Furniture and Home Renovations: Post-Pandemic Normalization and the Next Era of Growth

William Blair consumer analyst Phillip Blee joins William Blair Thinking Presents to explore the volatile demand for furniture and home improvement projects over the past four years and provide insights into the industry’s 2024 outlook, including key themes such as the housing market, deflation, rising ocean freight costs, and long-term growth potential.

Podcast Transcript

00:20
Chris
Hi everybody. It's August 28th, 2024. On today's episode of William Blair Thinking Presents we welcome Phillip Blee. He's an analyst in our consumer research sector who focuses on home and outdoor, automotive parts and services, and the discount and convenient space. He's here to walk us through this report he and his team published at the end of July, called “Furniture and Home Renovations: Post-pandemic Normalization, and the Next Era of Growth,” which looks at how the sector has been doing for the first half of 2024. What we're going to cover, really is what the outlook is for the second half of 2024 going into 2025.

Phillip, welcome to the show. It's a big report and it covers a wide spectrum of analysis for the furniture and home renovation space, including the housing market, potential for deflation and higher promotions, rising freight costs, the presidential election, and then an assessment of the longer-term growth potential of the industry. So in other words, we have plenty to talk about.

So, to start, I thought you'd give us a high-level overview of the report, including what it was that inspired you and your team to dig so deeply into this sector and especially this particular narrative. And then I figure we can talk specifics from there.

1:28
Phillip B
Great. Sounds good. And, Chris, thanks for having me. First of all, I mean, this space is very close to home for me. My mom's an interior designer. My dad's in residential and commercial real estate. So I've grown up in this space, right? Our house was constantly being remodeled. I'd probably been to enough furniture and hardware stores to last a few lifetimes. So, you know, needless to say, this is the space I love. I'm very close to it.

And so it's been a crazy sector over the past few years. It's been very exciting. You know, we saw the Covid pandemic-related boom. Organic demand was crazy. Everyone was spending all their time at home. So, you know, why not take that time to renovate and, you know, improve your life?

Supply chain and inflation happened. You know, this has been a space that's been deflationary over the past couple of decades. You know, all of a sudden prices were up 20%. Lead times were crazy, but demand was still there. And now we're in this normalization period, and it's been painful. It's been drawn out, ever since, you know, starting in 2022.

And then that's been exacerbated by shaky your weakening consumer backdrop, you know, and then along with the worst downturn in the housing market we've seen since the 90s, existing home sales have been steadily declining over the past couple of years. So, we really wanted to take time, write this report to contextualize where we are in this cycle, and then assess the growth potential for this year, next, and then the longer term. And I think the timing was very appropriate going into the second quarter, where expectations are really starting to shift towards what an interest rate cut means for the space, what it means for the housing market, and then we're going to see some sort of potential acceleration.

So, going into this year, expectations were for an interest rate cut and an inflection of housing by mid-year, and the industry largely to benefit from that. Obviously, that hasn't necessarily occurred. So, expectations were a bit elevated going into this second quarter. And I think expectations have still been elevated for 2025. So we really wanted to break down the key demand drivers here. What are the key risks and opportunities over the next 18 months?

We performed multiple consumer surveys spanning over the past two years to get an idea around sentiment and how that's involved. And then we really wanted to take a more long term view on the industry, what we can expect on that, or a more normalized demand environment. What demand looks like once we're past all this noise, and then who are going to be the major winners and losers in the space?

3:51
Chris
Got it. So let's talk a bit about second half expectations for the sector, which you know, you just you mentioned briefly, but you mentioned in the report that while the second half growth in the space appears overly ambitious after removing the multi year impact of volatile demand and pricing fluctuations, the stacked productivity trend paints a more tempered outlook and in line with the first half results. Those are your words. How might you break this down a bit for us?

4:16
Phillip B
Yeah, absolutely. So going to the second quarter the industry was largely expecting growth of about 5% in the second half. So that's a pretty meaningful inflection from the first half where sales were, you know, expected to pretty much decline by 1%. But comparisons, like I was saying before, comparisons are so choppy for the space between, you know, noise from pandemic related volume and then price, which really started to normalize a bit starting in the second half of last year.

So we really tried to remove a lot of that volatility by comparing sales productivity levels to pre-pandemic averages, which indicated that despite declines in the first half and 5% growth expected in the second half, expectations were actually relatively in line from a productivity standpoint compared to pre-pandemic averages. While growth of 5% was a bit jarring for the space, it wasn't as overly ambitious as maybe people were expecting.

