Spruce Point Capital Management Announces Investment Opinion: Releases Report and Strong Sell Research Opinion on Floor & Decor Holdings, Inc. (NYSE: FND)
NOTE TO EDITORS: The Following is an Investment Opinion Issued by Spruce Point Capital Management
Believes That Floor & Decor’s Ballooning Capital Expenditures and New Store Operating Costs in Lower Income and New Geographic Markets Will Severely Impair its Earnings Potential
Identifies at Least Ten Other Areas of Misperception That Suggest Floor & Decor’s Challenges Are Structural and Are Not Cyclical or Easily Fixed
Provides Evidence That Floor & Decor Recently Made Revisions to Key Revenue Claims, Numerous Omissions of Past Disclosures, Changes to Accounting Policy Language and Modifications to Business Practices That Obscure its Growing Challenges
Provides Evidence That CEO Thomas Taylor Enjoys Excessive Personal Travel Perks and Has Enacted Three Recent Stock Sale Programs as Floor & Decor’s Fortunes Sour
Believes the Board, Led by Two Former Linens ‘N Things Executives Who Oversaw a Similar Retail Growth Strategy Before the Company Restated Financial Results and Went Bankrupt, Is Ill-Equipped to Safeguard Shareholder Interests
Sees Growing Risk to Earnings From Potential Tariff Increases Under a Trump Re-election Given That 25% of Sales are Products Imported From China and a Majority of Products are Imported From Foreign Countries
Believes Analysts Fail to Include ~$620 million of Supply Chain Finance Debt, Legally Binding Lease Commitments and Asset Retirement Obligations Which Represent ~$5.75 per Share of Valuation Downside; Sees 40% to 60% Intermediate, and 100% Long-Term, Downside Risk to FND’s Share Price and Expects the Price to Underperform the Broader Retail Sector
Calls on Warren Buffett and Berkshire Hathaway to Explain Its Investment Rationale for Owning $480 Million of Floor & Decor Stock Given our Research Findings
July 01, 2024 09:00 AM Eastern Daylight Time
NEW YORK--(BUSINESS WIRE)--Spruce Point Capital Management, LLC (“Spruce Point” or “we” or “us”), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled, “Floored By A Bad Investment” that outlines why we believe shares of Floor & Decor Holdings, Inc. (NYSE: FND) ("Floor & Decor" or the "Company") face up to 40% –60% intermediate-term downside risk, or $39.75 – $59.65 per share. Download and view the report by visiting www.SprucePointCap.com for additional information and exclusive updates.
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Spruce Point Report Overview
Founded in 2000 and based in Atlanta, Georgia, Floor & Decor operates 225 warehouse-format stores and five small design studios across the U.S. that sell hard surface flooring products, decorative and installation accessories and products in adjacent categories in the U.S. The Company operates stores averaging 78,000 square feet and focuses on a target customer base of professional installers and commercial businesses (“PROs”) and homeowners. It currently has expansion plans to reach 500 stores. As of the trailing 12 months ended March 31, 2024, the Company reported $4,389 million and $224 million of revenues and net income, respectively.
The concerns we outline in our report include:
- Floor & Decor’s strategy is struggling, and we see challenges intensifying instead of improving.
- The Company touts that its visually appealing, customer-friendly large store format with a broad SKU assessment and everyday low prices are key advantages. Ironically, this retail business strategy is very similar to one that the Chairman of the Company’s Board, Norman Axelrod, and its Audit Committee Chairman, William Giles, touted while they were CEO and CFO/CAO, respectively, at Linens ‘N Things (NYSE: LIN or “LIN”). However, once LIN’s store growth fell below 20%, its sales goals widely missed expectations, margins contracted, and it was then sold to private equity firm Apollo before it filed for bankruptcy. Under Axelrod and Giles’ leadership, LIN also restated its financials for lease and supplier finance accounting, which is troubling in the context of our observations of Floor & Decor’s practices in these areas. Floor & Decor had consistently grown its store count by 20% until 2023 when growth slowed to ~16%. As a result, management is guiding to 14%-16% store growth in 2024 (blaming it on existing home sales weakness) while now signaling that 25%-30% of new stores will be smaller format. We believe the Company’s shift foreshadows a similar disaster that befell LIN.
