Floor & Decor: Risks Don’t Look Priced In – Floor & Decor Holdings, Inc. (NYSE:FND)

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There’s an attractive case for flooring retailer Floor & Decor (FND) at the moment. FND stock admittedly isn’t cheap, at 46x earnings and ~23x EV/EBITDA (both figures based on the midpoint of 2019 guidance). But the company has a path by which it can easily grow into that valuation.

Same-store sales historically had been running in the double-digits before decelerating of late (in part due to difficult comparisons due to hurricane-related repair and remodel). Management still sees mid- to high-single-digit growth going forward. New stores offer another driver, with management projecting over 400 stores, in the range of quadruple the quarter-end count of 106. The flooring market is competitive, but F&D seems to have a nice position relative to big-box rivals, specialty companies, and independent retailers. And FND, at the moment, might well be the purest play on the impressive growth in the laminate and LVP/LVT (luxury vinyl plank and luxury vinyl tile) category.

Adjusted EBITDA should climb at a ~30% three-year CAGR based on guidance, including a 25% increase this year. The company’s mid- to long-term outlook suggests 20%+ annual EPS growth. Between revenue growth and margin expansion, F&D can quickly bring its seemingly high multiples in.

That said, there are risks here that don’t seem priced in at the moment. Rather, with FND above $50, the market seems to be projecting something close to perfection in terms of both execution and the external environment. We’ve seen – on more than one occasion – how that plays out if any issues arise. And I’d be very worried that FND might see a similar stumble, even if it’s unlikely to duplicate the path of other fallen angels in its market.

The Case for Floor & Decor Stock

At its core, the bull case for FND is a revenue story. But that might well be enough. Comps have run in the double-digits for most of the decade, including a 10% increase (excluding the impact of the Houston market, where comparisons to hurricane impacts hit Q4 same-store sales) in 2018. 2019 guidance, per the Q2 call, is for same-store sales to rise 7-8% excluding Houston, albeit with a roughly 100 bps from tariff-driven price increases.

From a competitive standpoint, there’s not much reason to suggest those comps will stall out. Big box rivals Home Depot (HD) and Lowe’s (LOW) have targeted the category – but simply don’t have the space to match Floor & Decor’s selection. The average Home Depot store, for instance, covers a little over 100,000 square feet – while 7% of its revenue comes from flooring, per that company’s 10-K. The average Floor & Decor store covers 75,000 square feet, (again, according to the most recent 10-K) all of which are dedicated to the category.

Independent retailers, as is the case in many industries, struggle to match the pricing of the better-scaled competitor. Specialty rivals like The Tile Shop (TTS) and Lumber Liquidators (LL), meanwhile, have much smaller footprints:

source: FND March presentation. “specialty lumber flooring company” is Lumber Liquidators, “specialty tile flooring company” is The Tile Shop

As a result, neither has the breadth of F&D’s assortment: The Tile Shop, for instance, still doesn’t sell the LVT/LVP products that drove 20.8% of Q2 revenue, according to that quarter’s conference call. That category is growing at an impressive clip: as recently as Q3 2018 call, it generated just 18% of revenue up from 12% of sales in 2016. With some manufacturers of LVT and LVP like Mohawk Industries (MHK) and Interface (TILE) actually struggling with the transition (which takes away higher-margin legacy revenue), FND might well be the best pure-play on growth in the category.

Meanwhile, unaided awareness is just ~10%, per management commentary. And many of F&D’s stores are relatively new, suggesting more benefit to near- to mid-term same-store sales.

There’s an attractive, proven model underpinning the bull case here. (Indeed, we used Floor & Decor for a recent bathroom remodel, and likely will return for our next project.) And F&D can add new store growth to the comp figure. The company is in its seventh year of 20%+ annual unit increases, with a target of 120 stores at the end of 2019 (against an even 100 at the end of 2018). That figure is expected to rise to 400 or higher, a number Floor & Decor could hit within a decade (it would require a ~13% CAGR). In that scenario, a current ~$2 billion in sales could clear $10 billion in ten years.