That being said, demand is tough right now, and I think demand has gotten a bit tougher over the summer. Consumers may be a bit more shakier. You know, savings are running out and coming elections and all that kind of volatility is just causing some concern and that is typically an issue for higher price points, larger ticket discretionary items like this, and especially when there isn't any sort of demand around housing and, you know, anything triggering there.

So I think that that's brought down expectations a little bit further than probably what the industry was hoping for. But I don't think that second-half expectations are a return to growth necessarily. Is that overly ambitious at this point?

5:50
Chris
Let's touch on the housing market and how it’s impacting the space. So you mentioned that housing mobility has historically been a significant driver of demand in the market, where retail sales maintained an 80% correlation with existing home sales. How is the continued pressure on the housing market impacting the space? And, you know, what are your expectations moving towards a rate cut in the near future?

6:13
Phillip B
Yeah, it's it's a big trigger, right? If you think about home renovations, home improvement, even furniture, you move into a new house, whether it's bigger or smaller, different neighborhoods, different styles, it's a big trigger move. And you get a new mattress, you get a new couch. It's time to upgrade, you know, the kitchen counters or renovate the bathrooms.

And especially with our aging housing stock that we've had. The last housing boom was around, you know, 20 years ago. Typically, 20 years is a key kind of inflection point for wanting to renovate bathrooms or hardwood floors, things like that that are a bit more durable. So lack of housing mobility is a big problem for the industry right now.

It's causing a lack of organic demand here. And over the past year, we did a survey over the past 18 months, and our surveys have indicated that those who have moved were 30% more likely to complete some sort of home improvement project or furniture purchase versus those who didn't know. And, you know, that's across the spectrum of small to large projects or purchases.

So right now, the larger-ticket purchases are typically associated with a move. So I think that once we start to see that, I think that there's going to be a big potential uptick in demand here, especially across the larger-ticket or larger projects. Whole home renovations are sofas or beds, things like that, that are typically associated with moving.

So I think that we need to see the vast majority of Americans or existing homeowners have mortgage rates below 6%, the vast majority of them even lower than that. So I think we need to get mortgage rates in the 5%, 5.5% range before it gets more palatable for those who are wanting to move. and we've seen an uptick in consumers wanting to move.

Our surveys indicate that, you know, there's pent-up demand for movement, especially among younger generations, where homeownership rates are well below, you know, prior generations at this age. So the primary reason being more space, people want more space and people want more flexibility. And so there is demand out there. It's just right now the housing market is a bit frozen, which is causing quite a bit of uncertainty and lack of demand around this space right now.

8:16
Chris
I know you say that historically the industry has been deflationary, with prices decreasing by an average of over 1% annually in the 20 years leading up to the pandemic. How are we in terms of deflationary pressure right now in the market, and then what are your expectations in that regard?

8:31
Phillip B
Yeah, it's been a deflationary industry for quite a while. And, you know, that really comes to value. Discount furniture places have really taken hold, i.e., the expansion of Ikea. Those kind of concepts have really, really helped boost and then boost the value concept. And then the recession focused everyone focused on discount value for the ten years leading up to the pandemic.

That changed, obviously, during supply chain, during the pandemic era with all the organic demand, prices went up by quite a bit. We've seen them start to creep down. So the industry has been in a deflationary period over the past year. So prices are declining in the low single digits right now. And we've seen that accelerate a bit over, especially beginning in the summer, I would say, over the first and second quarter and into the third quarter of this year, people are trying to really fight for demand at this point. This seems less to be focused on churning through or turning through access inventory and more about stimulating demand that there really is a lack of because of the frozen housing market. People are trying to be top of mind and stay top of mind in the consumer. So when housing market does inflect, they'll be the first person that they think of and they'll be the first person to benefit from some of those larger ticket purchases. But it's been a very promotional environment.

And what we've seen is promotions aren't just limited to towards the mass or middle, middle ground players, or where the field is quite crowded. It's extending towards the very top end, the luxury, the premium players where they've even really leaned in to promotions and price adjustments to try and stimulate demand and edge out the competition.

10:06
Chris
And then you get these, these rising freight costs, which I know you believe that freight could be one of the biggest risks to gross margin expectations in 2025. So it's a bit of an opposite effect. Can you go into that a bit?

