2023-12-21 08:41:53 ET
Summary
- Floor & Decor is a hard flooring retailer with 207 stores across 36 states, aiming to grow to 500+ stores in the next decade.
- The market is overestimating the company's long-term growth potential and earnings power, leading to an overpriced stock.
- The unit economics of FND stores are not as compelling as believed, with lower returns on investment and potential cannibalization in existing markets.
The Setup
Floor & Decor (FND) is a hard flooring retailer operating 207 stores across 36 states at the end of Q3 2023. Their stores are large 78,000 square feet (sq. ft.) warehouses. FND came public in 2017 and laid out an aggressive growth plan to go from 72 stores in Q1 17 to 500+ over the next decade. They consistently talk about growing stores mid to high teens per year, which they have done thus far. It's a compelling growth story, and disrupting a fragmented market presents a compelling thesis. That is, however, until you get to the business today, where the growth story is beginning to show cracks. At 51x consensus 2024 EPS, FND's stock is priced for a dramatic rebound in results after a weak 2023 due to a weak existing home sales market. When you dig into the unit economics of the FND stores, they are not as compelling as management and the street believe. I recommend shorting FND as the market is overestimating the ROIC of the business and the company's long-term earnings potential.
Business Description
Operating in a highly fragmented industry, I estimate Floor & Decor has ~9% market share in the $30B+ hard surface flooring market. Competitors include Home Depot ( HD ), Lowe's ( LOW ), LL Flooring ( LL ), The Tile Shop, and local mom-and-pop stores. Floor & Decor's value proposition is a multi-pronged approach. First, due to the large footprint store format, they have the industry's most comprehensive in-stock, trend-right product assortment with an average of ~4,400 stock-keeping units (SKUs) in each store. Second, having a direct sourcing model allows them to provide low prices daily. Third, the large store format allows FND to be a one-stop shop for customer needs, including vanities, bathroom accessories, shower doors, and customer countertops. Low prices and many options is an enticing proposition. In addition, they have a design services team in every store.
2017
Floor & Decor operated 74 stores across 17 states when they came public in 2017, compared to today's 207 stores across 37 states at the end of Q3.
2023
State | Number of Stores |
Texas | 35 |
Florida | 29 |
California | 27 |
Georgia | 11 |
Illinois | 10 |
New Jersey | 9 |
New York | 9 |
Virginia | 9 |
Arizona | 7 |
Colorado | 6 |
Thesis
Floor & Decor has a good growth story, intending to go from 200+ stores to 500 over the next decade. They have a good customer value proposition, offering the most comprehensive assortment at low prices. Why is this short? I believe the street is overestimating the long-term growth potential and, therefore, the long-term earnings power of the business. The market's embedded assumptions are much too high, and when investors realize the store growth potential is not as good as it seems, the stock will re-rate to a lower valuation as this growth company matures sooner than expected.
What's interesting about this growth story is that when the company came public, they set out a goal to open 400 stores (note Thomas Taylor said when he joined the company in 2012, the goal was 300); now, the figure has moved to 500. When was this figure revised up? The 4th quarter 2021 earnings call , aka, peak covid and repair & remodel demand. I believe Floor & Decor, as with almost every other covid beneficiary, extrapolated recent trends and gave guidance based upon this. One way or another, the future growth story is less than the market anticipates. They will either open low ROI stores to demonstrate they can hit targets or will need to take down expectations as they approach market saturation. The market is not kind to low-growth "growth stocks."
Retailers expand into areas that offer the highest ROIC. As they enter new and less prosperous markets, the economics of the store are less than the initial ones. For example, they recently opened a store in Rochester, NY. Rochester is a declining city with little economic growth. It's improbable that this store has economics similar to the first stores opened in NYC, Dallas, or Miami. So, while the original stores may have great economics, future stores are unlikely to have similar returns.
On the Q1 2023 earnings call, Trevor Land, CFO, stated, "Most of our 2023 new warehouse store openings are expected to be in existing markets and weighted to the second half of the year." While some markets can handle multiple stores, there's likely cannibalization as every incremental store is added to an area.
Take Dallas, Texas, for example. FND operates seven warehouse stores, one design studio, all 45 minutes from Downtown Dallas, and 12 stores within 50 miles. While Dallas is a growing city, having 1-2 stores in this region likely generates far different store-level ROICs compared to 7.
