Description

Overview

Floor & Decor (FND) is a category killer, operating in the hard surface flooring retail segment of the repair and remodel home improvement market. The company focuses on providing a superior customer experience through the best prices, unmatched selection of in-stock merchandise, and great service. Founded in 2000, the company operates approximately 120 locations (YE19 estimate) across the US in 28 states.

Long-term the company should 4x store count, while expanding margins by over 50% leading to significant profit growth in the coming decade. FND is undervalued because this profit growth is not fully implied in the current share prices.

Competitive Advantages

The directly sources private label flooring from over 240 suppliers in over 20 countries, as compared to peers who purchase branded products through distributors. The company’s stores have ~76,000 square feet of retail space dedicated to hard flooring while peers Home Depot and Lowe’s dedicate ~5,000 square feet to the flooring category. As such FND has greater SKU availability and in-stocks, a huge advantage with the professional customer (~60% of revenues). By cutting out branded players and the one or two layers of distributor middlemen they generate a price advantage relative to peers of up to 30-40% at retail while generating GMs similar to HD.

FND provides superior service because their stores that have an average of 50 employees, focus solely on selling hard flooring, and are category experts. Because of FND’s warehouse model they carry significantly more inventory than peers. This may leave them with inventory obsolescence risk in a downturn. In addition, not all consumers want this warehouse/supply house experience.

Parallels to Home Depot

Home Depot (HD) is one of the best performing equities of all times with an ROIC in the mid 40s. At its core the model is providing great service at an Everyday Low Price (EDLP). Floor and Décor is an opportunity to invest in a flooring retail following this same service and cost leadership strategy, creating a flooring version of Home Depot.

Today the company has approximately 120 stores with a long-term potential of over 500 locations, versus management’s current projections for over 400. The company is only currently in 28 states, providing significant room to grow in underpenetrated markets. In 4Q18 the company opened their first store in Long Island which is reminiscent of Home Depot’s launch in Long Island in the 1989 when the company started putting up AUVs (average unit volumes) significantly higher than any other location. Management has indicated that they were highly impressed so far and conversations with Investor Relations indicate that they are hunting very hard to try and open many more of these high-volume areas in the dense northeast region. The main headwind to this expansion is finding good real estate. Something that should open up as Many other retail concepts are struggling. Long-term this should lead to rising mature store AUVs which are likely not fully captured in current street estimates.

When Home Depot launched, they were competing with many small independents that ended up being pushed out of business. The same is happening now with Floor and Decor pushing small independents out of business and taking market share. Currently Independents are estimated to have about 35% of the market while FND has sub 10%. Long-term they should take significant share given their price, service and in-stock advantages. The company estimates that when they open stores, they generate 40% of new store revenues by stealing from independents, 40% from big box stores, and 20% in new demand. Part of this new demand comes from mix shifting customers from soft flooring (carpets) to hard flooring and part of this comes from the superior prices lowering the hurdle to pursuing flooring renovation.  

Although Tom Taylor Lives in Boca Raton, not Smyrna Georgia, where the company is headquartered, he spends a significant amount of time on the road reducing the importance of a local CEO. In addition, given the small number of stores the CEO and c-suite can make an impact directly on current employees, something that is no longer possible at a Home Depot with 2,200 employees. I follow many FND employees on LinkedIn and recently saw a photo that was posted by an employee of an executive helping a customer load their purchase during a store visit. This is directly out of the Home Depot playbook of top executives helping when they are on site.

When Retail concepts work the returns are incredible given the low capital intensity per box, and the ability to use vendor payables to finance working capital. Floor and Décor finances ~2/3^rds of their inventory in this fashion. This leads to phenomenal FCF conversion at maturity and very strong cash returns.

Management Team

Tom Taylor the current CEO was a Home Depot lifer, starting at 16 and working there for the next 23 years. In his time, he rose the ranks until working as the Executive Vice President of Operations for all 2,200 Home Depot stores and then the Executive Vice President of Merchandising and Marketing for all stores. He then transitioned to working for Sun Capital Partners for six years where he added financial acumen to his strong retail experience. According to FND IR one of his other claims to fame is the hiring of Craig Menar, the current HD CEO.

In 2012 Tom moved to Floor and Décor and is taking his experience of living through Home Depot’s rapid growth phase. This experience of how to manage growth is extremely important given the company’s current 20% annual unit growth cadence and reduces the risks of missteps.

The C-suite is full of other highly experienced managers including Lisa Laube, Chief Merchandising Officer, who was previously CMO at Party City and Trevor Lang, previously CFO at Zumiez. Lisa has done a phenomenal job building out the company’s design centers which offer free design services. The firm has found that when someone uses these services the outcome is a ticket that is 3-4x the company average. The company is expanding the size of the box dedicated to these locations and is also building larger showroom portions of the store so people can better visualize the product in use.

Below the C-suite level the company has many ex-Home Depot regional and store managers who have come over to Floor & Décor given the rare growth opportunity that exists in Brick and Mortar retail. IR has indicated that some employees have even taken demotions to leave HD to go to FND given the significant promotion potential that comes from such a rapidly growing company. In fact, one glass door complaint was that the company was only Hiring ex-Home Depot employees, by far the best run competitor, not at all a bad thing for investors.

