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Lumber Liquidators Puts A Profitable Floor Under Your Portfolio

August 02, 2014
One of the things I look for as a value investor is a business that provides products or services that everyone needs. If the business also has some sort of competitive advantage, I get even more interested. Unfortunately, most businesses that fit these first two criteria also normally come with premium valuations that put them beyond the reach of serious value investors.

One thing you can definitely say about Wall Street and the average investors that pay attention to what the “experts” say is that they really know how to overvalue a good business and are quick to punish a stock price when unrealistic expectations fail to be reached. These situations are when businesses that meet the criteria for sustainable value creation meet the kind of market valuations that allow value investors to step in. I believe that the reason most investors fail to do well investing is stocks is that they are looking for excitement and mistakenly confuse that with profits. Most people do not like “boring”; value investors seek it.

The tag line on my website (Self-Made Millionaire Academy) reads: “Virtually no one gets rich overnight, everyone should get rich in their lifetime.” It is there to remind my readers that investing is not about “get rich quick schemes” that, more often than not, leave investors broke and broken; it should be about building wealth steadily over a lifetime. Warren Buffett (Trades, Portfolio), arguably the best investor of all-time once quipped that his investment style “is best described as lethargy bordering on sloth.” Finding fairly priced or discounted businesses with enduring value to their customers, taking a positon and holding for years of steady growth in the businesses profits, rather than living and dying with every quarterly earnings report, it the true path to wealth creation. Unfortunately, it can be seen by many as “boring’ and slow, steady returns do not make for the most scintillating conversation at cocktail or dinner parties. They just make you very, very wealthy over the course of a lifetime.

Value Created By Disdain And Disappointment

Fast growing businesses tend to become Wall Street favorites because they make compelling promotional stories when it comes to soliciting new clients. They do not, however, always create the most compelling investments for the benefit of shareholders. Always remember the greatest question any investor can ask their broker: “Where are your customers’ yachts?” When these exciting fast growth stories end, and they always do, it is rarely pleasant for those who own the stock, especially the most recent buyers. However, their heartbreaking losses can become the wealth building gains for the value investors who were patient.

Lumber Liquidators Holdings Incorporated (LL), appears to fit into this category quite nicely. On November 15th of last year, Lumber Liquidators reached its 52-week high of $119.98. Imagine the hopes and expectations of those who purchased shares that day based upon the glowing recommendations of the Wall Street investment banks. The stock price began to fall. It recovered much of its loss by February 2014; but then the decline began again. This time, by July 8th, the stock had fallen to $76.59; but the story did not end there and it did not end better.

On July 9th, the company revised its 2014 projections for earnings and revenue. The new guidance lowered expectations for this year’s revenue from a range of $1.15 billion to $1.2 billion to a range of $1.15 billion to $1.1 billion. The company also lowered its projection for this year’s earnings from a previous range of $3.26 - $3.60/share to a new estimated range of $2.60 - $3.00/share. The stock price plunged over 20% and investors fled in fear. I guess it is safe to assume that those investors who bought the stock at $119.98 on the advice of their “investment advisor” in November of last year will not be buying their yachts anytime soon.

But, those of us who were not privileged enough to have receive that sage advice to buy, might be able to find ourselves able to take advantage of the mistaken attempt to get rich overnight by others in order to help ourselves get rich over a lifetime. You see, Lumber Liquidators always had a product we all need, they sell flooring materials and we all need floors. The problem was, being loved by Wall Street advisors made the stock prohibitively expensive. Now, some disappointing short-term news has created an exceptional opportunity for long-term investors.

When I sell cover call options, I have a cute little term I use for it; I call them coin toss calls. The term originated from the old adage: Heads I win; tails you lose. My adaption of this adage to selling covered calls is: heads I win; tails I win a little more. Lumber Liquidators fits this definition in a business sense as they win by selling discount flooring to homebuilders if the market for new houses is strong and they benefit by selling flooring upgrades to existing homeowners who stay in their current homes and simply upgrade when the housing market is soft. Heads they win; tails they win a little more.

A Stable Business Is Fine But We Still Require Excellent Value

When evaluating businesses that have experienced sharp decreases in the stock price, it is important to understand the downside protection provided by the business fundamentals for any capital allocated at the present time.

In the case of Lumber Liquidators, the stock in not “cheap” by traditional metrics but establishing the true value of a business entails consideration of all aspects of the business based upon present conditions and future prospects. I don’t know what the short-term quarterly results for Lumber Liquidators might be but I do know that everyone needs a floor beneath their feet and that need should provide assurance that Lumber Liquidators will have customers who need their products no matter what happens in the housing market.

At the current share price of $53.49, the stock is priced 55% below its 52-week high. While this figure actually has no meaning in assessing the intrinsic value of the business, it is interesting to note how much more some investors were willing to pay just a few short months or even days ago. But every sustainable and profitable business does have intrinsic value.

