Floor & Decor vs. Macro (Part 3) | 2018 called, it wants its 34x PE back

Home Depot beat earnings expectations last quarter. Could FND do the same?

Note: This is Part 3 of last month’s paid article. This month’s paid article will be analyzing a different company.

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“Our market is on its way back to normal demand conditions,” he said. “We’re not quite there yet, but the pressures we saw in 2023 are receding.” — Home Depot CFO, Richard McPhail

“Once you bake in this incremental EPS growth potential from (…), you can suddenly see how their current 50x trailing PE can be considered undervalued. As highlighted earlier, Buffett’s acquired his initial Coca-Cola stake at roughly 28x PE. That’s not quite 50x PE, but you get the point — it wasn’t done at an optically cheap price. Despite that, KO 0.00%↑ has gone on to become one of Buffett’s legendary pillar investments.”

Table of Contents (FND Part 3):

1. AI-gen summary of this report (500 words)

2. Valuation & Risk

3. Beyond 2040: Road To Home Depot

4. <Download FND's Excel File>

Inverting FND 0.00%↑’s trailing PE of 50x implies an earnings yield of merely 2% (1/50). The reason for this extended valuation are threefold:

1. The Existing Homes Sales (EHS) macro indicator is highly correlated with FND’s sales performance, and this has been deteriorating recently in the face of rapid interest rate hikes;

2. This being a cyclical trough for FND has hurt their recent earnings growth;

3. Their market cap has not fallen at all despite that, causing trailing PE to appear highly inflated.

The latter point demonstrates the confidence that markets appear to have in FND’s future business performance — despite the cyclical trough it is currently experiencing. This is likely due to FND’s business moats, which we have discussed extensively in Part 1.

Also, the same valuation argument based on trailing earnings could’ve been made in 2018, when Trump’s import tariffs diminished FND’s relative cost advantage vs. peers from being vertically integrated to its international suppliers. Despite that, not only have FND’s earnings grown by 100% since then, its earnings multiples have also grown by an incremental 50% — resulting in a cumulative 200% increase in its share price. Not too shabby for something that was seemingly optically expensive at 34x PE in 2018.

Buffett is known for describing such moaty businesses as “wonderful businesses” . But is FND still undervalued at 50x trailing PE? We explore the entire spectrum of valuation possibilities in this Part 3 report with our “Earnings Yield Curve Methodology” (EYCM) — which does an apples-to-apples comparison of different companies with different valuations and different growth rates.

There are actually a startling number of parallels between FND’s circumstances in end-2018 vs. today. In 2018, FND was facing several major macro headwinds. First and foremost were the new tariffs that the US was placing against their imports from China. As we’ve explored extensively in Part 1, one of FND’s moats is their structural cost advantage from importing stock directly from their overseas manufacturers (thus skipping the middleman distributors stateside). When President Trump announced the import tariffs in July 2018, it implied that those relative cost savings would diminish disproportionately for FND relative to its peers, who didn’t have the same cost advantage from skipping the middleman.

source: Morgan Stanley (2018)

As the 2018 FND initiation report by Morgan Stanley above shows, FND was trading at a decently hefty 34x PE at the time. Thus, the negative tariff news sent its valuation into a tailspin, falling by -52% from a peak of over $50 to less than $25 at its trough. Despite that, FND 0.00%↑ quickly recovered soon after that and continued its climb by over +300% up to today. That -52% drop in 2018 looks like a pipsqueak over the long-term:

FND has gone from 34x PE to 50x PE despite higher earnings

The reason for this stroll down memory lane is because the main headwind for FND today is similarly due to macro — i.e. the relentless interest rate hikes which have been ongoing for over two years. Such hawkish Fed policy has unwound Existing Home Sales (EHS), which represents housing turnover. And since homeowners only tend to change their floor tiles when they’re selling or buying homes, the decline in EHS has been a substantial headwind to FND’s business over the past two years.

However, we’ve already covered in Part 1 how FND is most certainly a “wonderful business” with outsized moats — which are perfectly capable of withstanding cyclical downturns. As advocated by both Buffett and Howard Marks, this kind of 2nd-level thinking enables value investors to see past initial business troubles towards the durability of high quality earnings that will persist over the long-term — something which we’ve explored in great detail in Part 2.

In this Part 3 report, we’ll dive into FND’s valuation from the base-case and bear-case scenarios to determine the distribution of possibilities for its valuation — and see in highly objective numerical terms what Buffett really means when he says “a wonderful business at a fair price”.

Check out our previous stock reports:

1. Disney ($DIS)

2. Intel ($INTC)

3. Paypal ($PYPL)

4. Meta ($META)

5. Netflix ($NFLX)

6. Occidental Petroleum ($OXY)

7. Capital One ($COF)

8. East West Bancorp ($EWBC)

9. CD Projekt Red ($CDR)

10. Canadian National Railway ($CNI)

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"The Pace Of Getting There"

I want to give a huge shoutout to Alex from The Science of Hitting Substack (TSOH), who very graciously allowed me to lean on his research while analyzing FND. His incredibly detailed insights were extremely helpful in conducting my research. Please visit his newsletter at the link above and show your support to him.

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Preview:

How should we estimate their future Sales growth trajectory? This chart from Part 2 above shows how FND has historically sported a Sales CAGR of 26% since FY16 (dark blue dot, right of chart).

As we saw in Part 2, the greatest contributing factor by far to FND’s historical Sales growth (26% CAGR) is their store count growth (17% CAGR) — the latter aligns with historical non-Comp sales growth (i.e. from new store growth) of 15% CAGR normalized (rightmost purple bar in chart below). We also saw earlier how management’s target to reach 500 stores by 2030 from 207 stores today would require new store growth of 13.5% CAGR going forward…

In This Article: 3.700 words, 10 charts, 1 Excel file, 20-min reading time