you. I think it comes out $1.73 without it already in it. The patent income, again, was a limited portion of the difference between the 13.5 to 14.5% margin we had expected and the 19%. It was only a limited portion of the total versus your mathematical calculation.

Your next question comes from the line of Frank Bisk with Pilot Advisers.

Good morning. A few calls before, I guess you were talking about the industry and you said quarter one units were down 4% and quarter two -- units down 4% in quarter one, down 2% in quarter two. What segment were you talking about? Was this the carpet segment? Was this your -- everything as a whole? I wasn't sure if it's just the industry or you. I missed it.

I'm sorry, it was the carpet industry only.

Carpet industry only.

Right.

And could you give out that information for laminate industry as well as the Dal-Tile ceramic industry, as well?

I don't have those numbers. They don't -- there's not a published piece to get them from. The only numbers you can get for those are on an annual basis from the government.

Okay. You do not break -- you would not break out what your unit increase or decrease was in your carpet segment in Q2 or Q1, correct?

We're similar to the industry.

Okay. Thank you.

You're welcome.

Your next question comes from the line of [Jarrett Levin] with Highbridge capital.

Thank you very much for taking my call. I'm wondering, can you, in fact, break out any more detail about how much of the increase in the second quarter in your margin for Unilin was due to the royalty income? And then how much of that would be one-time settlements versus recurring legacy income? What we could expect in future quarters? Thank you.

We can but we chose not to. We believe if we give out the specific details, it will impact our negotiating posture with other companies on an ongoing basis. And it would be detrimental to the business. We have said that, out of the difference, the settlements that are nonrecurring is a limited portion of the difference. Which is all we're prepared to give out.

Thank you very much. If you said that before, I apologize.

No problem.

At this time, there are no further questions. Do you have any closing remarks?

We're quite satisfied with the quarter. We're working diligently to maintain and improve our business in all aspects. And will continue to react to whatever the economy does. We appreciate your support. Have a great day.

Thank you. This does conclude Mohawk's second quarter earnings conference call. You may now disconnect.