Lumber Liquidators (LL) is a company that investors have piled into over the last year as a housing recovery play. From late April 2012, the value of the company has nearly tripled. At a recent closing price of about $70 a share, the company is valued at $1.9B. The company trades at over 40x its 2012 earnings of $1.68 per share. Guidance provided by Lumber Liquidators for 2013 earnings is a range of $1.90 to $2.15. If the company were to achieve the high end of its guidance, it would be trading at a multiple of 32x its forward earnings expectations. From a valuation standpoint, a compelling argument can be made that Lumber Liquidators is due for a large correction. As a comparison, Home Depot (HD) currently trades at about 20x the consensus estimate of forward earnings. Home Depot also pays a dividend that yields over 2% and provided guidance for same store sales growth of 3% this year. Lumber Liquidators currently pays no dividend and guided for same store sales growth of mid single digits this year. With that in mind, why should an investor choose Lumber Liquidators over Home Depot if they are looking for a housing recovery play? Lumber Liquidators is a misunderstood story that has benefited from the foreclosure crisis. It is quite likely this company will soon see its performance and stock price come back to reality.
The Problem Presented By A Healing Housing Market
If the housing market is on the road to recovery as many believe, this does not necessarily bode well for Lumber Liquidators. The chart below shows the significant run the stock has had in the past year:
Lumber Liquidators has benefited significantly from the housing crisis. As people abandoned their homes in droves, these homes often were utterly neglected. Those being foreclosed on had no incentive to maintain their home. The bank foreclosing on the home did not have the resources to maintain the home. The result being that these homes eventually require significant remodeling in order to become marketable again. One quick way to update a vacant home is to install new flooring, baseboards, or molding. This is a relatively straightforward project in an empty house. It is an entirely different project in a fully furnished and occupied home.
As the foreclosed homes were sold to new owners and investors, significant money was spent to rehab these homes. Lumber Liquidators clearly benefited from this spending spree. The chart below from Realty Trac shows a graph of foreclosure sales since 2005 and the percent those sales made up of total existing home sales:
What is striking about this graph is that from 2009 to 2012 foreclosure sales ranged from about 35% back down to 20% of total home sales. If you look back to 2005, you will see foreclosure sales are about 2% of total sales and a blip on the radar.
This concept is vital to understand because as foreclosure sales continue to trend lower the low hanging fruit for Lumber Liquidators will disappear. The products offered by Lumber Liquidators are the type that you buy once and probably never buy again for your house.
Another dynamic at play is the significant investor interest in purchasing single family homes as rental properties. These homes represent another lost opportunity for Lumber Liquidators. Consider that an investor wants to spend as little as possible on the upkeep and maintenance of a rental home. Outside of an initial refresh, these homes will not have substantial upgrades done to them because the rental profit margins are too low to justify the costs. The dynamic of large institutional investors buying homes and turning them into rental properties has largely played out already.
The Threat Of Increasing New Home Sales
A large portion of the positive news cycle on housing these days centers around the recovery in new home sales. The publicly traded homebuilders have also seen their stocks roar back over the last 12 months. Investors in Lumber Liquidators need to understand that any positive new home sales headline is a net negative for Lumber Liquidators. This concept is a quite simple one to understand. When a new home is sold, there is zero potential for Lumber Liquidators to profit from this transaction. It does not supply homebuilders with flooring. Those buying new homes do not ask the homebuilder to provide them an unfinished home so that they can go to Lumber Liquidators and enjoy a DIY project. These homes are entirely furnished and the interior furnishings often come with 10 year plus warranties. In a way, every new home built is a lost opportunity for Lumber Liquidators.
The company would like for you to believe that the growth outlook is rosier than it may seem. One problem the company faces, and actually admits to, is future stores cannibalizing sales at existing stores. On the last earnings call the company CFO made the following comment:
Cannibalization has been a fact for us, even as a young chain, just because of the very large radius that an individual store draws from -- our strategy had initially been one store in every major market, one store in secondary markets, so as we came back to add the second store, there was ample opportunity to increase the market yields, but we were certainly going to impact the sales in that store.
This is a very wordy answer from the CFO that can be summed up in a slightly easier to understand way. A store such as Home Depot offers a wide assortment of products enabling it to have multiple locations throughout cities. Lumber Liquidators has a niche product offering and thus needs to draw from a large geographical area to support the costs associated with running a store. The company is saying that it now intend to try to grow its business by putting new stores in geographic locations where it already has a presence. This is concerning because this represents a meaningful shift in strategy. If the company previously acknowledged that it easily could over saturate a market, what has changed for it to be willing to chase growth in this manner?
An additional item of concern about the future outlook for the company is its significant growth in inventory. At the end of 2012, the company had increased its store count by roughly 10% from the end of 2011. Its inventory balance had increased by about 30% from $160M to $206M during that same time frame. Seeing the inventory increase significantly outpace the store count increase is worrisome. Maybe that is why the company was running this advertisement the last few weeks:
Note the fine print at the bottom where the company is desperately trying to pump sales before its first quarter ends in March.
Summarizing The Opportunity
The opportunity to buy shares of Lumber Liquidators today is ill advised based on all the factors noted above. The company has reaped the rewards associated with the foreclosure crisis. It now must contend with a stagnant economy lacking banks and investors buying and rehabbing homes in bulk. Additionally the company faces formidable competition from Home Depot and Lowes (LOW). At some point, these two companies will also start searching for additional growth. The lofty gross margins of about 40% that Lumber Liquidators enjoyed in Q4 2012 will see downward pressure as these larger competitors pivot hard into this business. I recommend liquidating this stock from your portfolio before the rest of the market realizes that the growth potential is not what it seems.