The 1st quarter of 2023 saw a lot of what we predicted at the end of the year: a continued decline in remodel business; the beginning of the impact of slower 2H 2022 starts; inventory reductions coupled with pricing pressure; and some offset from outperforming commercial and multifamily businesses.
On the macro side, the Fed continued its battle against inflation with rate hikes at each meeting of the quarter and continuing into Q2. The target Fed Funds target rate sits at 5.0 – 5.25%, the highest in 16 years, translating into a dramatic slowdown in housing starts. The first quarter averaged ~1.4MM (annualized) vs. ~1.7MM in the year before. It’s important to remember that these numbers are only slightly below the 1Q 2020 average (~1.5MM) and well ahead of 2018 and 2019 figures. The comps to the prior year are difficult but current volume relative to the post GFC average is still encouraging.
The 1st quarter impact on flooring & interiors revenue was muted somewhat due to large backlogs coming off of 2022’s extended build cycle, but the effects are already starting to be felt. We think the largest YoY declines to the builder business will hit in 2nd and 3rd quarter, with easier comps and possibly even some recovery by the 4th quarter of the year. Previous rate hike cycles have seen homebuilding recovery once rates pause, with any declines providing a further boost.
We continue to believe that market dynamics favor a remodeling boom beginning next year and continuing into 2025. Homeowners who bought into a low rate, low inventory environment in the 2019 – 2022 market will look to stay in place and make improvements to homes they purchased at a time when they had few options, and thus likely had to settle in one way or another. Flooring will be a first mover here as it is a medium-ticket project and less subject to financing costs than major renovations. Rapidly evolving trends will continue to drive remodel spend.
The question on everyone’s mind seems to be “when do we see light at the end of the tunnel?” We are in a bit of unique period without a lot of historical precedents. Inflation is high, consumer confidence is sliding and predictive of a recession, and rates are rising. At the same time the job market is strong and even inflation adjusted wages have held up well. I expect further contraction in the residential market (both new construction and R&R) through the next two quarters. It’s important to keep in mind that the full impact of the housing start slowdown is a lagged effect, and the later the trade, the longer the lag. Finishing trades like flooring, cabinets and countertops spent the first quarter benefiting from 2022 starts. Owners and operators should be careful not to be lulled into a sense of security when their top line doesn’t match the news they read. The housing air pocket is certainly coming for those who haven’t yet seen it.
That said, perspective is important. As mentioned at the beginning of this piece, while starts are down from the prior years’ boom, they remain above most of the post-GFC, pre-COVID period. We are not on the verge of catastrophe, but rather a cyclical slowdown after a historic couple of years. The banking scares of March and April seem to be behind us and markets are signaling that we are a quarter or so away from a rate pause, at which point we will likely see the machine up and running again.
Here are my high-level thematic predictions:
- Rates & Inflation – Expect at least one more hike at the next meeting and likely another after that. The biggest driver of CPI right now is shelter costs and that should begin coming down meaningfully with the new capacity of multifamily and SFR coming online this year, coupled with slower household formation last quarter. Expect inflation to continue to drop slowly and the Fed to be finished before year end
- Starts – Anecdotally we are hearing that builders are gearing up again for the next cycle, which is good news. Expect starts to lag for the next two quarters but to be moving positive by Q4. Expect multifamily starts to continue to fall as record capacity comes on line this year in response to affordability issues dating back to last year. Watch rents closely to see the downstream impact of these additional units
- Remodel – Consensus estimates (see chart below) expect the bellwethers Home Depot, Lowe’s, Floor n Décor, and Lumber Liquidators to all be posting YoY gains by the first quarter of 2024, some meaningfully before that. I agree and am even more bullish on 2024 than the broader market
- Pricing and Margins – We heard throughout the 1st quarter that builders and consumers have been very price conscious, trading down the value spectrum. MHK, FND and others announced accelerations in promotional programs and the channel had a difficult time working through excess inventory built up during last year’s supply chain crisis. I am not convinced we are fully through this yet. Inventory levels have largely normalized but consumers and builders will remain highly price conscious for the next couple quarters at least. Any further shocks to the system from geopolitical events or supply chain disruptions could lead to short term, but potentially painful margin compression
M&A – Outlook for Sellers
There was not a lot of activity in the early months of 2023 for reasons that are likely self-evident. Macro uncertainty, a focus on integrating prior acquisitions, dealing with excess inventory, etc. I see a potential bright spot in multifamily services where consolidation of property management customers is driving contractor consolidation. That market also has at least as many good buyers (ADG, ILG, Redi, Rasa) as high quality sellers, which should make any assets that choose to come to market highly sought after. Performance in that market should continue to hold up well and the fundamental drivers of consolidation aren’t going anywhere. Potential sellers in this market should think about positioning themselves for exit and how/when they are going to play in the ongoing consolidation of this market.
In distribution, buyers are open to look at assets at the right price and highly strategic deals may get done this year. I suspect that most sellers will wait until they have more visibility into a growing earnings profile and perhaps a friendlier financing environment early next year to support higher multiples. Potential distribution sellers serving both commercial and residential markets should be well served by that diversification this year and will be some of the most sought-after assets.
Commercial flooring (both new construction and remodel) remains highly fragmented and there are a few platforms (e.g., Diverzify, OneSource, InsideEdge CIS) that will look to add to the portfolio. However, these businesses tend to demand high working capital and the inherently project based nature of the work adds incremental risk. Potential sellers in this market should understand valuation expectations are typically well below the multifamily and SFR residential services market and many deals are struck with significant contingent consideration (e.g., earn outs) to mitigate future project / backlog risk.
M&A – Outlook for Buyers
For buyers the story is all about risk and cost of capital. With an uncertain macro environment, most buyers are staying on the sidelines until they have better visibility into a recovery. What’s more, credit spreads remain high for building products companies as banks are taking a careful approach to adding new risk. High financing cost and limited visibility into near term revenue and timing of a recovery are making buyers a little skittish, especially around larger, transformational deals.
Buyers should be ready to move quickly, however. A pause in interest rate hikes and a couple of months of good news is all it will take for markets to open back up. Buyers ready to expeditiously evaluate and close deals will be best positioned to capture value in the earlier days of an M&A recovery. Those who wait may miss premier assets or forced to pay up in an increasingly more competitive environment.
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