On Sept. 18, the Federal Reserve voted to lower interest rates for the first time in four years. There are certain stocks that can benefit from this move.
But first, I should temper expectations. For starters, investors shouldn't get too hung up on interest rates because they aren't predictable. Even voting members of the Federal Reserve are often wrong when it comes to forecasting interest rates a year in advance. Most people aren't going to have more insight than the Federal Reserve itself. Therefore, predicting where interest rates will be in a year or two is nothing more than a coin flip.
Moreover, interest rates can't fix a bad business. For this reason, investors still need to work hard at identifying strong secular trends and good businesses in these spaces.
All this said, there are solid businesses that can benefit from the recent rate cut. And I believe Floor & Decor(NYSE: FND), Driven Brands(NASDAQ: DRVN), and Tanger (NYSE: SKT) are three such businesses.
1. Floor & Decor
Floor & Decor owns and operates large, warehouse-style home improvement stores, not unlike Home Depot. But rather than fill its locations with general home improvement merchandise, the company primarily stocks items such as tile, hardwood, and other items necessary for floor installations. It's a big market, and Floor & Decor is niche enough to carve out its spot in the space.
At the end of 2020, Floor & Decor only had 133 locations. But as of the second quarter of 2024, the company already had 230 locations and expects to open more than 20 more before the end of the year. Opening new locations at this pace has allowed it to quickly grow both the top and bottom lines.
Targeting 500 locations by the end of the decade, there could be plenty of growth ahead for Floor & Decor's business, which may boost the stock to strong gains.
However, sales have recently slowed for Floor & Decor -- it's a problem common among home improvement retailers. Remodeling activity tends to slow when interest rates are high because people are less inclined to move or take out a home equity line of credit. But now that rates are coming down, it may reinvigorate a sluggish home improvement industry, benefiting Floor & Decor's shareholders.
2. Driven Brands
In my view, things would have to get pretty bad with the economy before most people give up washing their cars and changing their motor oil -- these things get done regularly. And that provides steady business for Driven Brands, considering it has more than 1,800 maintenance shops and over 1,100 car washes, as well as provides other services in the automotive space.
The main fault with Driven Brands is that it has a lot of debt -- about $2.9 billion as of the second quarter of 2024. That's a lot considering it's only generated $2.3 billion in revenue over the last 12 months. And when interest rates went up in recent years, interest payments also went up.
Now that the Federal Reserve is lowering interest rates again, Driven Brands should enjoy a measure of relief when it comes to servicing its debt.
Driven Brands is an otherwise profitable business. Earnings before interest, taxes, depreciation, and amortization (EBITDA) adjusts for debt servicing expenses. The company earned $283 million in adjusted EBITDA in the first half of 2024, with its main car wash and maintenance business segments individually earning a profit as well.
Management for Driven Brands is targeting at least $535 million in adjusted EBITDA in 2024 -- it's already more than halfway there. And with a current enterprise value of just $5.2 billion, this is a cheap stock today at less than 10 times this year's adjusted EBITDA.
3. Tanger
Tanger is a small real estate investment trust (REIT) consisting of 38 outlet malls as of the second quarter of 2024. One of the main things to watch here are its occupancy levels. It would be problematic if tenants were doing poorly and breaking their leases. But as of Q2, occupancy is strong at more than 96%.
This stock benefits from lower interest rates in a roundabout way. As a REIT, Tanger is required to distribute a certain amount of profits to shareholders as a dividend. And it's common for it to have a high-yield dividend.
To be clear, there are several things that can impact its dividend yield. But one of these factors is interest rates.
When rates are high, dividend stocks such as Tanger aren't in as much demand because investors can get good guaranteed returns from bonds. There's no point in taking as much risk with a stock. This can cause dividend stock prices to fall until the dividend yield is high enough to justify the added risk of investing in a stock rather than a bond. But this reverses when rates fall -- the yield from a REIT stock such as Tanger becomes more attractive.
I might already be a little late to point out the benefits of Tanger stock. It's up more than 40% over the past year, in part because investors likely anticipated the coming rate change and wanted to lock in Tanger's dividend at a higher yield -- after all, occupancy levels are strong, so there's reason for confidence in the business. But its dividend yield of 3.5% is still attractive, and the stock price could rise higher with future rate cuts, which are on the table.
More than just interest rate cuts
To close, I want to reiterate a point I made at the beginning: Investors shouldn't build an entire investment thesis on interest rates -- investors can't predict what rates will do, and rate changes won't make a bad company great. But I believe Floor & Decor, Driven Brands, and Tanger are good businesses in the first place. And these good business get an extra benefit from lower rates, which is why I highlighted this trio here.
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Jon Quast has positions in Driven Brands, Floor & Decor, and Tanger. The Motley Fool has positions in and recommends Home Depot. The Motley Fool recommends Tanger. The Motley Fool has a disclosure policy.
