Floor & Decor Holdings, Inc. (FND) Earnings Call Transcript & Summary

Thanks, and welcome to Nashville. I'm Rick Nelson. I cover those specialty retailers for Stephens. We are super excited to have the Floor & Decor management team with us. Representing the company is Trevor Lang, to my right, CFO. Matt McConnell is Senior Manager, Investor Relations. And to his right is Bryan Langley who is VP FP&A. I know Matt has some opening remarks, and then we'll hop into...

Quick safe harbor. Yes, thank you, Rick. I appreciate it. So before we get started, I'd like to refer you to the standard safe harbor language included in our press releases as we may make forward-looking statements within the Private Litigation Securities Act of 1995 throughout the course of the presentation today.

Thanks for that, Matt. This is going to be a Q&A fireside chat format.

I've thought to begin with Trevor, if you could size up the demand environment today. You've put up huge accounts last year. That's continuing. You're starting to lap some big numbers. People have been spending on their homes, hard surface flooring. You're starting to anniversary some of these big comps. Can you talk about some of the drivers that you see?

Yes. Thanks, Rick, for having us. It's a great forum, and it's great to actually not do these via Zoom like we've been doing for most of the last 2 years. So thanks for having us again. It's a great franchise and a great forum. Our business has been strong. Just to set the table, many of you guys may recall, prior to COVID shutting down in March of 2020, our same-store sales were running up about 6%. And I think they would have gotten better throughout 2020 had COVID not hit just for reasons we were -- they were centric to us also from a macro environment perspective. Once we opened our stores in kind of May and June of that year, our business just took off. So last year, so our same-store sales were up over 18% in Q3, up over 22% in Q4. So you're right, we're up against very big numbers this year. And we comped 11% in Q3 up against an 18% from the previous year. And at the time of the call a few weeks ago, our same-store sales have accelerated from that 11% to 16%. And again, we were up against 22% comps. And so business has been robust and has remained strong for us. I think probably the main reasons for that is the overall environment is still good for everybody in the home sector. I think we've done an incredible job on the assortment. Our merchants continue to do a great job in executing a really balanced assortment across good, better, best that is resonating with our consumers. We've done a good job at maintaining our price leadership. And probably in the current environment, with the complexity of what's going on in the supply chain, I think our in-stock levels have increased. You guys heard us call out on the last call that our inventories increased at a much higher rate than it did in Q2 relative to Q2 last year to Q3 relative to Q3 last year. Our in-stock levels have improved and then just all the tactical things we're doing from the -- at the sales at the website with Pro, with design. I think all those things are working in concert. The other large area that we called out on the last call that's a bit unique for Floor & Decor, and you're also seeing this from our larger competitors, is ticket is now the bigger driver of our comp. And that's the first time in my 10 years at Floor & Decor that that's been the case. People are just selecting with their wallet, the fact that they want more better and best products. And so we've now seen the biggest driver of our comp be through ticket versus through transactions. So those are probably the big ones I would call out. And so yes, we're very pleased that our business has accelerated as of the call in early November.

That's a great summary. So a lot of retailers that we're talking with here at the conference are speaking to these supply chain challenges. You mentioned you've been able to maintain good in-stocks. How are you getting ahead of these supply chain issues?

Our team came to us in kind of February and March of this year and said, hey, it feels like things are getting a lot tighter, complexities coming into the system. We'd like to go ahead and order ahead. And at that time, we said, okay, we trust you. We -- that sounds correct. And at that time, I don't think anybody knew how difficult it would end up being at this point. But -- so we made some early decisions in kind of the first quarter of this year to sort of get ahead of that curve. We started locking up capacity. We started building new relationships. We started using some brokers, which was new for us. And all the while our business was so strong, right? Our business was stronger than we thought. So we were making those decisions. I think in hindsight, that was smart, maybe a little bit lucky, too, because we did lock up that capacity. And we were able to get our manufacturers ramping up faster and to get those shipping capacity and constraints. It obviously came into much more of a fever pitch in late Q3 and the first part of Q4 where there was just too many people grappling for few -- to assets to get things to the United States, especially in L.A. I think you guys know it's been difficult across the U.S., but Los Angeles Port is where the massive complexity is. So that's come with a cost. We are paying more. As we said on the call, our container costs are double what they were last year. Our domestic transportation costs are up about 25%. And then we're now paying some duties on things coming out of China that we really weren't paying for last year. So all those things are driving up our supply chain costs. We had very modest increases in cost in Q3, really the second half of Q3. We passed along those retail increases as of the call in early November. Those cost increases had accelerated some, and we feel like we could pass along those cost increases. And then the final thing I said, and if you're looking at some of the real live data that's out there that's public today, we said on the call, we felt like the costs had gone up a lot. But hopefully, we were starting to see the tip of where those cost increases on the supply chain were coming. And if you look at some of the most recent data that you're having today on container ships and congestion, it looks like those have started to slow a little bit. And so maybe we were right. Hopefully, we were right in that we've hit the peak of some of this complexity. And if some of the more recent information that's coming out about container utilization and to be able to get things to the port, especially with the heavy holiday season that's now close, soon going to be behind us, let's all be optimistic that the benefits we've seen in the last few weeks in the market will continue. And we'll continue to see some of those pressures on the supply chain will come down, and therefore, the costs will come down some, too.

