Description
FND Short Pitch
Current Share price $79, target price $38, 52% downside.
Cost to short, 0.26%.
Percent of float short: 8.55%
FND is an outstanding company, Berkshire Hathaway owns some shares, David Poppe owns some shares, hell you probably own some shares. You’ve read Good to great, and you know that Home Depot has been one of the best return stocks of all times. You want to own the next HD, because the current one just ain’t that exciting with negative traffic and top-line held up by lagged completion of home projects and product inflation. In fact, I wrote the stock up a little under 2 years ago as a long.
In 10 years you’ll look back and say, dang I’ve made some decent money on my FND stock.
BUT
When you zoom into the August 2022 through 2023 time period, you’ll think, wow do I wish I had sold that stock at $79 on July 28th (or tomorrow July 29th) instead of holding it through that decline to $40 when rates were rising off of historic lows, goods and home related product demand was coming off meaningfully above trend levels, and FND was facing multiple years of tough comps.
But you might say – David Poppe said there were great returns on invested capital, yes he is right there are. And Munger said over the long-run your return will trend to the underlying ROIC of the business – yes that is also true. But also Recall that Charlie Munger had a 70% drawdown in his funds and was fine with it.
So – after that preamble that I wrote out because It was fun, I’ll talk to the reason I believe that FND is a solid short today, even into earnings next week on August 4th with shorts getting smoked on every guide-down. (in fact all the short squeezing and WINGSTOPPING has made the set-up quite interesting into the report)
I believe FY23 is likely to be a disaster of a year for FND. The punchline is that they will likely earn $4bn in revenues, not the $5bn the street estimates, they will earn a gross margin of 40.5% (could be worse due to excess inventory), spend 33.5% of revs on SG&A (elevated due to deleverage of the model, even though this implies SG&A down y/y) and end up with a 7% ebit margin and $1.92 of earnings. Applying the trough multiple of 20x from prior downturns this yields a share price of $38.
1) Demand is meaningfully above trend in flooring, and is currently reverting. Transactions were negative and have gotten more negative through the quarter. With home turnover down 20% in July (pre-covid 70% R-squared to comps) demand is about to/currently falling off a cliff.
a. Street estimates for FY23 were about 4.2bn in revenues pre-covid, today they sit at around $5bn on more recently updated numbers.
i. How is FND expected to achieve this 145% growth?
1. 92% increase in avg store count
2. Around 2-3% from acquisition of Spartan
3. 24% increase in average sales per store
ii. Does this make sense?
1. The stores were built, so that checks out.
2. They completed the spartan acquisition, that checks out.
3. They are currently selling more per store… but can this continue?
iii. The first 2 check out, but that third, selling 24% more per average store, when you’ve built a ton of new stores, well that just doesn’t make sense.
1. Sales/average store were 18.2 in 2017, 18.7 in 2018 and 18.6 in 2019.
2. Effectively flat due to new stores being opened at 65-70% new store productivity, and some cannibalization.
3. Sales/average store were 23.4 in 2021 and are projected to be 23.9 in 2022. That’s quite an increase. And the street at $5bn in revs assumes this to stay roughly flat in 2023.
4. In a normalized demand environment the average sales/store should have been roughly flat. Especially because new locations have been more in existing markets yielding increased cannibalization than in the past. Lowering average sales per store to $19.4mm yields $4.2bn in sales. A big cut versus consensus of $5bn.
5. Increase from above trend industry growth - This increase has been driven by a significantly above trend growth of the hard flooring industry +46% CAGR in 1H22 (reasonably should have been ~12-15%), because like furniture and all the other home related goods, people spent more when they couldn’t travel. It is just harder to turn off the spigot on flooring projects because they are related to home turnover, finding contractors, and planning out projects which can take months.
6. Part of this above trend growth has been pricing, however, historically flooring has been a deflationary category outside of new innovation and current channel checks indicate that deflation is coming. In conversations with management and on earnings calls they have indicated that they would pass through any cost savings from suppliers. No counting on inflation to bail you out as is more likely to stick at HD/LOW and ORLY/AZO.
a. This price is likely to reverse as commodity inflation reverses. While the company did not benefit in terms of gross profit dollars this does lower sales which means we have to assume higher SG&A as a percent of sales. It was 34.4% in FY19, fy22 projected to be 32.5%.
b. In fact the reversal of product and freight inflation could catch FND flat footed as their warehouses are full of old expensive inventory and their peers who turn inventory faster/do not carry as much inventory will be able to narrow their gap to FND creating a problem for FND – do they lower price and take a short-term gross profit hit to maintain price leadership or do they protect gross margin and lose market share.
iv. The final part of my thesis is that not only are they above trend but demand should go below trend
1. Home turnover is collapsing, and an excess of discretionary projects were completed in the FY21/22 time frame, a lot of them. This should be good for a 10-20% headwind to sales, but I assume only about 7.5% offset by the spartan acquisition to model $4bn of revs.
2. It wouldn’t be unreasonable to think that revenues could fall to sub 4bn in a difficult downturn to 3600-3800, this gets me closer to around $1.50 per share in earnings, of course very trough numbers.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
Guide down on 2Q call, continued deterioration, continued negative channel checks, pre-announced weak numbers, terrible 2023 guidance