Simple Businesses: Flooring Edition

In the near future, I would like to discuss my (and partially John’s) approach to filtering by using the S&P 500.

One company I was researching as I was thinking about my filters was Floor and Decor (although it isn’t in the S&P 500).

As a short introduction to my filters, I want to determine if I can, in a reasonable amount of time, understand what the company does (i.e. most pharma and cybersecurity companies are not going to make the initial cut).  Second, I want to determine if the company has a business model that is likely able to withstand competition and enable the company to earn “excess returns” such that the value of the business will grow over time.

Floor and Decor (“FND”) passes these initial screens for me.  The business is simple enough that I can understand it and there are certain aspects that allow it to be competitive in its industry.

FND is retailer of hard surface flooring, i.e. hardwood and tile.  If you ever have been in the flooring section of Home Depot, FND attempts to pull out that section and sell the products better.  The marketing position is relatively straightforward.  Currently the competitive landscape includes Home Depot and Lowe’s, who both offer competitive pricing, but with a distinct lack of focus on the sales aspects of flooring sales.  Try going to a Home Depot and standing in the flooring aisle and see how long before someone comes to speak with you (make sure to bring a good book).  This hands off approach has led to former Home Depot executives effectively pulling out an entire section of the big box stores and spreading out that entire aisle in a big box of their own.

FND stores are generally located near one of the big box retailers, sometimes right next door in order to gain from the foot traffic generated by these two large competitors.  FND’s warehouse format offers around 72k of square footage space in comparison to the average Home Depot, which typically runs around 100k square feet.  There are three other main competitors in this area.  Lumber Liquidators (“Lumber”), which sells only hardwood flooring, i.e. no tile, at much smaller locations in a generally less trafficked locations and generally smaller formats, averaging around 7k square feet.  Lumber’s focus, from its inception, has been on cost.  Lumber provides a much better selling environment with immediate and hand-holding sales approach to each customer who walks through the door.  Tile Shop is most similar to Lumber in the size of its locations, generally around 15k-20k square feet with a focus on tile as opposed to hardwood.  Prices and hand-holding sales approach are both important aspects for Tile Shop also.  Finally, the local Mom & Pop locations provide the trusted community name with a hands-on sales approach, but pricing at these locations is typically not as competitive on most products given the lack of scale sourcing and buying.

The business of retail flooring is not difficult to understand.  Additionally, the competitive landscape does not pose a huge barrier.

My thoughts on the competitive position are as follows:

In theory, Home Depot and Lowe’s should have never allowed Lumber, FND or Tile Shop to exist.  HD/Lowe’s scale buying and pricing power should have allowed them to undercut these upstarts before the upstarts gained sufficient scale to be in the ballpark of pricing that the Big Box retailers offered.  Bezos has often said how slow large companies are to recognize their weakness and adapt, and here is a great example of a competitive position that both HD and Lowe’s surrendered.  Currently, FND offers the best selection for all flooring options given its store footprint.  However, this footprint might not serve as an insurmountable advantage to the customers only looking for hardwood or only looking for tile, as both Lumber and Tile Shop have a pretty wide selection.  Although the scale offers the potential to lower pricing, Lumber is certainly big enough to now compete head to head on pricing with FND (Tile Shop is much smaller than both FND and Lumber at about 1/3 of their revenues).

I do not believe the business model of any of these companies currently provides a distinct competitive advantage.  In other words, it comes down to execution.

A review of FND’s numbers appear to show that execution has been great.  Growth in revenues and profits have been fairly steady over the past 5 years.

2012 2013 2014 2015 2016 2017E
Revenue $337.00 $444.00 $585.00 $784.00 $1,051.00 $1,318.00
Revenue Growth 31.75% 31.76% 34.02% 34.06% 25.40%
SSS 11.70% 22.10% 15.80% 13.50% 15.40% 10.00%
Locations 31 39 48 58 70 83
% Store Growth 25.81% 23.08% 20.83% 20.69% 18.57%
EBIT 27 27 33 52 79 105
EBIT Margins 8.01% 6.08% 5.64% 6.63% 7.52% 7.97%

Revenue growth has come from opening new stores and also consistent same store sales (“SSS”) growth.

This execution has garnered FND a hefty current valuation.  At roughly  $4B in enterprise valuation, FND’s valuation is certainly pricing in some future growth given its estimated 2017 operating income of around $100m.

I tried to sketch out a back of the envelope look at FND’s potential 2022 numbers.