And that should create some margin expansion, even if FND is more of a top-line story. CFO Trevor Lang said on the Q4 call that the company is aiming for “a little bit” of leverage to both gross margin and SG&A as sales grow. EBITDA margins, at the midpoint of guidance, will expand ~130 bps in three years, to 11.6%. If Floor & Decor can keep mid-single-digit (or better) comps going, that expansion should continue, particularly with near-term investments in distribution centers, support, and professional customer service being lapped in coming years. ~15% EBITDA margins plus top-line growth suggest a path to as much as $2 billion in EBITDA for a company with a current market capitalization of $5.3 billion and less than $100 million in net debt on the balance sheet.

The Cyclical Risk

One obvious concern about those forward-looking models is that they’re relatively linear. And that’s simply not the nature of what remains a cyclical business. Admittedly, it’s easy to forget that fact in year eleven of a macroeconomic expansion. And, to be fair, the housing environment hasn’t been torrid of late, with existing home sales dipping this winter (even on a seasonally adjusted basis) and relatively flat in recent years.

Lang noted on the Q3 2018 call that in a recession, “the value player takes market share”, as F&D did in 2008 and 2009. But as the CFO also pointed out, this is “a very different business” at the moment. And even market share gains in a shrinking market can lead revenue to stall out at best.

With external help, there’s a clear path for F&D to drive mid-single-digit-plus comps going forward. Again, competitive positioning seems solid, and there’s plenty of share to take from independent retailers. But it’s exceedingly unlikely that the external environment is going to stay neutral for years, let alone positive.

Meanwhile, the company’s aggressive pace of new openings raises ‘cannibalization’ concerns. 60% of new stores now are going into existing markets, according to the Q2 call, a noted change from recent entries into untapped markets like Boston and Seattle. Those openings will impact near-term comps – but they also add to the potential exposure to a recession. That’s true both in terms of same-store sales – with multiple stores presumably splitting potential market share gains from independents – and in terms of deleverage, should comps weaken below increases in rent, SG&A, and other factors.

It’s worth noting that investors at the moment don’t seem very worried about cyclical impacts, particularly in repair & remodel. HD stock, for instance, receives a 21x forward multiple, suggesting investors believe that behemoth can at worst muddle through any bumps in the macroeconomic road. But I’d also note that FND shares fell by half in the second half of last year. A guidance cut after the Q2 report in August was a contributor, admittedly, but the broad market environment in last year’s fourth quarter also played a role (and completely offset a brief gain following a guidance raise following the third quarter). Particularly at this valuation, it doesn’t take an actual cyclical swing to send FND tumbling. It only takes rising fears of that swing.

Have We Seen This Story Before?

In looking at Floor & Decor since its April 2017 IPO, it’s difficult not to see echoes of similar plays. Again, this is largely a revenue story by management’s own admission. Gross margin leverage is going to be relatively small, as the company likely reinvests at least some of its improvements into pricing.

It’s a story based on comps, and on whitespace. And there have been three stocks this decade in and around housing/construction that have had similar stories:

ChartData by YCharts

chart from IPO through January 1, 2016

ChartData by YCharts

chart since August 2012 IPO

ChartData by YCharts

chart since November 1, 2013 IPO

To be clear, I’m not arguing that FND is the next LL, TTS, or The Container Store (TCS). This is a better story – and those three housing plays all had company-specific issues. Lumber Liquidators faced allegations of high formaldehyde levels in its products. The Tile Shop has had multiple strategy changes and a mini-scandal involving its founder and then-CEO. TCS had a much smaller addressable market, which in turn suggested post-IPO whitespace projections were far too high.

Meanwhile, CEO Tom Taylor said after Q4 that the company was in good shape in terms of the talent pipeline for store managers (a problem which has plagued The Tile Shop on occasion). And he noted that “after seven years of opening 20% unit growth, we’ve got a lot figured out”. Given top-line performance, it’s hard to argue with that characterization.

Still, in this category, there have been several stories promising enormous footprint expansion – and they’ve all stumbled. It’s easier to model inorganic growth on paper than it is to execute in practice. That’s particularly true in a tight labor market, even granting F&D’s ability so far to find manager-level talent.