The average earnings estimate for 2014 from the analysts covering Lumber Liquidators is $2.72/share, toward the low end of the company’s revised guidance. Analysts do not like to be wrong and they especially do not like being wrong to the high side of actual earnings. That kind of wrong can get them fired. This current estimate is 1.89% below what the company earned last year so it should be a relatively conservative figure. If correct, this earnings figure would value the business at a multiple of 19.6 times current year’s earnings. The multiple falls to 16.6 times earnings when the consensus figure for 2015 is used. The 2015 estimated earnings figure represents an impressive growth rate of 18.19% year over year and would easily justify the current multiple of valuation.

Furthermore, the analysts are projecting that Lumber Liquidators will maintain an annual growth rate in earnings of 19.5% over the next 5 years. The current earnings multiple is very closely aligned with the multiple for the entire S&P 500 but the forward growth rate is far superior. This gives us a very strong indication that the company is undervalued compared to the broad market and this undervaluation should provide a modicum of risk protection during a broad market correction.

Over the last 10 years, Lumber Liquidators has increased it sales from $171.77 million in 2004 to $1 billion in 2013. During that same span, earnings increased from just $7.99 million to $77.4 million, an astonishing 10-fold increase in 10 years! That record of accomplishment goes a long way toward explaining why the company was so highly valued last year. The past might not predict the future; but, it does tell us with great certainty that the management team knows how to build this business and do it while increasing profits as well.

It is hard to find better protection for our allocated capital than a management team with a long-term proven record of exceptional results. Always remember, management does not determine share price, the market does that; management creates value for shareholders by expanding sales in a profitable manner. There are not a lot of management teams out there today that can boast of a record like Lumber Liquidators has built.

Final Thoughts And Actionable Conclusions

In my view, Lumber Liquidators represents a compelling value at the current price with an exceptional management team possessing an impressive record of accomplishment in terms of creating shareholder value. While it is not priced inexpensively in terms of present value, the value of selling products everyone must have and the future prospects for the business to continue its past growth rate, justify a premium to the broad market and there is none in existence. This represents an excellent example of what I describe as “equal to means cheaper than.” The current valuation is equal to the current market but the superior prospects for the business should justify a premium price.

Passive investors can simply buy the stock at the current market price and enjoy years of superb capital gains to come as the business grows and the stock price follows. However, there are also other potential ways to open new positions in Lumber Liquidators that deserve serious consideration, depending on your individual circumstances.

Discount minded investors might wish to consider selling the September 20, 2014 expiration put options with a strike price of $45/share for a premium of about $0.70/share. For each put option sold, the seller would have the obligation, but not the right, to buy 100 shares of the stock at $45 should it be trading below that price on September 20th. The $45 strike price of these contracts represents a discount of 15.6% to the current share price and the $0.70 premium collected by the seller represents an immediate return of 1.55% against the capital required to purchase the shares should it be required. Over the 48-day life of the contract the $0.70 premium collected represents an annualized return on capital of 11.8%. Not great, but not bad simply for agreeing to buy a stock in 48 days for 15.6% less than it costs now.

Those investors who are interested in buying the stock today and creating a synthetic dividend to enhance their investment returns can consider buying the shares at the current market price and simultaneously selling one September 20th covered call option for each 100 shares of the stock they purchase and collect a premium of around $1.00/share, representing a return of 1.55% for the 48-day life of the contract. This transaction would produce an annualized return of 14.2% against the allocated capital of $5,334.00/100 shares of stock purchased.

Should the price of the stock remain below $60 through September 20th, these options would expire worthless and the seller would retain ownership of the shares. Should the stock price rise above $60, the buyer of the options would exercise their right to take the shares at the $60 price and the seller would be left with the premium collected plus the additional $6.66/share capital gain. This $7.66 total gain over 48 days represents a return on invested capital of 14.36% or 109% on an annualized basis.

There you have it. One fine business; three compelling ways to open a new position. Sort of like an investing buffet.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


Rating: 3.3/5 (3 votes)

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Comments

robertcray
Robertcray - 2 months ago

That Lumber Liquidators is still in business is a little surprising inasmuch the online product reviews say their quality and customer service are horrible. Their gross profit margins don't seem reasonable and there are serious questions about the sources of the wood they get from China. Given the high PE ration I can't see that there is any moat or safety in the stock, maybe at $ 10-20/share but certainly not over $ 50.

Ken McGaha
Ken McGaha - 2 months ago

If everyone agreed on what constitutes compelling value, there would never be any compelling value to be found. It is the very existence of the disagreement on fair value of businesses that creates the opportunity for individual investors to outperform the market indexes by selecting the undervalued businesses and avoiding the overvalued ones.

If my analysis produced results that received widespread acclaim, who would be available to purchase shares and drive the price higher? Buying what the world hates and selling what the world loves is how contrarian investing works. When there are differing views on a particular subject, one is correct and one is wrong; time will always tell.

pravchaw
Pravchaw premium member - 2 months ago

I never knew this company till I read your article. The stock seems to have gone parabolic in 2012-13 and is now crashing. Thanks for the hat tip but I want to see some significant insider buying and guru buying to validate the thesis - falling knife and all.

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