Key Drivers of Profit Growth

Unit Growth

The company had 113 stores (and ~9% of the market) as of the end of 3Q19 and is projected to have 120 by year-end 2019. The company plans on growing units 20% annually for the foreseeable future with a current long-term target of “at least 400 stores”.[1] Analyzing their two most concentrated market, Tampa and Miami, which are still underpenetrated, yields a conservative estimate of approximately 422 stores for the US. Both locations are still under-stored, and long-term density should rise, potentially implying 500+ FND locations long-term. The firm is likely to have an investor meeting in a year where they will update this dated store target. Visiting stores and comparing online reviews it becomes evident FND’s mouse trap is superior to peers, and store growth should continue for a long period of time. Their current stores at 5+ years generate ~30% after-tax ROICs long-term. The company states in their 10-K that they generate over 50% Cash-on-cash returns in year 3.

Same-Store Sales

Floor and Décor grew same-store sales double digits for a decade until the industry slowed in 2018. Long-term company can generate mid-to-high single digit comps as they continue to build new stores that have a strong maturity curve, and increase brand awareness, currently 13% unaided. By nature of their superior model the company forces competition out of business, The Tile Shop (TTS) has delisted partly as a function of FND’s expansion. TTS has indicated ~20% decline in revenues in the first year an FND is opened next to their location.

Margins

The company’s margins are currently depressed due to three factors. Immature stores, pre-opening costs, and continued scale opportunities. Adding these three factors together long-term FND should be able to generate EBIT margins in excess of 12% versus current FY19 estimates of 7.7%. As of year-end 2019 approximately 43% of the stores will be under 3 years old. As stores mature, they trend to EBITDA margins in the low 20% range.

In the first-year new stores have 50% higher SG&A per store. Backing out this SG&A expense per store yields a margin uplift of 130 basis points. This is because stores are fully loaded with rent, labor, and utility expenses although revenues of year one stores are only ~70% of mature levels. In addition, long-term these locations continue to comp above the mature level until about 5+ years, leading to continued margin expansion.

Store pre-opening costs are currently at around 150 basis points. At maturity these costs should go to almost zero, aside from modest shifts in the store base. In the near-term they should decline as the company is becoming more efficient at opening new stores, as the company’s unaided brand awareness grows leading to lower required advertising costs to jumpstart sales and

Corporate cost leverage has been slow in recent years falling only 50 basis points from 2012 to 2018, however this is a function of building out the needed infrastructure to support the company’s current growth agenda. Long-term margins should expand as the business continues to scale. Recently the firm has spent significantly on updating their ERP which is now in the comp base and can begin to be leveraged.

Adding back pre-opening costs of 150 bps, 130 bps for leveraging store SG&A, and 100-150bps for corporate leverage yields a ~350 to 400 basis point uplift and 11.5% to 12% EBIT margins. Store visits and speaking with management give me confidence FND can achieve this target.

Valuation

At the current price the long-term revenue growth and margin expansion potential of FND is underappreciated. Under base case assumptions the market is valuing Floor & Decor at 14x on 2020 underlying EBIT, and 10x on 2022 underlying EBIT. This is a discount to mature and much slower growing peer Home Depot (HD) at over 17x and to Lowe’s (LOW) at over 15x EBIT. Two-year probability weighted price target $68, 35% upside (70% base, 15% bull, 15% bear).

Underlying EBIT is calculated assuming a $23.5 million in mature store revenue, assuming an uplift in average 5+ year revenue if store expansions topped, for all stores as of 2021 year-end and expected mature store EBIT margins.

Base Case: Two-year target of $69 (37% upside), 20% annual revenue growth (20% sq. Ft. Growth, 72% new store efficiency, 6% comps), 12% normalized EBIT margin of, 13x EBIT.

Bull Case: Two-year target of $90 (80% upside), 22% revenue growth (20% square foot growth 8% comps) an underlying margin of 12.5% EBIT and 15x underlying EBIT.

Bear Case: Two-year price target of $47 (8% downside) revenue growth of 15% (20% square foot growth 0% comps), underlying margins of 10%, value at 12x EV/EBIT.

Risks

Macro risk: The most recent downturn, 07-09, flooring industry sales fall over 40%. This time around the decline is unlikely to be as painful as housing is not overextended, and turnover is depressed relative to history. FND is exposed to the less cyclical part of that business, with ~95% or more coming from repair and remodel. In addition, the downturn lasted 18 months versus the typical post WWII downturn of only 11 months.

Competitive operating environment: FND competes with HD and LOW, as well as many independent players. No one currently is copying the FND model, however with such high ROICs and given their success is public knowledge post IPO, peers may attempt to copy them. HD and LOW are not likely to compete significantly with FND given it would require taking store selling space from other categories that are working well in their box. In addition, in speaking with the CFO of TTS he noted that they were unlikely to copy FND given the different model. Finally, the proprietary sourcing ability is difficult to master.

Long-term Opportunities

Commercial Market

Delivery from stores

Catalyst

Time

End of PE Overhang

Comps beat concensus

margins expand faster