- Since our inception, Spruce Point has repeatedly warned investors to avoid companies like Floor & Decor that consistently misforecast capital expenditures (“capex”) and provide inadequate disclosures. At a minimum, we believe bad forecasting shows that management has a poor handle on its business and may lack accretive investment opportunities – but beyond that, it is often an indicator of future disappointment for investors. Since providing capex guidance in 2016, the Company has cumulatively underspent by ~$330 million vs. forecast. Only a small portion of the variance is explained by COVID-19. The Company no longer regularly discloses the square footage of each new store opened and the actual breakdown of where its capex was spent, but – by our estimate – new store capex per square foot was increasing 29% per annum through 2021. Floor & Decor is also extending its property lease duration in a market where peers are doing the opposite. In tandem, the Company’s off balance sheet legally binding lease commitments relative to forward 12-month new store openings have exploded to 17x, a concerning sign to watch for the future.
- Our research indicates that regional differences represent a growing cause for concern as new stores are being opened in progressively lower median income markets, geographic challenges to growth are emerging, and new store operating costs are ballooning. The Company historically said it does not report results geographically because the regions have similar economic characteristics. However, since this disclosure was last made in 2018, we observe that the Company recently started talking about regional differences on conference calls. Our research indicates that the Company is weaker in certain regions, such as the Pacific Northwest, where building foundation differences result in less tile usage. The Company also appears to be opening stores in lower income markets. We find that stores opened in year-to-date 2024 were in zip codes with ~6% lower average median household incomes than in 2023 and ~10% lower than the stores opened in 2022. Notably, stores opened in 2022-2023 have underperformed, and we expect the problem to continue. In particular, we believe investors should pay close attention to a recent disclosure regarding new store selling and operating costs. In 2023, the Company incurred $154.9 million of costs for 30 new stores, but 60% were opened in H2’23 and 90% post-Q1’23. The true run-rate cost for the 30 new stores could be almost double or $310 million or $10.3 million per new store. This compares with historical store and selling operating expense of ~$6 million per store.
- Floor & Decor made numerous omissions and changes to financial reporting, accounting policy language, and business practices that we believe obscure its intensifying problems.
- Recent changes to business practices: The Company recently modified its sales return policy with language that we believe makes it more difficult for customers to return items. Coincidentally, the Company reduced its sales return allowance by $6 million when overall sales only increased by $149 million in 2023. In addition, the Company appears to be staffing stores with fewer workers which may be resulting in lower customer service and satisfaction.
- Recent disclosure omissions: The Company has recently made a broad array of changes to disclosures that should alarm investors. For instance, it no longer 1) reports “Adjusted EPS,” 2) makes claims about its Total Addressable Market (“TAM”), or 3) provides a detailed accounting of where historical capital expenditures were spent. Furthermore, the Company ceased to provide details of inventory in transit at stores or distribution centers and no longer says that supply chain relationships allow it to understand the best places to procure various product categories.
- Recent changes to accounting policy language and financial reporting: Floor & Decor previously reported a material weakness of internal controls related to financial reporting that it claims was rectified in 2019. Yet, over four years later, the Company continues to warn about its inability to maintain effective controls and we believe this presents several key areas of concern. First, the Company has claimed that e-commerce (recently changed to “connected customer sales”) is ~19% of total sales. In 2021, we find unexplained revisions to historical e-commerce sales claims. Second, sales to PROs are also material to the Company’s business and account for ~40% of sales. However, in 2023, we find unexplained revisions to reported PROs sales while the Company ceased to provide additional quantitative metrics such as PROs comparable sales, ticket size, and volume impact to the PROs business. Finally, the Company also made changes to accounting policy language concerning inventory valuation and loyalty points programs that could enable overstatement to both sales and gross margins.
- Investors should be skeptical of Floor & Decor’s management given public allegations of deceptive behavior. In 2015, the Floor & Decor management team was embroiled in a product scandal when a lawsuit alleged it acted unethically in the sale of formaldehyde-treated wood. The lawsuit claimed the Company mislabeled flooring as complying with formaldehyde limits following an employee whistleblower who publicly called out the Company’s behavior as deceptive. The case was settled in 2016 for $14 million. Management came away from the scandal unscathed and received pay raises that even included a shocking special bonus for the CEO. After the lawsuit, nothing changed on the management team. Today, the Company continues to be led by CEO Thomas Taylor, a former Home Depot executive who we believe makes excessive and lavish use of travel perks with the Company aircraft, and Trevor Lang, who transitioned from CFO to President in November 2022. Mr. Lang worked at Blockbuster (NYSE: BBI) as VP of Operations Finance through early 2003. By 2006, after discussions with the SEC, Blockbuster restated 2003 operating cash flow lower by an astounding -58%. He later worked at Carter’s Inc. (NYSE: CRI) from 2003-2007, where, as VP of Finance, he was responsible for the corporate accounting function. Carter’s later issued a non-reliance opinion on its financials for the period from 2004 to 2009 and disclosed that the U.S. Attorney’s Office was conducting an inquiry into the matter. Both Mr. Lang and the Company’s current CFO, Bryan Langley, also make claims to be CPAs. However, neither executive has an active or current CPA license, which is referenced as a false or deceptive practice under the Georgia Code unless a license is held.
