Warren Buffett (Trades, Portfolio) famously told us to be fearful when others are greedy, and greedy when others are fearful.
Could we use that proven advice when assessing Lumber Liquidators Holdings, Inc. (LL, Financial)? This young, small cap company has a strong history of growth on both the top and bottom lines. It also has a stock chart that looks like waves in hurricane season, as well as the attention of shorts and class action law firms.
LL currently has a place in the Buffett Munger screener (Charlie Munger (Trades, Portfolio) is Buffett’s partner in Berkshire Hathaway). It got on that list because of its strong and consistent earnings growth over the past five years, and because its PEG ratio is below 1.0, indicating it is undervalued at its current price.
Here’s a look at the company’s earnings (blue line) and share price (green line) over the past five years (the company began trading publicly at the end of 2007):
So, should we be fearful or greedy?
History
1993: Building contractorTom Sullivan begins purchasing excess wood from other companies and resells it from the back of a trucking yard in Stoughton, Massachusetts.
1996: The first store opens in West Roxbury, Massachusetts, eight months later, a second store opens in Hartford, Connecticut.
1999: Headquarters moves from Boston to Colonial Heights, Virginia.
2004: Because of growth, the company moves headquarters again, to Toano, Virginia.
2007: Publicly lists on the New York Stock Exchange, symbol LL.
2013: Number 17 on Forbes’ list of America’s Best Small Companies; several class action law firms announce investigations or plans for suits; sales go over $1 billion for the first time.
2014: Guru investor Whitney Tilson (Trades, Portfolio) announces he’s going short on the company; more class action law firms announce plans to launch suits.
History based on information at the company website and press releases at Yahoo! Finance.
Comments on LL’s history: A young company, one that’s been publicly listed since 2007. Grew rapidly to get to $1 billion in sales, but has attracted shorts and class action lawyers.
Lumber Liquidator’s Business
LL retails hardwood flooring. It operated 349 stores in 46 states and Canada, as of September 30, 2014 (Q3, 2014 press release).
Lumber Liquidators Holdings, Inc. is the parent company and operates through subsidiaries, including Lumber Liquidators, Inc., Lumber Liquidators Services, LLC, and Lumber Liquidators Canada Inc. It is a Delaware corporation with headquarters in Toano, Virginia.
LL carries solid and engineered hardwood, laminate flooring, bamboo flooring, cork flooring and resilient vinyl flooring, butcher blocks, molding, accessories and tools.
According to its 10-K for 2013, the foundation for its value proposition comes from its ability to source directly from mills, cutting out middlemen, for consistent quality and to reduce its costs. It adds that it is environmentally conscientious, and buys only from suppliers that practice sustainable harvesting.
It lays out the elements of its value proposition this way:
- Prices: generally lower than competitors, especially on premium products (less so at the entry or commodity level). In addition, “We are able to maintain these prices through our direct sourcing model, including the relationship with the mill, the proprietary products we develop and sell, the singular focus of our supply chain on flooring and our highly profitable store model.”
- Selection: “All of our products are sold under proprietary brands and across a range of price points and quality levels that allow us
- both to target discrete market segments and to appeal to diverse groups of customers.”
- Quality: “Proprietary brands..., allow us greater control over product design and production, which we monitor through an expansive network of experienced quality control and assurance professionals positioned both at the mill and at our distribution facilities.”
- Availability: focused supply chain; best selling products maintained as instock inventory.
- People. Positions its staff as hardwood flooring experts; educates store associates on product knowledge and engaging the customer in questions to identify appropriate products; call center staff are trained to support the associates.
The Other Side of the Coin
As we’ve noted above, LL claims to successfully manage availability. However that hasn’t always been the case.
In the Second Quarter 2014 press release, President & CEO Robert Lynch conceded, “"In certain key merchandise categories, primarily laminates, vinyl plank and engineered hardwoods, lower than planned inventory levels reduced our ability to convert customer interest into invoiced sales. Certain mills experienced production delays in meeting our open orders as we continued to enhance our quality assurance requirements....” That news caught analysts and the market off guard; the stock immediately dropped some 20%, prompting several of 2014’s class action announcements.
To cite one example of the legal threats, Strauss Law P.L.L.C made this statement in a press release on November 4, “...commenced an investigation into Lumber Liquidators Holdings, Inc. ("LL" or the "Company") to determine whether the Company's Officers and Directors have breached their fiduciary duties owed to the Company and its shareholders.”
We note that many such investigations are announced but do not necessarily lead to actual law suits, and that such announcements constitute allegations that have not been proven (and may not be proven) in court.
Revenue
Here's where the revenue originated, by product line, for the year ended December 31, 2013, from the Annual Report for 2013:
All operations and revenue are reported through one segment.
Competition
LL specializes in hardwood flooring, which competes with many other types of flooring including carpet, vinyl, and stone.
