By Raymond Mathis Dal-Tile International (DTL), with revenues of just under $1.0 billion, has become the largest ceramic tile manufacturer in the U.S. The company not only enjoys a commanding 26% market share, but it also has leveraged favorable economic and demographic trends to produce 12% annual top-line growth. Standard & Poor's recently initiated coverage on the stock with its highest investment ranking, 5 STARS (buy).
New management successfully revived the company's fortunes after the integration of a Dal-Tile acquisition in the mid-1990s did not go well. Since 1997, sales have improved at a 12% annual rate, margins have widened, and selling, general and administrative expenses, or SG&A, have declined as a percentage of revenue. On the balance sheet side, accounts receivable days have declined from 64 to 43, inventory turns have improved from 2.6 to 3.5, and debt has been reduced 47%. At the same time, manufacturing productivity improved 44%, from 33.5 square feet of tile produced per man hour to 48.2 square feet.
Dal-Tile's sales are concentrated in commercial applications, at 54% of revenues. Although commercial construction has recently slowed, Dal-Tile's commercial tile sales have been resilient. Also, sales for the whole ceramic tile industry have been concentrated in residential applications (71%), where Dal has significant growth opportunities. Recently, Dal-Tile's share of the U.S. residential market was only 14%. Given the surprising strength of new housing starts and existing home sales through the recent economic downturn, Dal-Tile is taking advantage of this opportunity by aggressively targeting this market.
TILE TIME. Residential construction is a ceramic tile growth opportunity for a number of reasons. The most obvious reason is that housing starts and existing home turnover have been running near record levels on an annualized basis. Add to that the fact that Americans are building bigger houses and are spending more on the construction of their houses. Statistics show that Americans are shying away from one-bathroom homes in favor of multiple bath construction.
Also, ceramic tile is rapidly taking market share from carpeting and other types of flooring. Demographically speaking, the aging of the Baby Boomers also weighs in favor of ceramic tile. Empty nesters and retirees are "trading up" to more luxuriously appointed homes. Furthermore, the U.S. population is increasingly migrating to the Southern and Southwestern states where Spanish influence on architectural styles causes ceramic tile to be used in more rooms.
As a result, from 1992 through 2000, overall sales of ceramic tile in the U.S. grew at a 10.6% compound annual growth rate in unit volume terms, while carpet volume increased at only a 4.4% rate. Year to date, Dal-Tile has improved revenue by more than 7%, while most carpet manufacturers have reported declines from the mid single digits to low teens.
SLUMP-RESISTANT. Recently, housing starts have begun softening along with consumer confidence and the U.S. economy as a whole. However, S&P forecasts a bottom for housing starts at about the 1.3 million annualized level, which would represent the highest cyclical trough in history. Housing sales are inversely correlated to interest rates, and with recent sharp interest rate cutting by the Fed, we anticipate a quick recovery.
Athough slowing housing sales may stunt Dal's growth in the near-term, we feel that it would take a much sharper downturn than we are forecasting in order to fully offset Dal's market share gains. Even with flattish sales over the next few quarters, Dal's cost control efforts and consistent debt reduction should produce bottom line gains.
The recent shock to the U.S. economy has produced ancillary effects that might benefit Dal-Tile. With the dollar weakening against foreign currencies, most notably the Euro, Dal-Tile's products will be more favorably priced against Italian and Spanish tile imports. Lower natural gas and gasoline prices should reduce Dal's cost of production and transportation.
~~OVERLOOKED.~~ S&P feels that the stock is overlooked and undervalued for a number of reasons. At just under one billion dollars in annual revenue and one billion dollars market capitalization, the stock is likely flying just below the radar of many investors. Also, those who are not familiar with Dal-Tile's successful turnaround may have bitter memories of the company's performance in the mid-1990s.
We feel the main reason however, is the effect of taxes on earnings. A cursory glance at Dal-Tile's year-over-year performance shows top-line growth, operating income improvement, and rising pretax income. However, due to the end of tax loss carry forwards, Dal-Tile is bearing a full tax burden, and this is weighing on bottom line earnings. It would take a bit of investigation for investors to discover that, on a pro-forma fully taxed basis, earnings have actually increased at a double digit pace.
UPSIDE POTENTIAL. S&P sees significant upside for the shares. With rapid growth, the widest margins amongst its peers, and a return on equity nearly double its next competitor, we would expect the stock to command a market premium. However, we find that the stock continues to trade at a discount to its peers.
The shares currently trade at a price-to-earnings ratio of 10.1, versus an average of over 11.1 for its strongest competitors, despite the fact that many of the company's rivals are posting declining sales. Using consensus long-term growth estimates, Dal-Tile shares have a p-e-to-growth (PEG) ratio of 0.73 based on our 2002 earnings estimate, which is substantially lower than the industry average of 0.85. The industry average implies Dal-Tile shares should carry a value of $19.02, a 17% price appreciation. Assuming a PEG of one, the shares should be priced at $22.35, which represents a potential 37% gain.
S&P's outlook on Dal-Tile shares is also supported by the company's strong cash flow. After factoring in a decline for 2001 due to higher tax rates, S&P's discounted free cash flow model implies an intrinsic value of approximately $34.
S&P estimates 2001 EPS of $1.32, with growth to $1.44 in 2002. After tax rates become comparable in 2002, and EPS begins to show year over year gains, we expect the stock to appreciate to our six to 12 month target price of $21. This represents a 28% increase from the current price. Mathis is an equity analyst following diversified retail shares for Standard & Poor's