- Through our research, we have identified at least ten areas of misperception about the Company among investors and we provide data points to counter these viewpoints:
- Competitive advantage in its large store size format and broad SKU assortment
- Product differentiation, pricing power, and money being made in all product categories
- Substantial adjacent product category opportunities
- Supply chain advantages and superior inventory management
- Sustainable visualization technology, design studio, designer services, and marketing advantages
- Homeowners are stable customers who drive fast growing and high margin installation services
- No increased competition from distributors
- No increased competitive threats from Lowe’s or Home Depot
- No increased unsecured credit risk to weaker commercial customers to boost sales
- No greater labor pressures than its peers and no customer service issues
- We have also identified a growing rift of insider alignment with shareholders. At its IPO, the Company touted its strong and long-term comparable store sales growth averaging high double digits. However, the post-IPO reality has been much worse. In fact, from 2018 to 2024, comparable store sales growth (“CSS”) averaged just 6.1%. The dismal performance becomes even more bleak when you remove the COVID-19 benefit experienced in 2021. Absent 2021, CSS averaged just 2.5%. The Company’s two private equity sponsors completely exited before the Company even reached 160 stores, or ~30%, of the 500 stores that the Company currently claims it can reach. In addition, Floor & Decor’s Founder, George West, also sold 60% of his holdings by March 2020 and has only retained a small residual stake diluted by stock issuance. Similarly, CEO Taylor has reduced his beneficial ownership by 64% since the IPO but has recently been a particularly aggressive seller. In fact, CEO Taylor has enacted three different 10b5-1 sale programs since March 2023 while the General Counsel and Chairman of the Board have also entered stock sale programs. The insider selling programs are eye-opening because 1) the Company received an SEC comment letter in late 2023 questioning its revenue and cost of revenue disclosures, and 2) in 2023, the Company amended and broadened the range of employees covered under its Clawback Policy for certain types of misconduct.
- Floor & Decor’s premium valuation is not justified. We estimate 40% – 60% intermediate and 100% long-term potential downside risk to Floor & Decor’s share price. We believe that some investors may be anchoring false hope and an investment bias to owning FND because Warren Buffett’s Berkshire Hathaway also has an equity position. Warren Buffett is one of the greatest investors of all-time and is known as an astute value investor. However, among Berkshire Hathaway’s $335 billion equity securities portfolio, a $480 million investment is a rounding error and may not be getting the proper scrutiny it deserves. In fact, based on some of Mr. Buffett’s own quotes, investing principles and maxims, we believe Floor & Decor falls short of a suitable investment. A majority of sell-side promoters have a neutral/hold/market perform rating and are waiting to see improvement in the business but believe the issues are temporary. We believe our research supports the case that its issues are structural and not cyclical since its customer profile has changed, competitive intensity has increased, and new store opening and operating costs have ballooned. We also believe investors fail to understand that the Company’s earnings will not be nearly as levered to the upside given diminished technology and proprietary product advantages, weakened marketing effectiveness, and long cycles for tile and floor replacement among other factors. We believe expectations for a recovery in sales and earnings prospects are way too high, especially as 2025 comes into focus. Floor & Decor trades at an industry leading 2.9x and 36x 2024E revenue and EBITDA, respectively, for no obvious reason. However, the market fails to include ~$620 million of supply chain finance debt, legally binding lease commitments and asset retirement obligations in the valuation. These factors alone account for ~$5.75 per share in downside. By ascribing a generous 1.5x – 1.9x revenue multiple, more aligned with a range of home improvement and building product peers, and using our base case estimates we see 40% – 60% downside risk in the intermediate term. If our research proves right that the Company’s problems are more structural than cyclical, and that the Company’s increased opacity and revenue misstatements are a harbinger of financial restatement, we fear the Company could be headed down the path of permanent equity impairment faced by peers such as Lumber Liquidators and Tile Shop. There is also a growing risk from Trump’s re-election and rising tariffs given that 25% of sales are tied to Chinese imports and a majority are from foreign sources. We expect FND’s share price to underperform both the retail sector and the broader equity market.