Within the hardwood flooring segment, the company describes the market as fragmented and competitive, “We face significant competition from national and regional home improvement chains, national and regional specialty flooring chains, Internet-based companies and privately-owned single-site enterprises.” Yahoo! Finance lists its competitors as CCA Global Partners, Inc. (privately-held, and the operator of some 2,700 retail flooring locations), Home Depot (HD, Financial), and Lowes (LOW, Financial).
Further, “We compete on the basis of price, customer service, store location and range, quality and availability of the hardwood flooring that we offer our customers. Our competitive position is also influenced by the availability, quality and cost of merchandise, labor
costs, finishing, distribution and sales efficiencies and our productivity compared to that of our competitors.”
Comments on the Lumber Liquidators business: A focused retailer with critical mass when it comes to finding a competitive edge: direct sourcing of products. It competes with everything from Home Depot to local flooring installers. Importantly, it has reached $1-billion in sales, which provides a sense of reassurance amid the claims of class action law firms.
Growth
The following chart shows how revenue has grown in the past five years (it has been a public company since 2007):
And this chart shows how EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) has grown in the same period:
In its 10-K for 2013, LL cites industry sources in noting several key growth issues:
- Hardwood currently enjoys an 11% share of the floor coverings market, and is slowly increasing its share;
- The hardwood flooring market will grow by 5% a year through 2018 (and perhaps more if the housing market picks up);
- Floor covering sales lag new home sales by about one year, and “... we believe we are well-positioned to benefit from an improving housing market in the coming years.”
Comments on growth: The much awaited strengthening of the housing market should work in LL’s favor, and it’s existing competitive edges should allow it to maintain and even grow its market share.
Management
Founder & Chairman: Thomas D. Sullivan, age 54, “He currently advises and supports our marketing and advertising departments and is active in our sourcing initiatives. He is involved with employee development initiatives and plays a key role in setting and maintaining our corporate culture.”
President & CEO: Robert M. Lynch, age 48, has held these positions since 2012. Before joining Lumber Liquidators in 2010, he held the same positions at Orchard Supply Hardware. Previously, he worked in various positions at The Home Depot, Accenture Consulting, and Ernst & Young. Reuters puts his basic compensation at $6,866,880.
Chief Financial Officer: Daniel E. Terrell, age 49, has held this position since 2006. Previously served as Vice President, Controller & Credit of Peebles Inc., a specialty apparel retailer.
Board of Directors: a board of nine, including two related directors (Chairman Sullivan and CEO Lynch) and seven independent directors.
ISS Governance QuickScore: LL receives a score of 6, on a scale in which 1 indicates less governance risk and 10 indicates more governance risk. The company receives red flags for Use of Equity, Pay for Performance, and Takeover Defenses.
Unless otherwise noted, the Management section is based on information at the company website and Reuters.
Comments on management and governance: Given the relative youth of Founder and Chairman Sullivan, as well as the ages of the senior officers, continuity should be no problem. Compensation, rather than succession, will be of concern to those who follow the thinking of ISS.
Ownership
Gurus: Five of the top investors followed by GuruFocus have holdings in Lumber Liquidators: Mariko Gordon (Trades, Portfolio), Columbia Wanger (Trades, Portfolio), Steven Cohen (Trades, Portfolio), Ron Baron (Trades, Portfolio), and Ken Fisher (Trades, Portfolio). Ron Baron (Trades, Portfolio) owns 2,190,374 shares, while the second largest position belongs to Mariko Gordon (Trades, Portfolio) with 1,116,711 shares.
Institutions: According to J3 Information Services, 102.4% of LL’s shares belonged to institutions on January 2, 2015. This holding of more than 100% is likely accounted for by institutional exchanges involving short sales.
Short Interests: Currently quite high, at 36.8%; as the following chart shows, it’s at the high end of a range that began establishing itself in 2010:
Insiders: A relatively high level of insider ownership, at 3%; not surprisingly the biggest position belongs to company founder Thomas Sullivan, who has owned 609,000 shares since mid-2013. And perhaps surprisingly, CEO Robert Lynch bought 6,000 shares last October and November.
Comments on ownership: On the positive side, guru Robert Baron is the third largest owner of LL shares, and both the founding chairman and CEO have solid stakes. On the negative, short interest is quite high, and the shorts include institutional investors.
Lumber Liquidators by the Numbers
Comments on LL statistics: The share price sits well below the 52-week high; Return on Equity is very good; the company does not pay a dividend; and there were no share buybacks in fiscal 2013.
Financial Strength
GuruFocus gives Lumber Liquidators a solid 9/10 for financial strength, and a modest 7/10 for Profitability & Growth:
What makes LL a financial standout is the absence of long-term debt. Looking at the 10-Year Financials, we see the company had $7 million in LT debt at the end of fiscal 2005 and fiscal 2006, and nothing since then. The company reports in its 10-K for 2013 that it has a $50 million revolving line of credit available if needed.