The importance of this is demonstrated through the company's incremental margins. Gross margins have been relatively stable over the several years, increasing from 40% in 2015 to an estimated 40.5% in 2023. Incremental Gross margins have been roughly 40-42% over this time, showing this is likely the go-forward margin.
The business does not display much operating leverage at EBIT as the incremental margins ranged from 1-15% over the past decade, even though revenues have over 10x. In general, retail store costs are mostly fixed. SG&A and Selling and store operating should be relatively fixed and fluctuate little whether revenues are higher or lower. This does not come through in FND's financials, though this may be due to the rapid store expansion obscures this operating leverage. On the 2022 analyst day, management stated, "Our medium-term target for EBITDA margins is in the mid-teens. In the long term, once we aren't executing 20% unit growth. We think we can get that to be the upper teens." I see them falling well short of their upper teens goal, stabilizing around 14-15%. Note D&A has been 4-5% of revenue, thus a 17% EBITDA margin is ~13% EBIT margin.
Store Level Economics
Same-store sales (SSS) is the most important key performance indicator (KPI) and is the most influential metric affecting business performance. FNDs had impressive results, with comps up a staggering 31% in 2021, though they have been challenged due to the decline in existing home sales.
The chart below shows SSS decline in all quarters thus far in 2023 and is expected to be the worst in Q4. On the Q3 23 call , management stated, "We are still developing our detailed sales plan for 2024, but we expect that if existing home sales remain at the current levels, our comparable store sales could decline next year. In particular, we anticipate our comparable store sales could decline more in the first half versus the second half of the year given our sales comparisons from 2023." Negative comps present a material headwind to the business. Unit growth mitigated the comp slowdown.
On a sales-per-store basis, revenues increased from $10.9m in 2012 to an estimated $21.1m in 2023. Pre covid, Sales per store were ~$18m. Unsurprisingly, sales/store rose dramatically in 2021 and 2022 to ~$23m and $24m, respectively. In 2018, sales/sf increased 3.6% y/y to $259, declined 4.6% in 2019, and was roughly flat in 2020. Due to lower ROI stores opening, I believe this figure will be ~$250 over the next several years.
One metric investors should become increasingly skeptical about is management commentary surrounding the unit economics of their stores. Whether it's Callaway Brands CEO on the Q3 2022 earnings call, "The business model is proven, with venues delivering an impressive 40% to 50% year 3 cash-on-cash return." Bowlero CEO : "So we've never had so much new build activity, which is great because our new builds are returning about a 45% cash-on-cash return on significant investments." And FND's " cash-on-cash returns of ~50% in the third year ." It's doubtful the returns are this high, as outlined below.
While it costs $8-10m to open a new store, leasing vs. owning the property obscures the true economics of the business. As I show below, the ROIC of the business is far less than what management is proposing, in my opinion. While the return profile is good, it's not the 40-50% cash-on-cash returns management discusses. Stores 3 years and older are likely stabilized or close, and I estimate they generate between a 13-16% ROIC. Again, this is a good return; however, when the company runs out of a reinvestment runway in the next 6-7 years, the inability to reinvest in the business results in an expensive maturing, cyclical business tied to existing home sales, interest rates, and the general macro backdrop.
Based upon management's Q3 commentary, they expect 2024 comps to decline unless existing home sales have a sudden turnaround, new store openings, and maturing are the primary revenue growth drivers. Looking out a few years, when existing home sales normalize, and additional stores mature, I estimate FND will be trading at 33x 2026 EPS and 26x 2028 EPS. My estimates assume revenue of $6.25B in 2026, with 43% gross margins and 7.7% EBIT margins and shares outstanding of 110.3m in 2026 (assumes ~800k shares issued per year for stock option awards). (The far right column in the table below depicts the risk-reward of the stock at different prices)
The catalysts to the thesis are: 1. SSS recovery is weaker than expected once existing home sales normalize. As maturing stores contribute less to SSS growth, and mature SSS is the key driver, the high growth investors expect will not come through. 2. Management has already slowed the pace of new store openings during the softer market. If management talks down new store openings and TAM, I expect normalized EPS estimates will be revised substantially, or management will continue opening stores at poor economics, resulting in lower ROI investments. 3. New store openings in less robust cities or ones with existing stores will weigh on growth, cannibalizing existing stores.