Great. So we looked at third quarter comps were plus 11%. Quarter-to-date, they have accelerated to 16%. What is driving the acceleration and the price increases that you're putting through? Is that, in fact, the driver? You mentioned the higher ASPs.

It is more driven by the consumers picking better and best. And so it's driven by retail increases. There are some of that retail increases that's price. But of that acceleration going from 11% to 16%, a bigger driver of that, as of the call, was just consumers are choosing more better and best products. So that's where we were. What will happen in the next year? I do think the pricing component will be more of the driver as we kind of exit this year and into next year only because, most of you guys know this, but I'll just make sure it's clear, we're on a weighted average costing basis. We turn our inventory just over 2x a year. So as we see these higher costs come into our weighted average, it starts off really small. But then as our inventory turns and those higher costs bleed into your overall cost, that will cause us to -- sort of retail is a little bit more as we come throughout the fourth quarter. So as we sort of get into next year, I think possibly more of that ticket increase will cause the complexion of our P&L to change, where ticket will likely be more of the growth driver like it was in late Q3 and Q4 as we get into next year as we pass along some of those cost increases.

And the Pro business has been outpacing the rest of the chain. Do you think that's true of the industry? People are getting more comfortable having the Pro inside of their homes. And why did the Pros shop your stores? And do you think you're gaining share of that Pro segment?

I think that is correct, our Pro business is meaningfully outperforming our consumer. But to be fair, last year, our consumer business was outperforming our Pro. So the Pros doesn't have the same comp that the consumer had because last year, that big acceleration in same-store sales we had last year was much more driven by the consumer. I think on the Pros, it's a number of things. I do think 60% of who we compete with today is the smaller competitors. There's something like 13,500 independents out there. I think they're having much more difficulty in getting inventory. I think if our container costs have doubled, I would expect that their container costs are up a lot more than double. And so as we have more inventory, and I believe our costs have not gone up as much as the smaller players in the industry, costs have gone up, that's 2 big wins for us. We actually have inventory, others don't in many cases. And the cost increases at the independents are higher. And the other thing that's important to mention, the better and the best where we've had a lot of growth over the last several years, in many cases, that better and best that we're competing with is more so with the independents in the home centers. And so that consumer who wants the better and the best, we've got the inventory, and a lot of times the independents do not. And then again, our cost increases are, we believe, not as big as theirs. So if you're a Pro and you were possibly buying a lot of your product or some of your product from an independent, now instead of having to wait 2 to 3 weeks, if you're having to wait 6 to 8 weeks and the costs are going up every day, we become a much more viable option in that environment. So I think that has something to do with our Pro business going stronger as well.

And how do you think your Pro business is faring versus the big box stores? You're capturing the share versus the independent, but do you think that's true versus big box as well?

I -- my guess is that's true. But on a 2-year basis, as I understand it, their business is incredibly strong because they had such big numbers last year, and their comps this year are smaller only because they had such huge comps last year. But from everything I've read, Matt, unless you've seen it differently, I think their Pro business is strong, too. I don't know that I can say our Pro business is better or worse than those. But I -- what I do know is our Pro business is very strong right now.

But then on Pro customers, you've got the in-store designer initiative. If you could speak to that, what sort of benefits that brings to Floor & Decor?