The absence of debt tells us the company has generated significant free cash flows; enough to fund its ongoing, rapid growth. It does not pay a dividend and its share repurchases have been relatively small.
The GuruFocus system issues two severe warning signs: one on the amount of short interest (noted above), and one noting that asset growth is faster than revenue growth.
GuruFocus explains the latter issue this way, “Total assets are all the assets a company owns. From the capital sources of the assets, some of the assets are funded through shareholder’s paid in capital and retained earnings of the business. Others are funded through borrowed money.” However, as we’ve seen, LL has not used debt in the past five years.
Free cash flow: the following chart shows us how free cash flow (blue line) had grown, then fell back. The green line shows us the share price:
Comments on Financial Strength: the chart above gives us some good insight into the share price performance. Most importantly, though, this company has no long-term debt, and that should it allow it to withstand quite a bit of adverse weather.
Valuation of LL
Companies that make it through the Buffett Munger screener at GuruFocus are described as “Good Companies At Fair Or Undervalued Prices”.
Lumber Liquidators earns “Good Company” status by having grown its earnings over the past five years, and done it consistently. It receives a 4-Star Predictability rating (4 out of 5) for this consistency. As we know, predictable companies generally outperform less predictable companies in share appreciation. In addition, a more predictable company is less likely to leave you with a loss if you hold it for a decade.
On January 28, 2015, LL ranked as the fourth most undervalued company on the screener, after PRAA, ARLP, and AHGP. This valuation was calculated by dividing the familiar P/E ratio by the average 5-year EBITDA growth. If the result, known as PEPG or PEG ratio, is less than 1.0, the company is considered under valued. If that ratio is 1.0 to 2.0 it is fairly valued, and anything over 2.0 over valued.
The PEG ratio for LL on January 28 was 0.81, which means under valued. We got that number by dividing its P/E of 25.00 by its 5-year EBITDA growth rate of 30.70%. You can also find the PEG ratio, without the arithmetic, by looking in the Ratios section of the GuruFocus Summary page.
And, how does that EBITDA growth look on a chart?
Looking ahead, the analysts followed by Yahoo! Finance expect earnings to grow by almost 22% in 2015, and average 18% over the next five years. While 22% and 18% are below the more than 30% over the past five years, such growth would still outpace the industry, sector, and S&P 500 (analysts expect the S&P 500 to average 8.37% per year over the next five years).
Finally, Lumber Liquidators has a good history of generating strong Return on Equity (ROE) numbers:
Comments on valuation: although beleaguered by failure to meet previous expectations, LL is still a robust company. Few others are likely to meet or exceed its ability to generate earnings of 18% over the next five years.
Opportunities & Risks
LL’s Annual Report for 2013 lays out the general theme of growing the business, around a couple of key elements:
- Stores: As well as expansion by growing the store count, LL is also doing more with existing stores. It has developed a new design, with a larger footprint, and in some cases, more ‘retail-centric’ locations. Combined, these elements have increased productivity and sales. At the end of 2013, 16% of stores had been converted to the new format.
- Marketing: The company’s Value Proposition idea has found its footing among consumers and the company intends to build on that to increase sales.
- Distribution: LL recently completed construction of a West Coast distribution facility and consolidated its East Coast distribution facilities, to improve product availability and productivity.
Like much of the housing industry, Lumber Liquidators will experience at least modest growth as prices recover and renovations of existing homes picks up. Of course, this depends a great deal on the general economic climate.
Risks
As noted, economic conditions have a direct bearing on LL’s revenues; one of the reasons for this is customers’ access to credit, whether through the Lumber Liquidators credit card or from banks and credit unions. The company has its own credit card, issued through third-party credit providers, and may not be able to access as big a line as it would like.
In 2013, about half of its products were sourced in Asia, and another 7% in South America. This exposes the company to a number or geographic risks, ranging from currency fluctuations to shipping availability and costs.
Although wood is a renewable resource, there are environmental situations and organizations to consider. The company depends on the integrity of arms-length suppliers to ensure it does not experience reputational harm. (for more on risks, see the annual 10-K reports)
Outlook & Conclusions
Considering the opportunities and risks together, along with some history and recent events, it seems likely Lumber Liquidators should continue to grow. and reward shareholders with capital appreciation.
However, recent events have shown that investors need a strong stomach to weather the ups and downs. This is still essentially a small cap company, with the advantages and disadvantages we might expect.
We also note investors need to be willing to live with a relatively high level of short interest, more than 30%.
Still, this is a stock worthy of further investigation by those looking for undervalued stocks with strong growth prospects.
And, to answer the question posed at the beginning of this article, if this stock were on my personal radar, I would be greedy, but also inclined to add a fairly tight trailing stop (maybe that caution explains why I’ve been less successful at investing than Warren Buffett (Trades, Portfolio)).