10:18
Phillip B
Absolutely. So freight, container costs, you know prices are 3x, over 3x versus last year where they stabilized you more in line with pre-pandemic leveles. And I think everyone is still scared a little bit jarred from 2021 when container cost surged closer to $20,000 after hovering around $1,500 for, you know, the decade before the pandemic.

Obviously we're not there yet, and retailers seem a bit more comfortable in the current environment where everyone isn’t ravenous for inventory and demand is out of control and they're afraid of losing the sale. But that being said, I think that there's a more minimal impact this year, but the space has a much larger exposure than most given the heavy, bulky, fragile, customized nature of the product.

If the average retailer spends about 5% of sales on freight, players in the furniture and home improvement industry are usually spending 2 to 4 times that. So there's potential for a much bigger impact, especially next year, especially if demand quickly inflects, retailers and brands are going to start to look to get a little bit deeper in the inventory to keep up with those sales under a better demand environment, especially if they're trying to fight for, to remain top of mind for a consumer, who is starting to look to renovate or, you know, refinish their home, and then there's also a lot of brands are going to start to renegotiate their contracts in the spring, which is keeping them a bit more insulated now. But, if prices, freight costs remain elevated at current levels, when they're renegotiating, they're going to lose a lot of that power. And, you know, there's a potential for a strike along the East Coast and Gulf Coast ports this year, you know, later in September. So that could cause some additional volatility.

So just given the exposure here in the overseas sourcing for a lot of these players in the space, I think that this could be, you know, a pretty meaningful impact on 2025 gross margins without, you know, as much power to take price like they had in 2021 where organic demand and was high. And, you know, pricing didn't matter so they could cover, margin with price. And I don't think that we're in the same environment now given the promotional structure of the space. I think that a lot of these costs would end up having to be eaten.

12:24
Chris
All right. So, obviously, we're into more or less the last stage of the presidential election. And, you know, you mentioned in the report that the near-term impact of an election cycle can be a significant headwind on demand, particularly for higher ticket discretionary purchases like furniture and home renovations, and so forth. Can you dive into this a little bit? Especially the reasons why furniture and home improvement tend to be so sensitive to the election cycle.

12:53
Phillip B
Yeah, absolutely. So, yeah, the consumer always gets a little wary around election seasons, right? I mean, there's just a lot of uncertainty. There's a lot of noise. And so retail sales usually trend down 0.7% during an election season versus what their average was heading into it. Necessities tend to be a bit more insulated here.

And on the opposite side of this, higher-ticket discretionary items tend to be more exposed here. So that really hits the space. So home improvement furniture, electronics and appliances are three of the most impacted categories historically over the past several elections, you know, which range down some 2 to 4% compared to pre-election season trends versus the broader average, around 0.7%.

So a lot of that has to do with larger ticket that is just becoming not as palatable, especially for, you know, a wary or more volatile consumer backdrop. And then marketing I think plays a more important role here where the consumer these higher ticket, you know, more considered purchases, you know, you need marketing to kind of stimulate that, that demand, stimulate that need.

And so these are, this is an industry that relies heavily on, you know, sort of that top of funnel awareness, starting to trigger that in, you know, the consumer's purchase decision journey. And that gets crowded out in this space, particularly the mattress industry. Right? That's a heavily reliant industry that relies on TV advertising and broadcast.

And that's tough during the election cycle, where there's expected to be quite a bit more investments in ad spend and political ad spend this year. And it's tough to cut through all that noise and reach the consumer to try and trigger that purchase. So I think that this could be a bit more of a risk, in the fourth quarter than what expectations are building in right now.

14:47
Chris
So let's look further out into 2025. In the report, you focus next year’s outlook primarily on interest rates, inflation, and tariff expectations. Do you mind just walking us through your expectations there real quick?

14:59
Phillip
Yeah, absolutely. So I think that the biggest question mark right now is, is around interest rates. Right. And so I think that even if we get a couple of interest rate cuts at the beginning of this year, you know, maybe a little bit more in the beginning of next year. I don't think mortgage rates are really going to become palatable until the spring, which really is more in line with when the real estate market really starts to pick up, or the housing market really starts to pick up. When volumes are pretty light in the fall, the winter phase, but really start to pick up during spring.

So I think that that's the more meaningful point of inflection here. So, if we start to see a big pickup in existing home sales beginning in the spring, it's still going to take a while for it to show up in the numbers. Right? So even if a housing sale occurs in May, we saw a 30 to 60 day closing period.