Again, that’s not to say that FND is headed for the single digits. But, as with the cyclical concern, there’s still a lot of execution risk here. F&D has opened stores at a 20%+ annual clip – but the majority of those stores now are in markets where the company already has a presence. That’s a different challenge in terms of marketing, talent, and other factors. Lang said after Q2 that the company had studied cannibalization closely – but the future results may well be different from what likely is still-limited historical data. (The Tile Shop, for instance, seems to have overexpanded in certain metros, which may have exacerbated some of its talent issues.)

This point admittedly may be unfair to F&D, which so far has executed almost perfectly. And it’s worth reiterating that this seems a better model than those of the two rivals and The Container Store. But it goes to the idea that the market, right now, is modeling in linear growth for years to come. The history of retail whitespace plays – cyclical effects aside – suggests that there usually are stumbles along that path.

LVP and LVT

Finally, one minor risk is precisely the growth of LVP and LVT. Both categories have unquestionably been a boost to F&D comps: again, they’ve moved from ~12% penetration to 20%+ in just three years. Some of that growth has come from losses elsewhere, primarily in stone, where management has called out weakness and often negative comps. But given F&D’s advantage in that space against specialty rivals and big-box players, LVP and LVT on a net basis no doubt have been major top-line positives.

But there is a catch from a bottom-line perspective. Laminates and engineered products are lower-margin, as FND management has noted. In addition, F&D loses the installation accessory sales that generally accompany natural materials – sales that actually are higher-margin. From a margin standpoint, LVP and LVT actually are a double-edged sword.

Here, too, it’s important not to overreact, or use the category as the basis for a short case (at least on its own). Again, the category has grown crisply over the last three years – and EBITDA margins still are rising, despite tariffs and significant investments behind the business. Still, given what’s priced in here, even modest margin headwinds can have an impact. And LVP and LVT, relative to the natural materials, likely will provide a headwind going forward, if a modest one.

Valuation Concerns

If Floor & Decor can meet its targets, FND stock may well have upside from the current $50+. 20% growth for a decade moves EPS to nearly $7. A 20x multiple on what then would be a mature business values FND at $137 – and $63 currently, discounted back at 8%.

Similarly, $10 billion in revenue (~17% CAGR, or roughly 4% comps assuming F&D gets to 400 stores) at a 15% EBITDA margin (+340 bps from 2019 guidance) gets EBITDA to $1.5 billion. That’s over $8 per share in EPS ($300M D&A, 25% tax rate, share count of 110 million) and suggests current fair value closer to $80 (including cash accumulated), or ~13% annual appreciation.

But both scenarios suggest an awful lot going right. 15% EBITDA margins may well be too much to ask, particularly given LVP/LVT impacts and management’s own commentary about leverage on both COGS and SG&A. Even 4%+ comps, on average, for a decade seems an aggressive target. So too does the 400-plus store goal; it only takes one macro hiccup to interrupt that target, and there’s the obvious risk that management at the moment is being too aggressive in evaluating the whitespace opportunity.

Indeed, FND now has well outrun even Street estimates: the average target price sits below $46 at the moment. And while analysts obviously don’t always get it right, the consensus number highlights the valuation problem here. It’s difficult to model upside from here without targets that assume that nothing really goes wrong for Floor & Decor for a few years.

To be sure, past performance suggests that may well be the case. But what would worry me at $50+ is that “nothing really going wrong” also includes factors well outside of the company’s control. It needs the macro and housing environments to stay neutral at worst (and favorable for at least a decent stretch). There are no shortage of housing-related plays for which the same is true – and for which upside is much easier to model.

None of this is to say that FND is a short. Indeed, at least per data from YCharts, short interest is at a 52-week low (7%+ of shares outstanding). There’s an obvious catalyst problem at the moment, and I’d be loath to bet against a strong operating model and solid management, no matter the valuation. But that valuation is a real concern at this point. Investors are treating FND like the next few years will be like the last few. I’m simply not convinced that will be the case – whether Floor & Decor itself stumbles or not.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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