Lumber Liquidators (LL) is a current pick of GuruFocus’ Buffet-Munger screen. The Buffett-Munger Screener can be used to find companies with high quality business at undervalued or fair-valued prices (click Here for more info).
Despite an impressive run beginning in 2012, LL shares are down ~50% from their highs for a variety of reasons which we will discuss.
Let’s look into the business model, recent troubles, and current valuation to determine whether this presents a buying opportunity for the long-term investor.
The business:
LL is the largest specialty retailer of hardwood flooring in North America. Since its first retail store opened in 1996, the company has developed a national store base and sells its flooring products through its retail stores, call center, website and catalog. The company’s sales network offers an extensive assortment of hardwoods, laminates, bamboo, cork, flooring enhancements and accessories.
Its biggest proclaimed competitive advantage is working directly with mills to provide customers with a broad assortment of high-quality products at a lower cost than its competitors. This leads its product offering to be substantially comprised of proprietary brands, including its flagship Bellawood brand.
The rest of its stated competitive advantages are what you would typically expect from a consumer-facing retailer:
While retail is often a difficult business, LL has shown a consistent ability to drive top-line growth across a variety of business cycles. Additionally, management has been able to grow book value and profitability alongside rising sales.
What has led to the recent price correction?
For a company that has shown an ability to consistently grow shareholder value (as measured by book value), the last 12 months have been difficult. The company has lagged on almost every measure of financial performance:
The primary culprit of poor financial results has been slowing existing home sales. Existing single-family home sales fell 3.1% during 2014 to 4.9 million, following three years of positive growth. As median home prices have rebounded to pre-crisis levels, existing home sales growth has predictably leveled off.
Because LL’s sales are strongly correlated to home remodels/improvements, weak existing home sales has crushed LL’s same store sales growth rate.
Unfortunately, this negative headwind may not abate any time soon. Total existing homes available for sale is nearing a ten-year low. And while housing affordability has buoyed existing home sales throughout the last three years of rapidly rebounding prices, this has largely been a result of lower interest rates, not rising income levels. With the large inventory of existing homes cut in half over the past five years, median sales prices up to pre-crisis levels, and affordability artificially inflated, LL may face slower same-store-sales growth for the foreseeable future.
Negative investigation overhang persists:
LL has also been under investigation for illegal importing practices. According to a report filed by the Environmental Investigation Agency:
"EIA's investigation revealed that since the 2008 Lacey Act amendments became law, Lumber Liquidators has imported millions of square feet of solid oak flooring from a manufacturer that freely describes its own illegal logging practices and that buys wood from suppliers that are under scrutiny by Russian authorities for illegal logging in the most threatened temperate forest in the world."
The investigation posits that LL acquired a large portion of its flooring materials from a supplier in China known for ties to illegal logging in Russian forests. These factors questioned the integrity of LL’s current sourcing practices, and led to an investigation of their importing practices by the Department of Homeland Security as of September of last year. The investigation is still ongoing and has yet to reach a conclusion.
If LL is found guilty that would be a clear violation of the Lacey Act amendment of 2008 and would lead to penalties ranging from $100,000 to $500,000. The largest costs would be compliance related however. If found non-compliant, LL would need to completely overhaul its entire supply chain process.
Whitney Tilson (Trades, Portfolio) has a major short position:
Tilson's primary argument has been that a large portion of LL's recent increases in gross margins can be attributable to decreased product acquisition costs (as a result of sourcing illegally logged wood).
“I now believe that my investment thesis a year ago – that Lumber Liquidators almost certain was (any may still be) sourcing illegally harvested Siberian hardwoods from Chinese mills – is only the tip of the iceberg. I believe that Lumber Liquidators is trafficking in tainted wood to a much greater degree than just hardwoods – and I think I will soon be able to prove this, so stay tuned.”
Despite the plunge in share price since his short pitch, Tilson reiterated his recommendation in October.
His short position has added to what has been a six-year trend of rising short interest.
Over this time, insider ownership has also shrunk from >40% to practically nothing.
Conclusion:
While LL appears to be a historically consistent compounder of shareholder value trading at a rare valuation, this may be one to put in the “too hard” pile. Existing home sales growth may see a pick-up from recent levels, but the next five years are certaintly less attractive than the past five years. Meanwhile, the latest EIA investigation may unmask the unfair practices that have lead investors to believe this is a competitively viable business. Additionally, the rapid reduction in insider ownership may reflect managements reduced faith in the underlying fundamentals.
For future potential ideas like this one, please reference GuruFocus’ Buffet-Munger screen.
