Back in February, we recommended avoiding Lumber Liquidators (LL) stock despite it hitting a 52-week low. Since that recommendation roughly two months ago, shares are down a further 50%. At half the valuation, are shares now cheap enough to get interested?
The business
We went deeper into the roots of the business in our previous article, but from a macro perspective, Lumber Liquidators is the largest specialty retailer of hardwood flooring in North America. 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.
While retail is often a difficult business, LL has shown a consistent ability to drive top-line growth across a variety of business cycles.
Two major overhangs
LL’s sales are strongly correlated to home remodels/improvements, meaning weak existing home sales have crushed LL’s same store sales growth rate. Total revenues are roughly flat over the past two years after a decade-long period of rapidly rising sales.
Unfortunately, this negative headwind will continue to persist for years. Total existing homes available for sale is nearing a 10-year low. 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.
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.
Amid these swirling allegations, the CEO Robert Lynch resigned unexpectedly in late May. Founder Thomas Sullivan will take over as the interim CEO while the company initiates a national search for a replacement. The stock was down nearly 20% on the news.
Guru Whitney Tilson (Trades, Portfolio) believes that Lynch's resignation is a strong sign that Lumber Liquidators has been "knowingly poisoning" its customers and is guilty despite previous denials. Tilson believes that “if Lumber Liquidators was a good company with no formaldehyde problem – or was the innocent victim of nefarious Chinese suppliers – Lynch never would have resigned”.
CBS also aired a 60+Minutes+special earlier this year claiming that 302 Lumber Liquidators were linked to health and safety violations. Corroborating the EIA investigation, 60 Minutes found that Lumber Liquidators' Chinese-made laminate flooring contains amounts of toxic formaldehyde that may not meet health and safety standards.
Valuation
Whitney Tilson (Trades, Portfolio) didn’t cover any of his short position when the stock was above $30 for a few reasons. Chiefly, he thinks regulators (most likely the California Air Resources Board and the Consumer Product Safety Commission):
“...will announce that their tests of Lumber Liquidators' Chinese-made laminate are consistent with the test results commissioned by 60 Minutes, myself and others; that, consequently, they will take strong action against the company (perhaps requiring some of the steps that I outline above); and that the legal liabilities will be enormous, especially once hard evidence emerges that the company was knowingly poisoning its own customers.”
Secondly, he simply believed that shares are overvalued aside from the allegations. While it's a wide range, he believes shares are worth roughly $10.56-$28.16. With shares down to near $20 however, they look like they’re getting quite cheap.
Even with EPS estimates down dramatically, consensus estimates still have LL earning $1.54 next year.
Using that years EPS estimate as a base, the implied EPS growth rate that is priced into the stock is fairly low. Using GuruFocus’ DCF Tool, it looks like investors are pricing in mid-single-digit EPS growth over the long-term. This is quite below the company’s 10-year average of nearly 20%.
Even using half the 10-year average as our assumed growth rate, shares would be about 20% undervalued.
Conclusion
While it’s still difficult to argue for taking a position in the stock given the huge downside to negative investigation results that could take years to unwind (not to mention the weak macro housing market), shares are getting to a range where due diligence is warranted.
No doubt that if LL survives this mess, the share price will be a bargain at some point. For now however, it may be best to simply keep LL on your watchlist.
For more ideas like this one, check out GuruFocus’ 52-Week Low Screener or the rest of R. Vanzo’s Articles.