Yes. We put in in-store design services, I don't know, maybe 5 or 6 years ago. Most of you guys know, a flooring project is not something you generally do all that often. It's complex. You don't know the 10 or 15 installation products you need to put in there. You don't know how level your flooring is, whether you're above grade, below grade, all these things that make the flooring project can be complex. If you have a designer who can help you make a lot of those decisions and just gives you confidence in what you're doing, so we've had a lot of success with the design over the years. Our penetration continues to grow. Our conversion rate continues to grow. And it's really that simple that I can come in, I know I want to do a bathroom, but that's kind of all I want to know or that's all I know. Our designers can help you build that bathroom such that you get all the products you need, all the installations you need. They can help you get installation help if you need. And I think that has just been -- endear a lot of trust with our consumers. And we know that because our ratings, when you go through the design services, are materially higher, whether it's Google or Yelp or any of the social media applications that are out there. We know the ticket is much higher because they have confidence in what needs to be done. The gross margin profile is higher. And so we're continuing to invest in that, and that has paid off with, again, our penetration with our design, we said in the last quarter was the highest it's been in the company. We've also put a lot of resources into that. We put in an officer-level position maybe 9 months ago to really help drive those strategies throughout the stores. We saw the success there. We then put in 3 regional positions to help all of our stores throughout the regions drive some of those design strategies. So it's still in the early phases, but we do think it's something unique and different that you can get at Floor & Decor completely free. It also helps our Pros, for example. A lot of our best Pros will say, hey, just go into XYZ store and work with XYZ associate, that then takes a lot of weight and time off of our Pros. They can just focus on installing and not have to worry about picking up product and helping design the piece. So it's a great strategy, and we're still in the early innings of executing that across our stores.

I'd like to also ask you about product categories, then I will open it up to participants here in the room. Laminates, luxury vinyl planks, that's been a big driver for some time, the outlook there and if could speak to other product categories that are driving the business today.

It has. You're right, Rick, it's been an incredible business. And there's really 2 main categories that drive that. We have a water-resistant now, actually very recently, a waterproof laminate. So in previous applications, if you were going to put in a laminate product, you could only put it in dry areas because laminate doesn't do well with water. But because of the technology improvements, you can put in this rigid core vinyl that's completely waterproof. Until recently, you could put in a water-resistant laminate. It's one of the easiest things we have to install. It's a wood-look product that is lower than our engineered and our wood products. And again, it's completely waterproof, whereas wood and engineered are not, for the most part. And again, it's very easy to install, so both the consumers and the Pros love it because it's not that hard to put in. And so the -- and the looks are fantastic as well. Our head merchants would tell you that it's hard to tell the difference between one of these products versus a wood product, and maybe you're going to pay half as much and the install is going to be half as much. So it's just a great product. It's been a great product across the industry. We feel like we've done a good job of leading the industries with wider planks, better warranties, better looks. Again, we have a new product called OptiMax, which is what they call an eco-resilient product that has no PVC in it. That's important to a lot of consumers because some people don't want PVC in their homes. So the merchants have just done a fantastic job of leading the industry with that product. When I started 10 years ago, laminate was, I think, 10% of sales. And as of our most recent filing, I think it's up to 26% or 27% of our sales. So I think that's a great category. I think it will continue to take share for all those reasons I just listed. The benefit for our business is we're a little bit agnostic as to what is the leading trends. In the 10 years I've been here, every one of those major 4 flooring categories, tile, woodstone, laminate has been leading. And when you have a big box and you can be a leader in those industries, today, it's rigid core vinyl. It's been deco in the past. It's been wood. It's been tile. We have the ability with our merchandising team to whatever is leading in that trends will, we think, will win in that category. So said simply, as long as hard surface flooring is growing, we're going to win because we have big stores. We can show the assortment, and I think that's probably the more important part. But yes, we are in a long term, probably 5 years of where rigid core vinyl and water-resistant, waterproof laminate has been growing at a faster rate than the rest of the business.

The question relates to the better and best mix. Is this due to the fact that you had more availability of product and assortment in those 2 categories versus the good consumer [ went bankrupt ]? Or it has had more availability of, I guess, dollars in the pocket [indiscernible]?

Yes. And I'll just repeat the question so people hear it. So the question was around good, better and best. Is the reason that you're doing better in that arena because you have the products? Or is it just because the consumer decided to spend more because they wanted the products? I don't know that we know for sure, probably some combination of both. I think we -- I'll say about this, we serve a higher-income customer. We estimate our income levels are $100,000 to $125,000. I think that consumer has enough discretionary income in this environment. Their houses are worth well more than they were last year. There's record levels of cash sitting in consumers' bank accounts, stock market portfolio, 401(k)s, all those things give that higher-end consumer the ability to put in what they want. So if I had to guess, I would guess it's more they're just choosing to do that because they can. But certainly having in-stock inventory is a benefit, especially when it's possible that other people don't have as good of in-stock levels as us. But I would guess the consumer is just choosing based on their own preference.

