Lots of people have made lots of money with clever financial engineering. And the really clever financial engineers make money, at least for themselves, even when their deals have gone pear-shaped. It remains a legitimate arrow in the investor’s quiver (Wharton grads are required to feel this way), although not one on which we want to rely: leverage and access to financial markets can be treacherous friends. The retail industry is perhaps my favorite illustration of the point. There are scores of retailers whose market cap is well below what
they’ve spent on buybacks, sometimes done under duress with an activist’s short-term oriented gun to their heads. And, of course, the whole industry is in disarray because bean counters focused energy on ways to maximize margins, ROIC, and bonuses while electing not to invest in the tools needed to stay relevant in a rapidly approaching internet age.
Instead, we seek to own companies that fixate on thrilling their customers and executing against a unique and innovative strategy. Floor & Decor Holdings (FND) is a great illustration of our vision, akin (in my mind) to prior investments I have made in companies such as CarMax (KMX) and Ulta Beauty (ULTA).1 At only $20B, the hard
surface flooring industry has never attracted the focus of a category killer until FND. Heretofore, the primary ways of buying were through: big box retailers with a very small SKU count and a miserable customer service experience; or through smaller independent stores without the size and clout to source directly and who, as a result, cannot offer remotely the same value or afford to have a meaningful in-stock position, which in turn
creates headaches for consumers and their professional installers as product is delayed or unavailable or different from the demo. Floor & Decor has invested the margin dollars from direct sourcing into a completely different experience for DIY customers and professionals alike. Their merchandising is unlike anything else in the industry. At 70,000 sq. ft., the store has large displays that produce a ‘wow factor’ and offer a much better ability to visualize the project. Consumers also benefit from the industry’s lowest prices, an offering of good, better and best, knowledgeable customer service and free design services. The professional gets the advantage of a store designed as a supply house to the trade. With a huge in-stock inventory and free storage for up to two weeks, FND removes the supply chain problems that cost professionals time and money.
The hard surface flooring industry is a great one for a category dominant retailer. Importantly, it is not a brand focused industry. Can you name who manufactured your flooring? As such, the power and economics will accrue to the retailer who has the loyalty and who aggregates demand. Hard flooring has had enormous innovation in the last decade as vinyl and waterproof products have gobbled up share from carpet due to ease, and low product and installation costs. Lower cost has allowed a fashion element to emerge as consumers can swap out flooring more easily. Demographics are great – the median house age in the U.S. is at a record level (37 years, up from 31 a decade earlier), and there has never been a larger pool of houses more than 20 years old in need of remodeling at a time when millennials are entering the home buying years. And although FND has developed a very helpful website to speed and ease the education and purchasing process, online-only competitors cannot compete in this industry given the weight of product and the need to see and touch it.
How are we so lucky to own a company with so much going for it and the ability to grow well north of 20% annually for much more than a decade? The market doesn’t have a favorable view on FND right now, mostly due to concerns of the cyclical nature of the housing market. But just like the analysis of KMX back in the day which revealed the used car industry to be much less cyclical than new cars, the repair and remodel flooring industry
is much more stable than new construction, which at this point is a very small portion of FND’s business. Moreover, again like KMX in the early 2000s, with a proven but wildly underpenetrated store model, FND will be able (in our estimation) to grow through any downturn and accelerate its share growth as weaker players fold.
There are other factors at work that have created this entry point, and which provide the fuel for future growth and margin expansion. FND is making big investments in new warehousing and store support facilities, and has invested in a new benefit-laden loyalty program for the professional which will cost a little margin before the top line kicks in. New store opening expense will increase over the next year or two as they open stores in more
densely populated markets such as Boston and Seattle, which will have great economics but cost more to open. Freight costs have also gone up, as they have for everyone in retail. And then there is the tariff issue, which has everyone in a panic. FND has a robust sourcing network in 16 countries and mercifully has had time to make adjustments in an effort to minimize the potential impact. But if you think about it, FND is unique because of
their large in-stock position. So, if large tariffs suddenly happen, FND inventory will become much more valuable for excess profits or share gaining. And vendors know who can help them grow their business. Would you give your capacity to Lumber Liquidators or Tile Shop both of which have tanked? Or would you give it to someone who can easily quadruple their store count?
Lastly, there is the Houston effect, which in some ways reminds me of the Long Beach effect which was such a good entry point for ULTA a few years back. In that case, ULTA’s big and long-planned promotion got stuck in containers at the Long Beach port during the longshoremen’s strike and never made it to the stores. That didn’t matter an iota in the long run, but when ULTA announced slightly weaker than expected comparable store sales
their stock got crushed. In this case, FND has to deal with the fact that last year, as Houston rebuilt from Hurricane Harvey, FND stores in that market had gaudy comparable store sales in excess of 100%. Math is math and same stores sales this year in that market will be down ~50% which will cause a meaningful deceleration in their reported company numbers. Irrelevant in the long run, but scary for short-term holders. All of these factors combined to create an entry point for this long-term, strong share gainer at a price about half of where it had been just seven months earlier.
And this entry point is not just about lower price, more pessimistic sentiment and easier expectations. Just like KMX and ULTA before it, FND has just gotten the flywheel of the virtuous cycle going. It is opening stores with less than a two-year cash-on-cash payback, despite an unaided brand awareness below 10%. Had you ever heard of them? The roll out of the professional loyalty program caused a significant uplift in the two markets where
they tested it for 18 months, and now they are about to roll it out chainwide. Their ever-increasing scale will allow them to source even more powerfully and widen that advantage, and they will become the trusted go-to partner for innovative suppliers, just like Kylie Jenner launching her makeup line exclusively with ULTA (don’t ask for my opinion on that...). They will get better real estate deals, and they will grow into their infrastructure. Just as ULTA used this playbook to take EBIT margins from less than 6% in FY ’10 to nearly 14% in FY ’17, FND’s growth and unique model will drive a decade of strong top line growth and margin expansion. If you have any friends in the hard surface flooring business, tell them to sell their business now while it has value (not legal or investment advice).
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