FND-new position--category killer waiting for the market to turn

 Understandable business

FND Competitive Strengths

·        Larger format stores at 78k ft2, than specialty retail flooring competitors

·        HD and Loews only allocate a small percentage of floor space to hard surface flooring

·        Wide inventory range and tools allow immediate availability, 4500 skus

·        FND source direct from manufacturer cuts out middleman margin

·        Customise for local preferences and quickly introduce new products

·        Direct sourcing allows EDLP to develop a strategy that creates trust with customers.

·        Full catalogue for in-store pick up or delivery from DC’s.

·        One stop for Pro customers, low prices, wide range, design services, loyalty

·        Decentralized culture, empowered store managers. Effective Training

FND Growth Strategy

·        Open warehouse format stores in new and existing markets. Based on FND internal research with respect to housing density, demographic data, competitor concentration and other variables in both new and existing markets, FND believe there is an opportunity to significantly expand their warehouse-format store base by a low- to mid-teens annual percentage growth rate over the near-to-medium term, reaching at least 500 in the United States within approximately eight years. Currently 230 warehouse format stores.

·        FND have a disciplined approach to new store development based on an analytical, research-driven site selection method and a rigorous real estate approval process. Their new store model targets on average net sales of $14 million to $16 million and four-wall adjusted EBITDA before pre-opening expenses of $2.5 million to $3.5 million during the first full year of operation, pre-tax payback in approximately two and a half to three and a half years and cash-on-cash returns of approximately 50% in the third year. Note lease financing assists these return metrics.

·        Based on challenging macroeconomic conditions, FND states that their class of 2022 and class of 2023 new stores are estimated to be below these targets. Historical returns especially on mature stores have been good. In the last result Q224 FND announced that they would slow store the rollout until economic conditions improve, to 25pa instead of 30-35pa previously guided.

·        FND aim to increase Comparable Store Sales. FND states that “because approximately 55% of our stores have been open for less than five years, we believe they will continue to drive comparable store sales growth as newer stores ramp up to maturity.” SSS has been 2017 16.6%, 2018 9.2%,  2019 4.0%, 2020 5.5%, 2021 27.6%, 2022 9.2%, 2023 -7.1% and 2024 to date down mid-high single digit. The main issue has been rising mortgage rates having depressed existing home sales to multi-decade lows. The low turnover of houses has reduced the transaction value and number of transactions across the franchise.

·        FND expects operating leverage as the store base expands, and SSS increases, plus several other initiatives including, online, pro customer, design advice service and the potentially large commercial market opportunity all supporting growth.

·        Below are historic existing home sales.

 

Industry Analysis

·        Floor & Decor operate in the large, growing, and highly fragmented U.S. retail hard surface flooring market and commercial surfaces market. That industry growth is expected to be driven by several home remodelling demand drivers. These include a large supply of aging homes, millennials entering their household formation years, existing home sales growth from the low supply of housing inventory, rising home equity values, and the secular shift from carpet to hard surface flooring.

·        FND believe they have a competitive advantage that will continue to increase share. As many competitors are unable to effectively compete with FND’s combination of price, service, and broad in-stock assortment. The competitive landscape of the hard surface flooring market includes big-box home improvement centres (HD/Loews), national and regional specialty flooring retailers, independent flooring retailers, and distributors. FND believe it can continue to gain market share in the hard surface flooring market with the largest in-stock selection of a broad sweep of products.

·        FND choose their store sites by focusing on key demographic characteristics for new site selection, such as aging of homes, length of home ownership and median income, FND expect to open new stores with attractive returns. When opening new stores, inventory orders are placed several months prior to a new store opening. Significant investment is made in building out or constructing the site, hiring and training employees in advance, and marketing the new store through pre-opening events to draw the flooring industry community together. Each new store is thoughtfully designed with store interiors that include vignettes and interchangeable displays, racking to access products to allow ease of shopping and an exterior highlighted by a large, bold Floor & Decor sign.

·        The FND supplier base is diversified but 25% of products came from China, a lower number is anticipated in the future. The largest supplier accounted for 13% of net sales in fiscal 2023, while no other individual supplier accounted for more than 10% of our net sales. A direct sourcing model is operated.

·        Competition Risks-FND states that although largely fragmented, some competitors are larger, better capitalized, have existed longer, have product offerings that extend beyond hard surface flooring and related accessories, and have a more established market presence with substantially greater resources than FND. In addition, while the hard surface flooring category has a relatively low threat of new internet-only entrants due to the nature of the product, the growth opportunities presented by e-commerce could outweigh these challenges and result in increased competition in this portion of FND’s connected customer strategy. Further, because the barriers to entry into the hard surface flooring industry are relatively low, manufacturers and suppliers of flooring and related products, including those whose products FND currently sell, could enter the market and start directly competing. FND believe the key competitive factors in the retail hard surface flooring industry include localized product assortment, product innovation, in-store availability of products in job-lot quantities, product sourcing, product presentation, customer service, store management, store location, and low prices.

·        Currently, none of FND’s associates are represented by a union.

·        The hard surface flooring industry is highly dependent on existing home sales because homeowners often replace flooring before selling a home or shortly after purchasing a home and, to a lesser extent, new home construction. In response to increasing inflation, the U.S. Federal Reserve began to raise interest rates in March 2022 and continued to do so through July 2023, contributing to negative existing home sales for over two years.

