Third quarter results are out for hard surface retail flooring with Floor & Decor (FND) and Tile Shop (TTS) beating expectations, and Lumber Liquidators (LL) disappointing again. In this article, I want to focus on the two big players in the space: FND and LL. Specifically, I'd like to discuss the positives, the negatives, the likely near-term and long-term outcomes, valuations, and impacts of tariffs and other intangibles.
Floor & Decor
FND continues its decade-long streak of double-digit comp store expansion. It is the category-killer in the hard surface flooring space posing a significant threat to independents, TTS and LL. It's the go-to place where pros and end users can find basically everything flooring related that's needed for a remodel (and they'll soon be adding countertops). The only thing they don't carry is carpet - no loss since soft surface flooring has been shrinking for over a decade. FND mentioned that its 2018 vintage of new stores continues to outpace previous years' classes in both sales and operating profits, and the long-term white-box story is still intact. Indeed, Sears' recently announced bankruptcy is another example of how FND can likely add more square footage at favorable rates.
In the short term, FND said it does not believe the recently imposed 10% tariff will impact Q4 even though it had a material decrease in inventory count at the end of the quarter. Of course, that was explained away (on the call) as the result of a DC relocation, and management believes it has enough negotiating power with vendors and inventory on hand before any turns start to impact whatever tariff-induced inventory price inflation that may occur. Tile and stone are still the predominant product segments for FND, and there are many sourcing alternatives to China for these products. For the rigid vinyl/waterproof category, there's not really anywhere else in the world to buy, yet, so that's a supply curve shift that will impact the publicly traded players in the space: Home Depot (HD), Lowe's (LOW), LL and FND. Some see a risk in HD keeping prices constant to gain share. However, I don't believe this is a particularly big risk as FND, along with LL, offers better pricing than its big box peers and has demonstrated an ability to take share from big and small alike in past. I see no reason why that should stop now. Indeed, I expect tariffs to create an opportunity for FND to grab more market share. Here's one example:
On the FND call, and in contravention to something specified by Mohawk (MHK), FND is not seeing a consumer shift to lower-priced flooring products. My take on this is that since a large portion of Mohawk's North American customers are some of FND's direct competitors, and since MHK telegraphed a price hike in early September, MHK's retail network began promoting lower-priced items as they are finding it more difficult to compete on quality in the waterproof and hardwood segments. Therefore, the pricing discounts FND can extract from vendors, coupled with a disciplined price strategy, are allowing FND to continue to take more share from independent retailers as they will not be able to get as favorable terms from distributors, i.e. middlemen, like MHK.
A short-term risk to FND besides a trade war, which again, is overblown as I see this as a long-term advantage for FND (and LL, too), would be a slowdown in the housing sector. However, as FND pointed out on the call, they were able to take share in 2008-2009 (the prior housing market slump), and it's very likely that if home prices come off a bit more, they'll soon hit an equilibrium price point at which housing sales start to recover. I doubt we are looking at a housing crisis as opposed to a temporary slowdown, even though interest rates are rising, they are still at historic lows. Regardless of how housing plays out, this is yet another opportunity for FND to take share as they are bigger, faster and stronger than independents. In fact, the biggest risk to FND right now is a management change. Rumor has it that Tom Taylor is close to achieving the goals he set out when he took over in 2012, and if FND hires an outside candidate, then there are some risks that the CFO, Trevor Lang, or the Chief Merchant, Lisa Laube, may bolt if they are passed over.
Longer term, I don't know how FND can continue growing SSS comps at double digits, but I feel confident that FND can continue to grow while opening up boxes and achieving its goal of 400 warehouses nationwide. Ultimately, this will be a company that can achieve somewhere between $5 and $7 billion a year in revenue and likely returning a lot of cash to shareholders in the form of buybacks and dividends once it crosses its maturity inflection point. Unless independents get better sourcing options or FND makes a serious strategic blunder, FND will continue to outperform and take market share.
Another disappointing quarter on the top line, but the bottom line looked quite good. Another positive takeaway was the growth in installation is higher than I expected. LL seems to be able to put together a solid turnkey flooring solution. Its installation sales will be north of $125 million on an annual run rate, and while installation growth will slow down as this service anniversaries in Q4, it will still continue to add nicely to comps and ASPs. Installation services allow LL to compete favorably against big box, FND and independents. LL's installation is more seamless and not as onerous as the process at either HD or LOW and FND does not offer any type of installation. LL will be able to provide a product materially better and cheaper than independents due to the aforementioned tariffs and pricing disadvantage that independents are currently experiencing. What does this mean? LL has a pathway to increase market share that does not overlap with FND's market share accretion.