I ran two slightly different scenarios:

Great

Store Count Growth: 20 units per year

SSS growth: 8% per year

Operating Margins in  2022: 11%

Ebit Multiple: 20

1 2 3 4 5
2018 2019 2020 2021 2022
Revenue $1,741.03 $2,218.38 $2,756.56 $3,362.62 $4,044.22
Revenue Growth 32.10% 27.42% 24.26% 21.99% 20.27%
SSS 8.00% 8.00% 8.00% 8.00% 8.00%
Locations 103 123 143 163 183
% Store Growth 24.10% 19.42% 16.26% 13.99% 12.27%
EBIT $156.69 $210.75 $275.66 $353.07 $444.86
EBIT Margins 9.00% 9.50% 10.00% 10.50% 11.00%
Valuation $8,897.28

Projected CAGR from today’s valuation over the next four years: roughly 25%

Good

Store Count Growth: 15 units per year

SSS growth: 5% per year

Operating Margins in  2022: 10%

Ebit Multiple: 20

1 2 3 4 5
2018 2019 2020 2021 2022
Revenue $1,622.09 $1,951.48 $2,308.10 $2,693.98 $3,111.27
Revenue Growth 23.07% 20.31% 18.27% 16.72% 15.49%
SSS 5.00% 5.00% 5.00% 5.00% 5.00%
Locations 98 113 128 143 158
% Store Growth 18.07% 15.31% 13.27% 11.72% 10.49%
EBIT $145.99 $185.39 $230.81 $269.40 $311.13
EBIT Margins 9.00% 9.50% 10.00% 10.00% 10.00%
Valuation $6,222.53

Projected CAGR from today’s valuation over the next 4 years: roughly 14%

I don’t actually think the either scenario is entirely unrealistic given their current growth, however, I do think you are paying for this future growth, which is entirely uncertain at this stage.

A few notes on valuation.  I used a back of the envelope 20x EBIT multiple, which may appear high at first.  FND is trading around 40x EBIT multiple currently and even in my great scenario FND will only have 183 locations.  Management sees their model growing to around 400 nationwide locations, so even in 2022 there could still be a significant growth runway.  Once again, I am using rough numbers and giving FND every benefit of the doubt.  If I sketch out a lot of variables in a positive light and still cannot justify purchase of the stock at its current valuation, I feel comfortable passing.

Additionally, the SSS numbers in both scenarios are both consistent and positive, outcomes that are unlikely to occur.  Retailers, especially in industry-specific sectors, will have their ups and downs.  I can imagine a 5 year number that matches some of these projections, but a lumpy path to reach these projections.  The lumpiness of the sales numbers will also provide a much better valuation for potential buying opportunities.

Let’s discuss some potential pitfalls.

Secular Growth:  FND is benefitting tremendously from a growth in hard flooring at the expense of carpet.  Don’t ask me what these people are thinking, I love rolling around on the carpet with my kids.  But, there has been a clear shift among homeowners to install more hardwood flooring and tile at the expense of carpet.  This tailwind has benefitted all players, including FND’s main stand-alone competitor, Lumber Liquidators.  Tastes shift, and carpet could easily see a resurgence.  FND could obviously start selling carpet, which is something I believe they could do given their footprint, but the shift could slow their growth if they fail to anticipate such a shift quickly enough.

Lumber’s competitive position has been hampered over the past two years due to its ongoing reputational damage from the 60 Minutes episode that aired in 2015 claiming its products being imported from China were tainted with formaldehyde.  For a period, FND actually stopped selling imported hardwood from China, but has since resumed.  Lumber, however, has not resumed its importing and therefore has suffered from a price and quality standpoint.  The reputational cloud hanging over Lumber’s head is starting to dispel and I imagine Lumber will restart its imports from China in the near future.  This move will allow Lumber to more competitively price its hardwood.

There could come a point where Home Depot and/or Lowe’s wake up to the need for a better sales approach to their flooring (around 8-10% of their sales).  A more aggressive approach by these Big Box competitors could hamper FND’s growth and profitability.

Low-Hanging Fruit: FND’s growth has been spectacular in recent years, yet, a part of me always worries with fast growing companies that the early growth is only possible because of the prime locations that are cherry picked early on.  I seriously doubt FND’s 300th location will be as “prime” as any of its first 50.

A few positives on the competitive landscape are also quite possible. 

Mom and Pop stores are most likely to suffer the most as a result of larger corporations continued growth in the flooring area.  Lumber, FND and Tile have all grown without taking much market share from HD and Lowe’s (the most likely the reason for the slow response) because the upstarts have been taking share from the family owned flooring store right across the street from the local car dealership.  These Mom and Pop stores will continue to lose share.

Given the current scale of Lowe’s, HD, FND, Lumber and Tile, it is tough to imagine another large scale operator entering the flooring space in the near future.  The need to gain scale to compete with the larger players on pricing would make it difficult.

I do not own FND currently, but it is simple enough for me to understand and I like their model enough to put it on my watchlist.  FND estimates that they can scale business to 400 locations (from the current 76) over the next 15 years.  This gives FND a long runway to grow into their valuation.  Additionally, it give Mr. Market quite a bit of time for me to watch and wait for an irrational pricing opportunity in FND’s valuation.


Matt Brice is the portfolio manager of The Sova Group, LLC. Matt can be reached at matt@thesovagroup.com. 

 

 

 

 

 

 

 

 

 

 

 

 

 

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