FND have 230 (June 2024)  warehouse-format stores and five small-format standalone design studios located throughout the United States. FND plans to continue opening new stores for the next several years. This growth strategy and the investment associated with the development of each new store may cause operating results to fluctuate and be unpredictable or decrease profits. Suitable properties need to be accessed on agreeable terms. Certain new store openings are expected to be smaller stores in smaller markets. FND has limited experience executing this strategy, and cannot guarantee that will be a successful strategy.

While net sales at new stores are generally lower than net sales at stores that have been open for more than one year, new stores have historically been profitable in their first year. The ability to open new, profitable stores is important to the long-term sales and profit growth goals.

Operating History

FND operating results are generally very good but recent issues are evident. Overall they show a well-run business but one that is markedly slowing into the poor operating environment and the large and ongoing reinvestment impacting returns (cyclical or secular?)

ROE has been high at 21% on an average historical basis but is falling with earnings and is currently 13%. Above the cost of capital but the trend is not great, due to investing in a poor operating environment.

GM ave 28%, has been very stable showing good price and cost control.

EPS growth 5 year rolls have seen 54% cagr slowing to 14% in the last five years. FND saw its first negative earnings in 2023 and will see another in 2024. Earnings stability has been very good.

TA growth at 30-35% 5 years rolls, shows the extent of reinvestment. The actual reinvestment rate is 89%, again very high.

NPM has averaged 6.8%, compared to other retailers, TSCO 6.8%, HD 9.4%, COST 2.2% and POOL 8.6% most relevant. Overall not too bad. The NPM did show a promising improving trend up until the last year.

Working capital looks fine as does cash reconciliation. Inventory levels are currently 12% of sales, 12-19% historic range.

Overall the numbers show a company in a strong growth mode with reasonably good operating numbers up until the last two years when interest rates started rising and existing home sales plunged and with it renovation spending.

Management

FND has a highly experienced management team with a proven track record.

Tom Taylor, who joined FND in 2012, spent 23 years at The Home Depot (HD), where he helped expand the store base from fewer than 15 stores to over 2,000 stores.

Trevor Lang, was promoted to President in November 2022 after serving as the Executive Vice President and Chief Financial Officer since 2014 and Chief Financial Officer since 2011. He brings more than 25 years of executive leadership experience.

In November 2022, Bryan Langley was promoted to serve as Executive Vice President and Chief Financial Officer. He joined the Company in 2014, and has served in various positions of increasing responsibility in corporate strategy, financial planning, and accounting.

FND emerged out of PE around 2016. Almost all capital has been deployed into the store expansion. There have been minor acquisitions, too early to judge their success.

The management appears very analytical and operates according to an established formula.

Balance Sheet

FND does carry a reasonable level of debt, 3X, but almost all of these are capitalised lease payments. The level of debt is a little above other retailers, HD 1.9X, POOL 1.7X and TSCO 2.5X.

Debt doesn’t appear to be a problem.

Other

Amortisation charges are low given there have been hardly any acquisitions.

SBC (p/t) appears high at 11% of NPAT, for a retailer.

The historic PE has been high given the historically strong growth rate at 37X with a std dev of indicating a 28-46X range. unlikely to see these types of PE ratings until growth picks up, at least.

FND has downgraded forecasts as the environment continues to be very tough. The last result saw another downgrade. Comps will begin to become easier in 2H24 and conditions appear to be stabilising. Consensus sees earnings falling in 2024 then a sharp rebound thereafter.

The market is clearly concerned about the timing and extent of any recovery. Whether FND is over-investing, and whether returns can be maintained as the store count increases is another aligned issue. FND appears to be well placed versus the competition. Whether the LT target of 500 stores TAM will be achieved and the time frame is another issue. Appears FND is a category killer but in a cyclically poor period. If there are structural issues eg competition then the thesis is broken.

Pre-opening Expenses --accounting

FND account for non-capital operating expenditures incurred prior to opening a new store or relocating an existing store as “pre-opening” expenses in the P&L. FND pre-opening expenses begin, on average, three months to one year in advance of a store opening or relocating due to, among other things, the amount of time it takes to prepare a store for its grand opening. The majority of pre-opening expenses are incurred during the three months before a store opens. Pre-opening expenses primarily include the following: rent, advertising, training, staff recruiting, utilities, personnel, and equipment rental. A store is considered to be relocated if it is closed temporarily and re-opened within the same primary trade area. $6m in 2023.

As part of their ongoing efforts to improve cash flow and liquidity, FND facilitates supply chain finance programs through financial intermediaries. Suppliers that participate in a supply chain finance program extend our payment terms by approximately 40 days on average. Amounts due to financial intermediaries for suppliers that elected to participate in a supply chain finance program totalled $114.0 million and $82.5 million as of December 28, 2023 and December 29, 2022, respectively, and are included in trade accounts payable in our Consolidated Balance Sheets

CONCLUSION - VALUATION

The housing market continued to be impacted by a number of macroeconomic factors during fiscal 2023, including rising interest rates and higher home prices putting pressure on housing affordability and resulting in declines in existing home sales, inflation, and a shift in consumer spending toward services. FND believe these factors directly contributed to a slowdown in demand for flooring resulting in year-over-year declines in our comparable store sales and net income.

The thesis-busting criticism is that one way or another, the future growth story is less than the market anticipates. FND will either open low ROI stores to demonstrate they can hit their targets or will need to take down expectations as they approach market saturation. The market is not kind to low-growth "growth stocks."

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." 

At $97, assuming an 17% eps growth for 5 years and an 28X exit multiple generates a return of 8%. At the end of 2028, FND should have opened around 366 stores so about 72% done. Therefore a higher PE rating is appropriate at that point. The extent of operational leverage should be a large and positive at some stage.

 

 

 

 

Please note the disclaimer.