Another positive LL pointed out was its robust pro consumer sales (29% of sales). I was initially concerned about LL's introduction of installation as on the surface this service seems to compete directly with LL's pro customer. But with such a large percentage of product sales going to pros, it's clear that LL is able to overcome this objection, and with a larger number of retail locations (i.e., more convenience), this is another way for LL to differentiate itself from FND in the pro biz.
On the income statement, it appeared that LL is finally reigning in its adjusted SG&A expenses. In Q3, that number was at 32.9% although some of this was due to LL's (possibly unsuccessful) experiment with pulling back on advertising by about $700,000 vs 2017 Q3. However, there is still SG&A leverage hidden in the store base, as LL's quarterly SG&A per store of ~$231,000 and adjusted SG&A per store of ~$219,000 was substantially improved both on a YOY and sequential basis. Keep in mind this is a company that historically didn't exceed 30% in SG&A until 2014. I believe LL management can trim some costs, expand the store base, and very shortly (by early 2020) get this down to 32%-32.5% with the long-term goal of getting close to 31%.
Some other positives were that hardwood (lower margin product) is decreasing as a percentage of sales and manufactured/waterproof (higher margin) is increasing rapidly. However, the flip side to this is hardwood typically has a higher ASP, but LL's addition of installation to the ticket more than offsets the material sale decline. But if we were comparing apples-to-apples, and LL's percentage of hardwood was back in the mid 40% range then product sales, and hence its contribution to comps would be up materially, possibly a couple hundred basis points higher than where it currently is.
With respect to the tariffs, LL was a bit more conservative in its guidance for Q4 than FND. Some of my Chinese sources working in hardwood told me that LL was the earliest to the table to begin negotiations for vendor discounts to offset currency declines and the 10% tariff. However, LL management told us that margins would likely take a 50bps to 100bps hit in Q4. I am completely nonplussed why FND would see almost no gross margin erosion and LL would. Perhaps, this is a forecast that LL has set to manage expectations. If I had to bet, I'd expect LL to see less margin erosion than FND in hardwood and manufactured products. However, due to FND's huge volume of tile and stone purchases and their ready availability worldwide, it's possible FND can more than offset any gross margin hit in categories (laminate, vinyl and hardwood) that overlap with LL. One other point I'd add here is that LL may have an advantage in rapid source relocation due to its reduction of dependency on China as a result of the laminate controversy that is almost four years old. Lastly, I believe LL CEO Dennis Knowles (based on his experience at LOW) when he says he can steer LL through a housing-related slowdown, and surgically target remodels as that becomes more important during times when homes are staying on the market longer.
With respect to gross margins, after taking into account the antidumping and countervailing duties receivables, LL put up a reasonably respectable 36.2%. Now that LL has hired a new sourcing guy to replace Marco Pescara, and since he's going to be spending a considerable amount of time in Asia in Q4, I'd look for LL to manage the tariffs fairly well. Even if we get to a 25% rate on tariffs, there are significant opportunities for LL to shift hardwood elsewhere without significant risk to quality. Moreover, 100% of its laminate is now sourced outside of China, either domestically or from Canada/Europe, and LL's tile business is relatively small without any of it coming from Asia. As previously mentioned, relocating the rigid vinyl category is not currently feasible (unless Vietnam becomes an option), so LL does not have the same ability to relocate product purchases for the majority of its product sales compared to FND. If FND's and LL's respective management commentaries are to be believed, then this is possibly the reason for the margin guidance. However, there is some risk in shifting a substantial amount of purchases from one country to another, and quality could suffer (for both LL's hardwood business and FND's tile business.)