And then you know, these are more considered bigger ticket purchases. So it takes a while. There's still a journey around it. There's a big consideration period, usually lasting 1 to 3 months. I think home improvement, the home improvement category will be prioritized here. Obviously, you know, consumers usually want to finish anything like that, before they get furniture.

You know, you don't want to dust and paint all over your brand new furniture. So I think home improvement is better positioned to see a quicker inflection, maybe by mid-year. And then, you know, furniture I think will be more of a third or fourth quarter story where it's still going to take a little bit longer from a consideration period.

Lead times are a bit longer. So I think that that's going to be against what expectations are currently for things to start to normalize on January 1st. I think that that's probably overly optimistic at this point. I think the first half is still going to be a bit choppy, and probably a bit promotional. I think we need to see the housing market start to inflect, and organic demand to really start to spur before we see some normalized around price. Tariffs are a bit of a wild card.

Around a third of the industry is still sourced from China. So, you know, any sort of 60% increase in tariff would obviously have a very meaningful impact on this model. I think names that have obviously a bigger manufacturing presence domestically are better positioned here. I would call out the mattress industry in particular, where they have a very strong domestic presence, and then probably some of the premium players where they have a more diversified supply chain, particularly throughout Europe or domestically. They kind of insulate them a bit more versus some of the discount, you know, hyper value focused players, which still primarily focus sourcing from China.

But in general, I think expectations are still a little bit built up for 2025, still expecting some growth. But I think it's very much heavily relying on interest rates starting to see a recovery here in the housing market.

17:44
Chris
So last question, and this is at the end of your report, you say that despite a potentially choppy second half of 2024 and a potentially weaker half of 2025, your belief is that the furniture and home improvement market should maintain stable growth in the 4% to 6% range over the long-term horizon. Can you break down some of the trends and tailwinds you're seeing that support that? It doesn’t have to be all of them, just a few.

18:07
Phillip
Yeah, absolutely. So I mean, I think a lot of this comes down to volume, right? I mean, remarkably volumes have been flattening out right around 2019 levels this year. And, you know, while that seems depressing compared to all of the growth we saw in 2020 and 2021, it's actually pretty encouraging if you think about the we're holding units while existing home sales are some 25% below 2019 levels. And so I think that there are several structural tailwinds in the housing market that should support elevated growth here and that are supporting unit demand right now. But I think we really could start to see an acceleration. And we have pent up demand across younger generations, population growth and markets with more favorable housing demographics, the need for more space. There's still a housing shortage here in the US. And that's causing aging housing stock, which is rising the need for remodels. Rising home prices are providing better returns and providing more reassurance around investing in the home. And that, I think, most importantly, you know, the increasing importance of the home. Obviously, the pandemic, you know, changed how we view the home and how much time we spend at home. In 60% of our survey respondents work from home at least one day a week with a third working fully in a remote capacity. And that skews higher income.

So I think that the home has taken on a whole new meaning for a lot of Americans. And I think that that's going to support higher elevated spend. There's also an increasing services component, you know, 50% of home improvement projects are done by a professional. 25% of design projects are completed by a professional. And that continues to increase. And with that, the scale of renovations and the price of renovations should increase. And I think a lot of that comes down to services are becoming more accessible to a lot of people. And, you know, the value of DIY is losing some of its luster. Interior design services were previously thought of as something only available to the ultra-wealthy. And, you know, they’ve become available to the masses and through, you know, either online offerings and AI, so I think those are some key drivers in the space and prices historically been a headwind. We talked a little bit about that. But I think we could see some stabilization in the space. Retailers got smarter during the pandemic and consumers got used to a bit longer lead time.

So I think that there's going to be less need for hyper promotions and discounts under a more normalized demand environment. That being said, value is still very important. You know, the rise of the dupe culture is still very much alive here. So, you know, still expect value players do very well here. But I don't think we're going to be seeing quite the need for as much, deep discounts as what we've seen in the past.

20:49
Chris
Got it. Well, Phillip, this has been great. For those interested, the report is called “Furniture and Home Renovations: Post-pandemic Normalization and the Next ERA of Growth.” In addition to what we spoke about today, it also includes a proprietary consumer survey that focuses on the evolving consumer sentiment around the housing market and the impact on demand and purchasing behaviors for furniture and home improvement projects, along with valuations and stock thoughts for each relevant company he covers.