And maybe just to tie off that side of best. So the consumer this year shows up and it doesn't have the inventory with you, like you said, it's not a purchase every year. So next year or 18 months from now, maybe the supply chain will be better for everybody. How do you hold that new customer coming in who's looking for better and best that might go in? How is the strategy [indiscernible]?

Yes, great question. The question was, okay, maybe you're winning more today because you have better in-stock to maybe some of your competitors. In a year or 2 from now when that -- when the supply chain issues are abated a bit, how do you keep that customer? How do you keep that success? I think when people buy flooring, it's kind of a 3- or 4-legged stool, the decision-making process. I think price is important. It's one of the legs, for sure. Probably we think, based on our research, the more important is, do I like this product? There's really not a lot of branded products in our industry. Most of it is unbranded versus whether it's Floor & Decor or competitors. And we have our own brands, but meaning there's not a brand that goes across all retailers like there would be in apparel or electronics or something like that. So I think the main driver of what drives someone to buy the product is, do I like this product? Is it going to look good in my home? Does it match my paint, my furniture, my wallpaper? Second is do I trust this brand, right? This is an expensive purchase. Is this going to last? And are they going to stand behind their products? Does my installer believe that the products are going to be good for an install? I'm below grade, I don't have level floors, all of those things. And then price is in that decision-making as well. And so I think the reason that we will have success and what we've seen work, and our business has been incredibly strong in the 10 years I've been at Floor & Decor, is we win in all those categories. And then in-stock, especially for the Pro business, right? Can I trust that you're going to have this if I need it in a week or less versus having to wait 3, 5, 6, 8 weeks, depending on what's going out there? And so I think once people experience the brand and they have a good experience and they know -- they'll figure out during that process that our prices are lower than our competition, you're kind of, why would you shop anywhere else? I trust the brand, I like what I put in, they have it in stock, they have a great website, they have great sales associates, very liberal return policies that most of our competitors have restocking fees, for example. The totality of that entire service is better with us. So I think that's how we'll win, especially if you're talking about someone who's buying in an independent because in many cases, especially in that better, best category, their prices are 2x ours, sometimes 3x ours. So I think that's where we win. And so let's say, you're right, you come out a year, you did a bathroom, you really love it. You feel like you got good value out of that bathroom. Now you're ready to do a kitchen or a basement or another bathroom and at least can at least try Floor & Decor. And then you come back to that whole virtuous cycle of they've got it in stock, their prices are lower, they've got good salespeople, they got a good website, good return policies, I think all of those things will allow us to continue to win when they're ready to do that next project.

Trevor, can you speak to some of the labor challenges that retailers are discussing and how you're combating that? And are you able to pass through higher prices on the labor side?

Yes. I think every retailer out there has talked about the difficulty of labor. There's not enough people in the workforce. I think last I read, there's something like 5 million people who have left the workforce that possibly may not come back in. And people are paying more, including us. We have a couple of benefits. Our average wage rate is now above $16 an hour. So we're fairly well there. The other piece about our business is about 60% of the hours in the stores are more full time and management hours. So we don't have as many -- a percentage of our labor is not so much dependent on the part-timers and the lower-income people because we've got a lot more of our hours are the full-timers and the people who make well above that $16 an hour. But it's tough. It's hard to get that other 40%. There's a lot of people competing for it. You guys may recall on the second quarter call, we called out, we took about 1/3 of our lower-paid associates and gave them a pretty big raise. And so that's in our P&L in Q3 and Q4 this year. It will obviously be new to the P&L because we did it in the second half of this year. And then we're also currently evaluating, as part of our plans, do we want to do something else for those associates? And so we may talk more about that in the February call. So I mean it's tough sledding, but as you guys have seen in our business, our business is great. As we said earlier, our comps accelerated from 11% to 16%. On a 2-year basis, our comps accelerated from 15% to 18%. So it's hard. We wish there was more people available like every other retailer, but I think we're doing as good, if not better, as anybody else in this environment. And again, the majority of our hours are people that are more full-time or management positions. And so we have a bit of a benefit relative to others.

Given the trends in the industry and given your success with these, are you doing anything different from a real estate perspective [indiscernible]?