A reverse DCF on FND implies the following assumptions: 1. The company can increase warehouse stores to 520 by 2038. 2. Revenue per SF will increase 5% annually through 2038 and 4% annually thereafter, implying 4% SSS comps from 2039 to 2053 as no new stores are added during this period (which seems highly unlikely). 3. A WACC of 9% 4. Operating margins will expand to 12.5% in 2053. The market assumes management hits every target they laid out: 500+ stores and mid to high teens EBITDA margins. The risk is to the downside as the bull case for the stock is already heavily priced in.
Since 2023 and 2024 are abnormal years, I use 2026 as my base case, where I estimate they will generate $3.39 in EPS, at 25x equates to a $85 price target in 2026, or an -8.5% IRR over the next three years.
Q3 Results
Floor & Decor's third quarter remained challenged due to weak existing home sales of 4.02m, down ~16% y/y. FND's results have a high correlation with this indicator. As more homes are sold, the demand for repair and remodeling increases as new homeowners look to renovate and improve the newly purchased homes. Same-store sales came in at -9.3%, in line with estimates, and a deceleration from -6% in Q2 and -3.3% in Q1. For Q4, they guided SSS of -15% to -12% and stated, "We believe the ongoing impact of these monetary policies will continue to suppress home remodeling into fiscal 2024, which could lead to a decline in our comparable store sales for the year." QTD trends were comparable store sales of -11.9%. Management previously guided 2024 store openings of at least 35 and has now revised it to 30-35 due to the worse-than-expected environment. Wall Street expects Q4 comps to come in at 13.7%, with negative comps in Q1 and Q2 2024, turning slightly positive in Q3. While FND reported better than expected EPS results of $0.61, sales came in light at $1.1B vs. estimates of $1.12B. Commentary around project size typically was homeowners choosing to do projects in phases or smaller sizes. Instead of renovating a kitchen and bathroom, homeowners choose to renovate only the kitchen. Finally, the last interesting comment from management was, "About 20% of our stores, maybe just a nudge above that, are on minimum hours today." A decline in SSS at these stores will have an outsized impact as almost no other costs can be taken out at these stores.
Risks
A dramatic fall in interest rates may restart the housing market as more homeowners are willing to sell if they can purchase a new home with a similar interest rate. Homeowners are reluctant to sell due to the dramatic step up in interest costs. Going from a 3% mortgage to a 6.5% mortgage on a $300,000 house increases the monthly payment from $1,265 to $1,896, a 50% increase. A more robust than anticipated increase to SSS will likely drive the stock higher in the near term.
The second risk is the higher short interest in the name. Currently, 17.6% of the float is short, and it would take almost 15 days to cover the position entirely. Shorts are likely playing for the same catalyst and could cause indiscriminate buying should the thesis not come through.
Poorly capitalized competitors, including LL Flooring ( LL ) (see my previous writeup here ) and mom-and-pop shops, will be challenged during the slowdown, leaving market share up for grabs. FND has been a market share taker over the past several years and would be a beneficiary if stores closed in their markets.
Balance Sheet
FND has a relatively healthy balance sheet, funding ongoing growth capex with internally generated cash flow. The bulk of FND's debt stems from operating lease liabilities, $1.45B at the end of Q3 2023, while carrying just $195m of traditional debt.
They typically turn inventory ~2x per year and, on average, carry just below $5m per store. Like many retailers and other companies, FND exited the boom R&R years with excess inventory, holding almost $8m per store just as spending began to roll over. Today, they are down to just over $5m per store, which will likely get worked down slightly in Q4 as they pull back on inventory restocking until trends improve.
Summary & Forward-Looking Items to Monitor
While FND has a good value proposition for customers, the economic return on these stores is not as promising as management lays out, in my opinion. As the company matures sooner than the market expects, revenue and earnings estimates will be revised downward to reflect the lower mature store count and lower sales per square foot, as market saturation negatively affects store economics. With the stock trading at 33x 2026E earnings, the risk-reward skews negatively as the market is already pricing in a robust recovery post-2024, growing for several years after that. I believe these optimistic estimates are unlikely to come to fruition and that FND is an excellent short.
Key indicators to monitor going forward are: 1. Comparable store sales. 2. Mature store revenue and EBITDA margins 3. Gross margins 4. Unit ROIC 5. What markets is FND opening new stores in - new or existing markets? 6. Sales per store and sales per square foot.
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Floor & Decor: The Economics Are Worse Than They Appear