Background
Lumber Liquidators Holdings Inc. (LL, Financial) is the largest specialty retailer of hardwood flooring in North America, offering an assortment of domestic and exotic hardwood species, laminate, vinyl, cork, tile and more.
Headquartered in Toano, Virginia, the company was founded in 1993 when Tom Sullivan, a building contractor, began buying excess wood from other companies and reselling it from the back of a trucking yard. In November 2007, Lumber Liquidators had its initial public offering. It currently has 385 stores and plans to have more than 500 stores by 2022.
In 2013, Lumber Liquidators revealed its poor sourcing practices resulted in the destruction of tiger habitats and forests. Then in 2015, the company found its Chinese-made laminate floors had a high level of cancer-causing formaldehyde. The stock price dropped from the peak of over $110 in 2013 to as low as $11 in 2016 before recovering to the current price of around $39.
New management was installed to fix the problem. Current CEO Dennis Knowles took over in March 2016. Knowles served 15 years in various roles at Lowe’s Companies Inc. (LOW, Financial), including chief store operations officer from 2012 to 2015.
In the most recent quarter, same-store sales were up 8.8% and the gross margin, excluding certain one-time items, recovered to 35% from the 2015 low of 28%. The stock responded very positively and was up 36% on the day of the announcement.
Thoughts on stock
With an experienced, solid management team in place, Lumber Liquidators looks like it is finally moving in the right direction. Same-store sales turned positive this year and the gross margin has recovered. After a 250% increase in the stock price during the process of derisking, the question now is if the stock is attractively valued.
We think the price is fair, but does not offer enough margin of safety.
We think the company's normalized earnings is around $2 a share based on the current store count of 385, normalized sales per store of about $2.9 million, normalized gross margin of 35% and net margin of 5%.
Normalized sales per store of $2.9 million
From 2008 to 2014, the average sales per store was $2.92 million a year. In 2008, the company possibly benefited from the boom period in 2007. Between 2012 and 2014, the company benefited from very cheap sourcing from international companies, which caused problems later on. Therefore, $2.9 million per store seems to be a reasonable assumption. The company’s competitive advantage was in good sourcing. It remains to be seen whether that competitive advantage remains after the company steers away from questionable sourcing and becomes larger.
Normalized gross margin of 35%
Prior to 2011, the gross margin hovered around 35% with the net margin at 4% to 5%. Gross margins improved significantly between 2012 and 2014. Moreover, the improvement in gross margin directly dropped to the bottom line. We believe the margin improvement in those years was largely due to the decision the company made to start sourcing questionable supplies from international markets. Therefore, there was no need for higher marketing and promotions to win customers over. For a 4% to 5% net margin business, a dropdown of 6% gross margin improvement would double the earnings. Going forward, the gross margin is likely to be more or less the same as prior to 2012 at about 35%. The net margin is likely to be at about 4% to 5%. These are consistent with the much larger store chains Home Depot (HD, Financial) and Lowes. In the most recent quarter, Lumber Liquidators achieved a 35% gross margin, excluding certain one-time items, and is expecting the margin to remain in that range in the short term.
We think Lumber Liquidators could be a double-digit grower off its normalized base. The company guided more than 500 stores by 2022, which is about 5% to 7% store growth a year. Combined with 3% to 5% same-store sales growth, the company could be a double-digit grower on a normalized basis in the medium term.
If the $2 normalized earnings is about right, with the stock price at $39, Lumber Liquidators has a 20 times price-earnings (P/E) multiple with a good balance sheet growing at a double-digit rate for several years. It is not expensive, but it does not provide a good enough margin of safety for several reasons:
- It takes time for the earnings to return to normal. The current consensus earnings estimate for 2018 is 63 cents, with individual estimates ranging from 16 cents to $1.31. The journey for the turnaround could mean material volatility and uncertainty.
- The ultimate liability caused by Chinese-made laminate flooring is still unknown. Although the fine and legal fees would not usually kill a company of reasonable size, the Chinese-made laminate flooring does contain excessive chemicals that could cause cancer. The short sellers estimated there could be one million people exposed to this flooring. A few cancer cases could bring another wave of negative headline news and bigger damage to Lumber Liquidator’s reputation and financials. In fact, even after the stock dropped from $100, there are still more than a quarter of the shares shorted on this $1 billion market cap stock. Is there something the short sellers know that we do not?
- It is hard to have a significant competitive advantage in this highly competitive, highly fragmented market. To us, selling flooring is a commodity business. Companies usually brag about the material and the look of their flooring, rather than the brand name it carries or where they buy their flooring from. High-quality flooring material can be sourced by people who pay a higher price. It is a mystery to us what the company could offer over its competitors other than price.
- Selling flooring appears to be a quite cyclical business. This is demonstrated by the volatility in Lumber Liquidators’ same-store sales.
- The company's valuation does not appear attractive compared to Home Depot and Lowe’s. Home Depot is at 19 times 2017 earnings. Lowe’s is at 15 times. These two companies have much bigger scale (therefore stronger purchasing power), longer track records of excellent operations and much stronger brand names. They have a bit lower growth, but also much lower risk. We believe they are equally attractive from a risk-award point of view.
Lumber Liquidators' shares would appear attractive below $30.
Disclosure: We do not own LL shares.