So the question was with the success you had and as you think about your real estate strategy in the future years, are you doing anything different? Nothing hugely different recently, but I will say some of the trends we've changed over the last 3 to 4 years is we've done -- we've been very intentional in taking on more of the cost of the buildout of the store ourselves. There's a lot of benefits to that. It allows us to open the store quicker. It allows us to open the store where it looks better. It allows us to lower our future maintenance cost because we can build the store a lot better than a lot of our landlord partners can because we do them all the time, obviously. It allows us to meaningfully lower our rent per square foot. Wasn't that long ago, our rent per square foot might have been $15 per square foot. Now we're in the mid- to upper-single digits in rent per square foot, and we're going into more expensive locations. So that's -- it's impressive, but it's really impressive when you consider opening stores in Boston and Long Island and the Bay Area and Seattle where the costs are materially more. Because of that, we've said -- now part of this is macro, so we need to have some humility, but also our new store performance for the class of 2021 is going to be the best in our history, both from a top line and a bottom line perspective. We're pretty much wrapped up with the class of '22. We're focused now on the class of '23 and '24. We'll -- our plans, assuming we keep 20% unit growth, which we intend to, that will be 32 new stores next year. And from everything we're looking at, because we do very detailed pro formas for every store, we think the class of '22 is going to be an incredible class of stores as well. So the real estate team and the new store visual merchandising team and the operations team are doing a great job. And we're pleased with the fact that, obviously, our new stores are the best class of stores we've opened in our history. So I think a lot of things are going right on the real estate side. It is -- I will say there was a great article in The Journal over the Thanksgiving holidays that I think this year, '22, that's coming up, is the first year since 2017 that there's going to be more retail openings than closings. So it has gotten a bit more competitive. There are more people opening retail locations, a lot of people taking old retail locations and turning them into either fitness centers or distribution. So that will make it a little bit more competitive than it was maybe as we were in the COVID -- right after those COVID years. But again, we've got a great team, a great leadership, a group that's managing that real estate and feel good about our future with new stores.

Just to follow up on that. What are you seeing in terms of rent given the increase in demand for real estate? Are there meaningful changes that way?

Our rent per square foot with the class of '22 will be lower than the class of '21, so that's good. Now part of that is because we're taking on more ownership. You guys may know we own, I think, 3 or 4 stores now, and those have been incredibly good investments. We own our distribution center in Houston that we're about to own. That's also been an incredible return on investment. We bought, for example, the land for -- next to our Savannah distribution center, and that land is up materially. So we're going to own more. That obviously brings down your rent per square foot because when you own, you're not paying any rent. And we're getting a good -- we think we're going to get a really good return on investment. So we're using that balance sheet that we have to try to own more real estate. We do very detailed return on invested capital to make sure we're going to get a return on owning that real estate. But that's another way we can bring down our cost is actually owning some of the real estate.

So in that same vein, there aren't as many [indiscernible]?

That's right.

So the prime locations for Floor & Decor. What areas or opportunities we see out there because we just haven't seen as many bankruptcies and litigations of these relatively [indiscernible]?

Yes. The question is with less retailers going bankrupt or closing stores, how are you going to grow at 20%, where you just don't have the same maybe availability you had in real estate before? We're doing a lot more ground leases. So I'll just give you one example. One of our stores in Long Island, for example, was a driving range. And so we go in and say, hey, let us just build everything. We'll take all the costs. We'll start paying rent day 1. If you're a landlord, that's fantastic. You're going to get a little bit more rent than you were as you were doing a driving range, and we manage everything. You just collect rent check. So that's pretty appealing if you're a landlord. So we're doing more ground leases. We're doing more, where we'll go into an old building and just either raise it or completely redevelop it. And so that's part of the reason our CapEx costs are going up is because we're doing more of that. So that's how we're getting around that. You're right, there's not as many Sports Authority's and Toys "R" Us's there were, but we're taking more real estate that we're taking on the complete project is how we're working through that.

So you've been growing the store base at a 20% clip. How long -- you got 160 stores now. How long do you think you can maintain that clip? And how many annual store openings would the current infrastructure support?

Yes. We've been growing at 20% since 2013, right? So we're getting close to almost a decade of 20% unit growth, right? If ultimately we said, we think it's 400 stores, you have to be careful because you'll be there before you know it. The words we've used is the next several years. We intend to have an Analyst Day probably in March, mid-March. And I think we'll kind of come out with sort of the definitive statement on what's the ultimate store count. We've said 400 stores since we went public. So we'll hopefully have an update there on what we think the ultimate store count is. And I think we'll also probably talk about at that time at what point we think 20% unit growth is -- how long we're going to do that for. So for the foreseeable future, for the next several years, we think we'll continue to grow at 20%. But we've also said in some of these calls, once you get to 38, 40, 45 new stores per year versus this year, we'll do 27 new stores, that's starting to feel like the level that it makes sense to cap at that level. So more to come on that when we have our Analyst Day in mid-March next year. But for sure, the next several years, we feel good with 20% unit growth.

