The fundamental growth narrative of Floor & Decor (NYSE:FND) is based upon the three pillars: commercial expansion, store expansion strategy, and design-led initiatives. The company continues to make progress on each of them. In February 2022, the company acquired Wisconsin-based distributor KRS Inc to further diversify into the commercial market. KRS Inc. is a leader in commercial hard surface flooring in Wisconsin. Additionally, it continues to invest in high-quality designers in order to enhance its design services. When customers use design services to help them make purchasing decisions, the company gets better margins and average tickets. In line with the company’s growth strategy, the company also plans to open one more design studio and 26 new warehouse format stores in the remaining part of the year.
There are a few near to medium-term headwinds like interest rate increases and DIY slowing but the strong backlog of PRO business, as well as commercial projects, should offset some of their impacts. Also, the remodeling demand trends have held up pretty well so far. The latest data point for remodeling demand was the Home Depot’s (HD) Q1 result which topped estimates and the company raised guidance for the year. If we take a longer-term view, macro-headwinds should eventually subside. The stock has corrected due to concerns related to the macro environment and long-term investors can use this opportunity to bet on this secular growth story at reasonable valuations.
Floor & Decor posted the Q1 results with revenue of ~$1.03 billion beating the consensus estimate of ~$1 billion and growing ~31.5% Y/Y. Same-store sales increased ~14.3%Y/Y while adjusted EPS decreased ~1.5% to $0.66 but still came in better than the consensus estimate of $0.65. The gross profit margin decreased 340 basis points to ~39.7% primarily due to higher transportation costs. Operating income decreased ~2.1% to ~$94 million compared to ~$95.9 million in Q1 2021. Net income for the fourth quarter decreased ~6.4% to ~$71 million from ~$75.8 million in the same quarter last year.
Expansion in Commercial End-Market
After a good success in growing its residential business, FND has started focusing on commercial markets as well in recent years. Last year, in June 2021, the company acquired Spartan Surface Inc. which focuses on Architecture and Design firms. Architecture and Design firms account for ~60% of the commercial addressable market and acquiring Spartan gave the company instant access to this market.
For targeting the remaining 40% of the market, which includes owners, builders, developers, general contractors, and commercial flooring installers the company uses regional accounts managers (or RAMs). They have performed well in recent quarters, with sales increasing by 80% year over year. Given the importance of RAMs to the company’s commercial business, Floor & Decor plans to onboard 16 RAMs in 2022, with 7 RAMs already added in the first quarter. This should help it maintain momentum in commercial sales.
In February 2022, Floor & Décor acquired KRS Inc., a Wisconsin-based distributor. KRS is a market leader in commercial hard surface flooring in Wisconsin, which should aid the company’s expansion. In addition to FND’s organic and inorganic growth initiatives, macros remain supportive as well. The AIA architecture billing index increased from 51.3 in February to 58 in March indicating better prospects in commercial flooring demand in the coming quarters.
Comp Sales Growth Prospects
Around 58% of the company’s warehouse stores have been opened after 2016. As these stores continue to move up the sales maturity curve, I believe they should be able to support the longer-term comparable store sales growth target of mid to high single digits.
Additionally, the company is focused on building a consistent, high tech, best in class, and seamless design service experience for homeowners and PRO customers. The involvement of design services in purchase decisions boosts the margin and average ticket, complementing the comp sales. The fourth quarter average ticket benefited from an increase in the sales penetration rate from design-led initiatives. The company plans to continue investing in designers to improve its design service. The ability of the company to attract and retain high-quality designers should bring in new customers.
In addition to investment in designers, the company also plans to open one additional design studio in the Atlantic during the second half of 2022. The company is in the early stage of benefiting from these initiatives. I believe the comps sales should further improve as more people become aware and familiar with the company’s design services.
Store Growth Opportunity
The company believes there is a significant opportunity to grow the warehouse format store base in the United States from 166 as of March 31, 2022, to at least 500 over the next 8 to 10 years. The new store model delivers strong financial results with average sales of $14 million to $16 million and a minimum of $2.5 million in four-wall adjusted EBITDA before pre-opening expenses in the first year. The pre-tax payback is approximately two and a half to three and a half years and cash on cash returns of approximately 50% in the third year. With a strong track record and lucrative return profile, the company appears to be confident in its store expansion strategy. In the remaining three quarters of fiscal 2022, it plans to open 26 stores and I expect this high new store growth should continue in the long term.
During the Covid-related lockdown, there was a significant increase in DIY demand and many investors are worried about what will happen to it with the economy reopening. There are also concerns about rising interest rates.
For the first quarter, 2022 comp-store sales transactions declined 2.1% and the second quarter-to date transactions have declined 6.7%. The management attributed the slowdown to the tough comparisons from the previous year. Although in Q1 22 the transaction decline was more than offset by the increase in average ticket size, the investor worries have led to a significant decline in stock prices. However, I believe there are other factors as well that should partially offset these headwinds.
With the economy reopening, demand from PRO customers should increase. Pro accounted for 33% of sales in Q1 2022 for Floor & Decor, with the top 10% of the PRO customers shopping ~11 times on an average during the quarter. The average PRO purchases were 25% higher than the previous year. Good exposure to the PRO segment should bode well for the company. Further, in the commercial space, there were a lot of maintenance projects that were deferred after the Covid hit. Now that the economy is reopening, management anticipates strong orders in commercial-related projects. These tailwinds could help to mitigate some of the DIY demand slowdown.
Valuation and Conclusion
The stock is trading at ~24.29 times fiscal 2022 consensus EPS estimates versus its five-year average adjusted P/E (FWD) of ~48.20x. Given the expansion in commercial business, design-led initiatives, and opening of new stores, the longer-term growth prospects appear promising. While there are some short to medium-term cyclical headwinds, the company’s long term secular growth story remains intact and investors can use the recent correction as an opportunity to buy the stock at attractive valuations. Hence, I have a buy rating on the stock.