I've always loved the idea of an investment doubling my money, and I don't think I'm alone in that. Emerging technological and consumer trends are often good places to find doubling-caliber investments. But market-beaters can come from anywhere, even from the otherwise-boring flooring industry in which Floor & Decor (FND -0.28%) operates. In fact, the stock has doubled since last December, crushing the market even in this extraordinary year.
As mundane as tile and wood flooring sounds, this company is approaching this retail sector with fresh energy, and I believe the stock could even double again over the next few years.
Image source: Getty Images.
New Floor & Decor locations galore
Floor & Decor first opened for business in 2000 and went public in 2017. When the company launched its IPO, it operated just 72 warehouse-format stores in 17 states. But by opening up new locations at around a 20% annual rate, it has quickly grown to 113 locations, with its sights set on 400 locations total within 15 years.
The company believes its stores are appealing because they're huge spaces full of in-stock items. Indeed, F&D stores are huge -- over 72,000 square feet of retail space on average. And as a rule, the company keeps stores fully stocked with display items. This model contrasts with home-improvement stores like Home Depot and Lowe's, which have large stores but only small sections dedicated to flooring. It's also different from the format of competitor Lumber Liquidators (LL), which has a small consumer-facing showroom with a larger warehouse in the back that may not have all items in stock.
Another noteworthy aspect to F&D's business model is that it sources its flooring products directly from rock quarries and flooring manufacturers. This allows it to save money on third-party fees and pass the savings directly to consumers. That creates an environment where prices are always low, so promotional pricing events aren't needed to generate traffic.
In F&D's third-quarter earnings call, CEO Tom Taylor reaffirmed the company's long-term guidance by saying that it plans to grow locations at a pace of 20% annually for "the foreseeable future." At that pace, the company will have twice as many locations in just three-and-a-half years -- mid 2023.
Profitable growth for Floor & Decor
When companies quickly expand as F&D has done, moves are often made at the expense of cash flow and profit. Investors sometimes ignore red flags, expecting improved profitability once the company reaches scale. But efficiencies of scale don't always come, leaving those companies with negative cash flow from a bloated store count.
That's not the case -- so far -- with F&D. The company is solidly profitable, with $41 million in net income in Q3, and it has earned $115 million so far this year. And even though the company is expanding fast, spending around $1.2 million in pre-opening costs for each new location, it still generated $68.6 million in free cash flow in Q3.
And it's not as if the flooring industry is going through a boom cycle, either. F&D management cited research showing that the industry as a whole only grew comparable sales 1% in the third quarter, and competitor Lumber Liquidators attests to the struggle. It's comp-sales through nine months are down 1.4%. And the decline accelerated even further in its third quarter, with comp-sales falling 3.6%.
Against this backdrop, it's clear (if a little surprising) that F&D is doing something right, growing comp-sales 4.6% in Q3.
But there's cannibalization to factor in
Even though Floor & Decor is still predicting comp-sales growth of 4% to 5% in the upcoming fourth quarter, this has been revised slightly down from previous guidance. The downward guidance, in part, is due to new store cannibalization. Part of the company's growth strategy right now is to open new locations in existing markets. In fact, 60% of new locations in 2019 are being opened in existing F&D markets. Cannibalization refers to these new locations pulling sales away from existing locations. It's happening -- more than the company anticipated.
Cannibalization is troubling for any company, but even more so for a chain as small as Floor & Decor. With only 113 locations, it should certainly be able to spread them out enough so they don't steal each others sales. Guidance for 2020 includes opening more than 20 new locations, many in existing markets, meaning the problem will only get worse if this trend continues. However, CFO Trevor Lang reassured investors in the Q3 earnings call by saying, "[w]e believe the class of 2020 will not be as cannibalistic next year."
There's a lot to like in this flooring plan
Investors will need to hope that Lang is right because cannibalization could alter the company's long-term growth prospects -- at least the speed at which it grows from here. Continued cannibalization could cause management to take a step back and rethink its pipeline. However, consider that the company is still profitable even with the cannibalization that has occurred. Therefore, it's certainly something to keep an eye on but doesn't completely derail the thesis.
Otherwise, there is a lot to like with this growth stock story right now. Assuming the company continues to profitably execute its 20% annual unit growth plan from here, both store count and profits will double over the next few years. If the stock follows the profits, investors today will see their money double as well.