As you look at where you're taking share over the past 3, 5 years, how we look at it, is that fairly from more independents you're taking over to pick off? Or how do you see where it's been and where it's going to go going forward?

So the question was, as you guys are growing at a much faster rate than the industry, where are you taking that market share? Are you taking it from the independents? Are you taking it from the home centers? We do some pretty good consulting work with one of our larger consulting firms to look at that, and we do that kind of every 3 to 5 years. As a broad trend, I'd say we're taking more of that from the independents, and we should. 60% of the industry today roughly is the smaller competitors. As mentioned, there's something like 13,500 of those independents out there. So as a broad theme, I would tell you, we're taking probably a little bit more of that market share from the independents. But I would say on the home centers, and Matt, maybe you can correct me, until recently, I think both of them called out as flooring comping above the company average. But before that, I don't think they called their flooring comping above the company average for 3, 4, 5 years, depending on which one you're talking about. So we're also -- I think we're definitely taking market share from the home centers as well, but more so, I would say, from the independents. And I just looked at these numbers the other day. If you look at our results, the year before we went public, we did just over $1 billion in sales, and The Street has us anything close to $3.4 billion this year. So I think that's about a 27% compound annual growth rate per year. The industry has probably only been growing 2%, 3% on a low year, maybe 8% or 9% on a really good year. And so we're definitely taking a lot of market share from both of them. But I do think, based on the data we have, more of that market share is coming from the smaller players than it is our larger competitors.

In markets where you have enclosed space or closed stores, what are the main drivers as to why you closed the stores? Or is it just a relocation into [indiscernible]?

We've never like closed a store just to say we're not going to be in that market. I think we've done 3 relocations, 4 maybe -- 3 locations, I believe. So we've done a relocation in South Florida. We've done one in Orlando. We've done one in San Antonio. In that case, in almost every case, the reason we relocated was there was a class of stores when the company was first started that were like 45,000, 50,000 square feet. And those stores were some of the most productive stores we had, but they were just way too small, right? Our new stores now average 80,000 square feet. And each one of those cases, when we relocated in San Antonio, when we relocated in Orlando, when we relocated in South Florida, the sales volumes just went through the roof because we built a much bigger store. The stores looked better and better design studios, better back-of-the-store operations. So we've probably got about 10-ish or so stores that -- or some of those older stores that are maybe too small or maybe not in the right location. We'll relocate those kind of as the leases come up is generally how we do that. We're doing one in Houston next year. We're doing one in Atlanta next year. So we've got a handful of stores that are just too small or too old, but it's not a big number. I don't -- there may be 1 or 2 stores that we ultimately just close and because we need to move a store 45 minutes away, but it's a very small percentage of the stores today. We have stores in traditional retail. We have stores in manufacturing light distribution. We have stores that are off the freeway. We have stores that are not anywhere close to anybody. And we do great in all of them. We're a bit of a destination. So I'm not saying it doesn't matter where we put the stores. It does. We are putting more stores in better locations. But our -- because we're a bit of a destination, we can have stores in many type -- different type of applications. Most of our highest-volume, best-performing stores are not in traditional retail.

Shifting the conversation to the gross margin. So you're guiding to a lower gross margin in 4Q, rising supply chain costs. How should we think about next year? We've got store growth, we've got sales growth, but what about margin?

Yes, it's a great question, Rick. We have been dealing with inflationary pressures more so from tariffs for most of the last 3 years. And our strategy has always been to focus on delivering the gross profit dollars, not so much gross margin rate. And we think that has allowed us to continue to be the low-price leader, which is important to us as well. And so you guys have probably heard me say this many times over the last several years, but in a simple example, our gross margins aren't 50%, but it just makes the math easy for me. If you have a product that you were paying $1 for and now that product cost you, because of supply chain or tariffs or whatever, that product is now costing you $1.02 or $1.05 and you were selling it for $2, the way we think about it as those costs come in, let's now -- if the cost went from $1.02 to $1.05, we'd raise our retails in that example to $2.02 or $2.05. And so mathematically, when you work through that, you still get to the same gross profits that you were going to have before you have the cost increases, but the rate comes down pretty meaningfully. And that's exactly what happened. If you take the midpoint of that 39% to 40%, that's a 300 basis point decline in gross margin versus last year, but we're still going to have good gross profit growth. And so that's the way we're thinking about it today. If it is -- if indeed these supply chain cost increases are -- I think we're not supposed to use the word transitory anymore, but I'll use it for now. If those are really transitory, then what should happen in 6 months or a year, those costs will come down and then our gross margin rate will go right back up is how we think about it. If longer term, the supply chain costs are going to be more permanent, then I think we will have to think a little bit more about that because we do want this model to run at kind of low 40% gross margin, not 40%. We were running kind of in the mid 42s for most of the last year. So I would say simply that our expectation is that more ships will go in the water and container costs will come down. More trucks will get in the U.S. and more truck drivers, and that will bring down trucking costs. If that's to happen, when that happens, then you'd see -- you'll see those supply chain costs come down, and you'll see -- you should see our gross margin rates go back up. So just to finish that question as you think about the next year, and again, my crystal ball is probably no better than anybody else's in this room, but I think as you get to the second half of next year and those costs hopefully do come down some, and we're up against lower gross margins this year, then one would think that we've got gross margin opportunity in the second half of last year. Conversely, we're up against record gross margins in the first half of '22 this year, and we're going to exit this year at that 39% to 40% assuming we hit those numbers. So you're probably going to have lower gross margin in the first half of 2022 is how people should -- I would encourage people to think about next year.

