Lumber Liquidators (LL) has seen its shares take a hit after a reported federal investigation, where allegedly its headquarters in Virginia had been searched by authorities. This type of risk is why we like to focus on the numbers with respect to our process. No matter how sweet the story may sound or how nicely an author can write prose, the numbers don't lie. Let's see what the numbers say about Lumber Liquidators.
- Lumber Liquidators earns a ValueCreation rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 43.8% from 31.3% during the next two years.
- Lumber Liquidators is the largest specialty retailer of hardwood flooring in the US. The company's product offering is substantially comprised of proprietary brands, including its flagship Bellawood brand.
- Lumber Liquidators' cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 2.5% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. The firm had no debt at the end of last quarter.
- Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
- Lumber Liquidators' growth story has been impressive. Total sales have roughly doubled since 2007, while its store count has grown from 116 to roughly 300 over the same time.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Lumber Liquidators' 3-year historical return on invested capital (without goodwill) is 24.2%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreationTM rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Our discounted cash flow model indicates that Lumber Liquidators' shares are worth between $47.00 - $79.00 each. You'll notice this range is significantly below its current stock price. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $63 per share represents a price-to-earnings (P/E) ratio of about 37.5 times last year's earnings and an implied EV/EBITDA multiple of about 19.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 13.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 14.3%. Our model reflects a 5-year projected average operating margin of 14.5%, which is above Lumber Liquidators' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5.7% for the next 15 years and 3% in perpetuity. For Lumber Liquidators, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $63 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRiskTM rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Lumber Liquidators. We think the firm is attractive below $47 per share (the green line), but quite expensive above $79 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Lumber Liquidators' fair value at this point in time to be about $63 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Lumber Liquidators' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $86 per share in Year 3 represents our existing fair value per share of $63 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements