2023-09-13 10:30:23 ET
Summary
- Floor & Decor has been growing at a high pace for two decades but right now we are seeing growth rates slow down.
- Over the long run, Floor & Decor has several pillars of growth - improving margins, opening new stores, high comparable store sales growth.
- Although the company is growing with a high pace, the existence of a moat is questionable.
Companies growing with a high pace are often fascinating for investors – and it happens quite often that we also assume a great business model when a company can grow with a high pace for two decades. And growing with a high pace for two decades is certainly an accomplishment, but no guarantee for a business being a great long-term investment.
The specialty retailer Floor & Decor Holdings, Inc. ( FND ) is a company fitting that description. It is one of the businesses I didn’t know before and that came to my attention by listening to the podcast “Business Breakdowns” (which was already inspiration for a few other new businesses I analyzed in the last few months). But while I saw an economic moat around the other businesses from the podcast I covered, I have a different perspective on Floor & Decor (of course, the podcast is not really claiming that every business covered has an economic moat).
In the following article, we take a closer look at the business that has the potential to continue growing with a high pace but is in my opinion missing a wide economic moat around the business. And as always, we start with a business description.
Business Description
The business model of Floor & Decor is easy to understand as we are dealing with a specialty retailer and the products sold are already in its name. The company was founded as FDO Holdings in 2000 by George West. In 2017 the company changed its name to Floor & Decor Holdings, Inc. and had its initial public offering. The company has its headquarter in Atlanta and about 12,000 employees right now.
Floor & Decor is offering tile, wood, laminate, vinyl, and natural stone flooring products as well as decorative accessories, wall tiles and installation materials and tools. And in fiscal 2022, the business generated $4,264 million in annual sales – compared to $3,434 million in the previous year this is a 24.2% year-over-year increase. Operating income also increased 17.1% year-over-year from $339.0 million in fiscal 2021 to $396.8 million in fiscal 2022. And diluted earnings per share increased from $2.64 to $2.78 – an increase of 5.3% YoY.
And despite solid growth rates, Floor & Decor already seemed to struggle a bit in 2022. When looking at the last 10 years, growth rates were even more impressive. In the last ten years (between 2012 and 2022), Floor & Decor grew revenue with a CAGR of 28.96%, operating income increased with a CAGR of 31.30% and earnings per share increased with a CAGR of 35.63% in that timeframe.
Floor & Decor: Revenue, EPS and FCF (Author's work)
Although Floor & Decor is reporting in one single segment, we can look at different product categories. And the biggest part of revenue ($1,185 million or 28% of total sales in fiscal 2022) was generated from laminate and vinyl followed by 23% of total revenue ($964 million) from tile. And about 17% of total revenue were generated from “Decorative accessories and wall tile” ($745 million) as well as “Installation materials and tools” ($713 million).
When looking at the second quarter results for fiscal 2023, we see the picture getting a little bit worse. Net sales still increased 4.2% year-over-year from $1,090 million in Q2/22 to $1,136 million in Q2/23, but operating income declined 10.7% YoY from $106.4 million in the same quarter last year to $95.0 million this quarter. And diluted earnings per share declined 13.2% YoY from $0.76 in Q2/22 to $0.66 in Q2/23.
Pillars of Growth
And although growth slowed down in the last few quarters, we can expect that Floor & Decor can continue growing with a high pace – similar to the impressive growth metrics in the last decade. To achieve long-term sales and earnings growth, the business is relying on several pillars of growth.
Floor & Decor Investor Day 2022
A very simple way to grow for Floor & Decor is by opening new stores. In Q2/23 the company had 203 warehouse stores and five design studios. And for the full year fiscal 2023, the company is expecting 32 new warehouse stores. And management sees significant whitespace potential and has a target of at least 500 stores. And when looking at competitor The Home Depot, Inc. ( HD ) with over 2,300 stores in North America, the business should have significant upside potential and assuming a growing number of stores is not unreasonable.
Floor & Decor Investor Day 2022
Over the long run, management not only sees growth potential by opening new stores in new markets (and areas without a store), but also by growing comparable store sales in its already existing locations. And during the last decade, the company not only increased the number of its stores with an impressive pace but also reported high comparable stores sales growth.
Floor & Decor Investor Day 2022
While fiscal 2021 was clearly an outlier – and Floor & Decor was one of the businesses profiting from COVID-19 pandemic – comparable store sales increased 9.2% in fiscal 2022, which is an impressive comparable stores sales growth, but below the 10-year average of 14.5% for the years 2012 till 2021. In the second quarter of fiscal 2023 however, Floor & Decor had to report decreasing same store sales (6.0% decline).
But the company can not only grow by improving its top line and generate higher sales. It can also grow its bottom line by improving its margins. While Floor & Decor already has a rather high gross margin – much higher than its two main competitors Home Depot and Lowe’s Companies, Inc. ( LOW ) – the operating margin is much lower. And in the years to come, the company can focus on improving its operating margin by lowering its expenses.
In total, Floor & Decor sees a total addressable market of $49 billion to $54 billion for its business and the company certainly has the potential to gain market share in my view.
Floor & Decor Investor Day 2022
Macroeconomic Headwind
In theory, the business has growth potential in the years (and decades) to come – but for the next few quarters we should be rather cautious. The company was profiting from very favorable trends in the housing market in the last decade (or even longer) and according to different metrics the housing market is starting to struggle.
When looking at some numbers we see growth slowing down. In the last few quarters, the total amount spent on construction is still growing year-over-year, but growth rates are not as high as they have been before (despite an improvement in the last two months).
And the number of housing permits also declined from its previous peak and is now fluctuating at a lower level for several months in a row.
We can clearly see the construction of new houses slowing down, but Floor & Decor is not just profiting from people constructing new homes. It can also profit from people renovating existing homes. In my last article about Home Depot I wrote:
But aside from people buying or building new houses, there is another important market that should not be ignored - renovation. And we should not be too optimistic here either: When times are tough, people don't spend money on renovation. With disposable income declining (as it is often the case during an economic contraction), huge investments (and a renovation is a huge investment) are often postponed. But over the next few years, people might rather tend to renovate their houses (especially when they can't afford to buy a new house) and this could be a tailwind for Home Depot over the next 5 to 10 years. And with the average age of housing stock in the United States increasing (53% of houses are now 40 years or older), renovation might be a bigger issue in the years to come - and contributor to growth for Home Depot.
And when the economy is heading towards a recession, we clearly see a risk for Floor & Decor and lower sales for several quarters seem likely. People might build less houses, people also might postpone renovations – but over the medium term these are essential investments and those already owning a house won’t postpone renovations forever.
Economic Moat
Aside from the growth potential a business has, another aspect is of similar importance for me as long-term investor: The question if a company has a wide economic moat. And retail companies usually face huge difficulties to build a wide economic moat around the business. Retail companies are not able to generate network effects, they are also not able to generate switching costs – most products can be seen as a commodity, which is available at any retailer and therefore the price is the only differentiating factor for the customer. Cost advantages might be the only way to generate a competitive advantage compared to a company’s peers (and some manage to establish a brand name). But with Floor & Decor competing with Home Depot and Lowe’s – and both companies generating higher sales – it will be difficult to generate advantages.
It seems like Floor & Decor is trying to pass on its products as cheap as possible to the customers – similar to Costco Wholesale Corporation ( COST ). But it doesn’t make much sense to compare the business model and see a similar economic moat as Floor & Decor does not have a membership model. And customers at Costco shop there regularly – maybe weekly, maybe twice a month. Customers of Floor & Decor do not have to shop with such a high frequency as I usually don’t need a new floor every few weeks.
And we should be very cautious not to see economic moats where none are. Of course, the business is reporting extremely high growth rates – but high growth rates by itself are not an economic moat. We are looking at a rather young business and it can grow by gaining market shares. How well a business is able to defend itself against competitors remains to be seen.
It is helping when the business is focusing more and more on its “Pro” customers – they are rather leading to recurring sales and higher levels of stability and consistency. And “Pro” influences about 40% of sales (the company is also including Homeowner sales that have been influenced to buy at Floor & Decor by a “Pro”). And these professionals will lead to recurring revenue and will buy at Floor & Decor again and again if they are satisfied with the service and products.
Floor & Decor Investor Day 2022
And although I remain skeptical about an economic moat, the numbers are indicating one. When looking at the stock price we see a clear outperformance compared to the S&P 500 (SPY). However, we are only looking at around 6 years of data which is not enough to draw conclusions.
When looking at the margins over the last decade, we see a stable (and even slightly improving) gross margin and an improving operating margin – of course, we see some fluctuations. In the last ten years, the company did also report an RoIC of 10.78% and in the last five years, the RoIC was 12.42%. An RoIC above 10% is indicating an economic moat. But in case of Floor & Decor, I would be rather skeptical if the company actually has an economic moat.
Floor & Decor: Margins and Return on Invested Capital (Author's work)
Intrinsic Value Calculation
Usually, I am looking at the price-earnings ratio as well as the price-free-cash-flow ratio. But in case of Floor & Decor, looking at the price-free-cash-flow ratio doesn’t make much sense as the company has wildly fluctuating P/FCF ratios. The company is investing heavily in its expansion and new stores and therefore has a rather low free cash flow – in some years the free cash flow was even negative.
Instead, we can look at the price-earnings ratio since the IPO. Right now, the stock is trading for 35.1 times earnings and although the stock is trading below the long-term average (P/E ratio since the IPO was 40.82 on average), the stock seems rather expensive. And in the last few years, the stock was trading for much lower valuation multiples on several occasions.
We can also calculate an intrinsic value by using a discount cash flow calculation. However, we must make realistic assumptions for free cash flow in the years to come. As basis we could take the net income of the last four quarters (instead of free cash flow). When taking this amount, the company must grow 11% annually from now till perpetuity followed by 6% growth till perpetuity to be fairly valued (assuming 10% discount rate and 107.8 million outstanding shares).
When looking at the past growth rates (see section above), 11% growth seems like a realistic and achievable number for Floor & Decor. Earnings estimates see the company grow its bottom line with a CAGR of 11.44% in the next few years. During its 2022 Investor Day, management was even more optimistic and assumed 24% to 26% growth for operating income and the number of new stores should grow about 20% annually. And due to the high capital expenditures, Floor & Decor is not expecting a positive free cash flow before 2024. But with lower capital necessary for expansion over time, free cash flow will increase.
Another problem we need to mention is the constantly increasing number of outstanding shares. Since the IPO, the number of outstanding shares increased from 97.25 million to 107.8 million right now. This is resulting in a CAGR of 1.5%. However, the company is increasing the number of outstanding shares with a rather slow pace and in the last three years the number of outstanding shares increased only 1.3%. Although I rather like to see companies decreasing the number of shares (or keeping them at a stable level), I don’t see this as a major problem for Floor & Decor.
Conclusion
Floor & Decor is certainly a great growth story up until now and it can be a great long-term investment in the years (and maybe decades) to come. Compared to its competitors Home Depot and Lowe’s, the business is still rather small and can continue growing with a high pace by gaining market shares from these competitors and opening stores in areas it isn’t present yet (and we are not even talking about international expansion). Of course, the underlying market will also grow (most likely).
And although the business can be a great long-term investment (and growth story) we should be cautious as I don’t really see an economic moat protecting the business at this point. Continued growth seems likely at this point, but without an economic moat the risk of growth suddenly vanishing should not be ignored. And I am trying to shift my personal investing more and more to only investing in high-quality companies with a wide economic moat. As I don’t see a clear economic moat in this case, I will rather pass (but we can keep the business on our watchlist as the right price can make almost every business a great investment).
For further details see:
Floor & Decor: Impressive Growth, But Will It Last?