I don't know very well relative to the elasticity of pricing. But do you envision that price increases that you will be able to implement to the consumer will hold into the second half of next year? Or as supply starts to come out and your competitors [ start ], do you see pricing to be more at risk?

The way we think about it is we -- oh, sorry, the question. The question was as your pricing versus your -- versus -- how elastic is your pricing? And will you keep that pricing if indeed costs were to come down and maybe even your competitors were to start lowering pricing, I think, was the gist of the question. We have a very good process for evaluating the market, what do our larger competitors do on their pricing? As best we can on the independents, what is their pricing? It's a little harder there because there's a lot of them. They do it very differently. The price you see is not the price you pay. So it's much harder to do that on the independents. But again, we have a pretty good process for watching that. What I would expect to happen is if indeed we get into an environment where the costs are going down in the second half of next year relative to where they are this year, I would expect us to start lowering our retails at a rate as our costs come down, which would drive that gross margin rate, the exact math of what I did before, so I would expect that we would take our retails down. We like being materially lower. If you look at my 10 years here, probably 8 out of 10 of those years, we've been taking retails down even though our gross margins have been going up because that allows us to put more pressure on our competitors. So I guess if indeed that does happen, I would expect that as our costs come down, our retails would come down and our gross margin rate would go up.

Can you talk, Trevor, about the number of distribution centers you have today? And as you grow towards this 400 store level, how many DCs will you need? And when is the next one coming?

Yes. So we have 4 big distribution -- well, they can hear Rick's question, I guess. So we have 4 large distribution centers today: Inland Empire, L.A.; Houston, Texas; Savannah, Georgia; and Baltimore, Maryland. We are expanding our Houston distribution center as we speak. We're doubling the size of our Houston DC. We're actually relocating it. We'll open that in very early '22. I think that gives us kind of 15% more capacity. And we probably will open a DC every year to 1.5 years as long as we continue 20% unit growth. The simple math, the way to think about it, the new stores that we're opening on average are about 80,000 square feet. We probably need about 20,000 square feet in a distribution center. The majority of what we sell is coming internationally, and even some of our domestic partners will go through our distribution centers. So we've got to have somewhere to store that inventory before we send it to the stores. So it becomes a bit of a math equation. If you're adding 20% new stores, those new stores are averaging about 80,000 square feet, and you need about 20,000 square feet of distribution center space. When you work through that math, it's usually every year to 18 months that you're opening a new DC. Our new DCs are averaging about 1.5 million square feet. And so we'll probably add something. The Houston one will open early '22. We'll probably have something up in the Pacific Northwest coming soon because we're growing our business out there. Then we'll come back to the East Coast and really to be Baltimore, Savannah the year after that because we like those ports. We do very well there. So kind of every year, 1.5 years is how we think about it today.

Given the demand for [ absence leasing ], are you doing more ground leases as well for that?

We like to. We got very smart and lucky in Houston. We actually own that distribution center, and we're very pleased we did. As I mentioned, we bought some land in Savannah a bunch of years ago that's worth way more than we paid for it, and so we can build out there. It gets hard, though. There's just not a lot of space left in America next to the ports. You can do some railing in, but it makes it slightly less efficient if you have to do that. So probably yes in Savannah. We'd like to in the other markets. But I would guess there's not the availability or the cost doesn't make sense as you get into places like the Pacific Northwest and L.A. So we'll do as much of that as we can. But outside of Savannah and Houston, my guess is we'll have to do more leases there than we will building our ground leases.