On the downside, LL still has disappointing traffic. It seems to have trouble bringing customers into the store, or its conversion rate has dropped. Either way, this is something that the Chief Customer Experience Officer, Charles Tyson, and the SVP of Store Operations, Mark Gronemeyer, need to fix in a hurry. The clock is ticking, and if we don't see a material uptick in traffic in 2019, then LL should make personnel changes. The last thing I had hoped to see was at least 50bps to 100bps tailwind from Hurricanes Florence and Michael. Unfortunately (for LL and not the people who live there!), just not as much damage was done and fewer homes affected than what we saw from Irma last year. However, since there's very little FND competition in the Carolinas and the Florida panhandle, it sounds like this will be a push for LL vs. the very substantial headwind FND is facing from Harvey in Houston.
Both companies will gain share with or without tariffs. Perhaps counter-intuitively, the higher the tariffs the greater the long-term gain for both companies. FND and LL can compete more favorably in a higher cost environment vs. independents. Both companies are grabbing a greater share of the pro wallet, but FND is much further along and just finished rolling out its rewards loyalty program. FND has the edge with the pro, both in its warehouse format and by not offering installation to compete against its own pro customer. As far as LL goes, it does very little tile business and has a lot of room to expand its wood-look tile line up. Its installation business is growing rapidly and should add nicely to sales for the foreseeable future. For the homeowner, remodeler or DIFM (do it for me) customer, LL has a bit of an edge as it can offer a one-stop shop solution from extensive product selection, to attachments, to the installation.
Financially, FND is currently in a much better position, generating almost $1.7b in annual sales, while LL is a little under $1.1b. FND has a healthy net operating margin of about 8%, while the high end of LL's forecast is 2%. But what we are concerned with is the future, and FND's operating margin has been shrinking, albeit barely. As FND has signaled that as it moves into more expensive and densely populated markets with higher rents and spends more on pre-opening expenses, it may see an increase in its SG&A. However, right now, and until there's some reason to doubt FND's execution and the operating expense leverage associated therewith, I'm confident forecasting net operating margin will stay at a healthy 8% for the time being. For LL, there is more upside potential. SG&A should shrink as a percentage of sales, and its store productivity should improve with the continued addition of new stores. Unfortunately, LL is running out of new markets to tap and will possibly cannibalize existing markets hurting comps as it expands its store base from 409 current units to its stated goal of 500 stores by 2022 (at some point, this will become an issue for FND as well, but not until FND has at least doubled its store count from current levels.) Here's a quick look at unit productivity (in 1,000s) and sales per square foot for both companies:
As metrics for both are improving, and for LL, they are bouncing back after a rough few years, at some point, FND will begin to level off. Regardless, the product mix shift to higher margin manufactured products, along with operating leverage, gives me optimism that on the high end LL could achieve 37% gross margin and 32.5% in SG&A by 2020. If tariffs stay at 10% or ratchet up to 25%, and factoring in increased waterproof sales as well as some price inflation, then perhaps margins remain flattish at 36% with SG&A at 32.5%. If, in two years' time, LL is doing $1.2b with a 3.5% operating margin, or $42 million, and depreciation of ~$20 million, LL has an EBITDA of $62 million. With a 10x multiple and a current market cap of ~$355 million, LL could see a 72% return in two years or possibly double if it can hit a higher gross margin and the trade war ends.
For FND, I believe margins will decline very slightly as tile and stone becomes a smaller percentage of sales, and tariff-induced sourcing changes invariably result in a few minor hiccups. Therefore, I estimate gross margins shrinking a bit to 40.5%. As mentioned earlier, until I see any reason not to believe management, I'll assume SG&A will come in around 32.5%, for my aforementioned 8% net operating margin. If FND can hit $2.45b in sales by 2020 with estimated depreciation of ~$65 million, we'd see $261 million of EBITDA. Clearly, FND deserves a premium multiple due to its stellar comp sales growth and extended runway for growth, so using a 20x multiple, I come up with a valuation of ~$5.2b. That would be a return of 65% in two years.
Lastly, for several of the reasons I outlined in my previous article, I believe LL is a very attractive candidate for an acquisition. Its vast store base, well-known Bellawood brand, and relative Amazon-proof (NASDAQ:AMZN) business model make it a compelling acquisition or PE target with a market cap barely above its inventory and cash value. Ultimately, I think FND is the better company, but LL has a slightly better value and is priced cheaper relative to its future prospects. However, I am comfortable recommending buying both companies. After the recent October sell-off, I currently have an overweight position in LL and home improvement relative to my overall portfolio, and it's for this reason that I am not currently long FND.
Disclosure: I am/we are long LL.
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.