Can you maybe talk about them I guess, the design studios for the -- how it factors into that [ 400 ] number as well as this conversation [indiscernible]?

Yes. The question was around our design studios and how we're thinking about opening design studios and how does that factor into our supply chain strategies. So for most of you, in case you don't know, our stores are averaging, I think, around 77,000 square feet. Most of our large-format stores are in more suburban areas outside of the dense urban populations. We always knew that we -- most of our customers will share their information with us. So we have really good demographic profiles for our customers because most of our customers will store their product with us for a week or 2 before they come pick it up. So we have cell phone numbers and addresses, and so we can use that data to understand where our customer base was. And when we looked at a market like Dallas, for example, we have a lot of stores, very high-volume stores, incredibly profitable market for us. When we looked at that market, we weren't getting a lot of that higher-income urban business. They just pay more and get their flooring from a much more expensive independent inside the urban areas. And so we knew we couldn't put 80,000 square foot stores in those densely populated markets. So we opened the store. I think it's 11,000 square feet, maybe it's 14,000 in Dallas. I forget. It's a gorgeous store. If you guys haven't been there, you should try to go see it if next time you're in Dallas. It's just as good-looking as any of the high-end mom-and-pop independents there. But the pricing is the same as our warehouse stores. And so we're materially below the competition down there. That store has been opened just over a year, and it's doing fantastic. So really, the strategy was let's get some of that higher-income urban population customer who's just not going to drive out to the suburbs to buy flooring, and that's exactly what's happening. So we're pleased with the performance. We've got 2, so -- but it's only one store. It's the first one really. We sort of have one in New Orleans, but that store is very different than the one we did in Dallas. We're going to open one early next year in South Florida, a market we also do very well in. We're going to open one in Houston, another market we're doing it. Both of those stores open in January. We're excited about that. We've also got one in Atlanta and Washington, D.C., we're working on. So great. We're pleased with it. We think it's going to be, again, basically the ability to get to that higher-income customer where you can't put an 80,000 square foot store. And so they'll never be as material or as productive to the business as the big-box stores, but I do think they're a good return on investment and will provide us the ability to get a customer who otherwise just wouldn't go out to the suburbs.

And you serve -- do you carry inventory at those locations that you serve [indiscernible]?

Good question. So the question is on those smaller stores, do you have inventory on site? Or do you service them out of the distribution centers or the existing stores? Most of it is coming from the existing stores. So we've got plenty of inventory in those stores, especially Dallas, our Mesquite store is like a really big store, so we can carry extra inventory there. But that is one of the benefits, too, is that we can have the inventory, in some cases, the same day. Now most people probably don't need to like rush out and get their floor in the same day. But we can service, and the intention is that we service the majority of those sales out of those existing stores that are in the suburbs. I think we have like -- we're about to have 11 stores in the Dallas market. So we've got plenty of surrounding stores that we can service that design studio out of.

What's your exposure to China? I know that was in reduction mode. Where are you today? And where does that go?

If you go back in 2018, about half of what we sold came from China, Rick. We're now down to about 30%. And what Lisa would tell you, our President, is the remaining 30% is harder to move. The other 20%, we could move. Even -- said another way, even paying 25% tariffs, it's still better product at a lower cost. I do think over time, it's possible that, that number could continue to come down. Many of the vendors that we source from are large, complex businesses that have decided that it's important for them to grow their business. So they're actually building manufacturing capabilities and capabilities in other parts of East Asia. So in some cases, they're going to Vietnam, they're going to India, they're going to Cambodia. In some cases, they're actually coming to the United States. This is public information, but one of our large manufacturers -- or actually 2 of our large manufacturers of China has built a big plant in Tennessee, and another one has built a big plant in Dalton. And so these companies want to grow their business, and they understand there's complexities between our 2 governments. And so they're building manufacturing capabilities outside the United States as well. So it could be the same vendor, but that vendor is creating the same product out of Vietnam or building it out of Dalton, Georgia. So we're still paying the same vendors, it's just that they've built manufacturing capabilities outside of United States. So that 30% could continue to come down, but it's not going to come down nearly as fast as the 50% coming to 30% because many of these manufacturers have great products. They have very low-cost, efficient manufacturing operations. And even with paying that 25% tariff, in many cases, it's still more economical to get that product from China.

And with that, Trevor, Matt, Bryan, thanks very much for joining us here in Nashville. Great session. Thanks for all the questions. I want to keep you guys on track. I know you had a busy day.

Awesome. Thanks for having us, Rick. Enjoyed it.