Lumber Liquidators (NYSE:LL) is a low cost provider of flooring which operates discount stores across the United States. They maintain this “advantage” by locating stores in low-rent areas (translation – inferior locations), developing direct relationships with mills, and most importantly, sourcing about 40% of their total product from China. Typical stores are 6,400 to 6,600 square feet and leased for five years with renewal options. Each store has a manager and a few associates paid a low base salary plus bonus. The company was founded in 1994 and went public in 2007. Tom Sullivan, founder and chairman, owns roughly 13% of the shares outstanding.
Hardwood floors represent 57% of their sales with the company’s flagship Bellawood product making up 20% of net sales in 2009. LL also sells laminates (18%), moldings (13%), and bamboo/cork products (11%). Their top ten suppliers accounted for 69% of 2009 flooring purchases with 44% sourced from Asia, 37% from North America, 13% from South America and 6% from other locations. All foreign purchases are negotiated and paid for in USD. In 2009, 88% of orders went through their Virginia distribution center. They are expanding a new program where goods are shipped directly to stores from China. LL’s hardwood flooring market share was roughly 10% in 2009 (8-9% in 2008 and 7% in 2007).
Bulls view LL as one of the few remaining retail growth stories as management aims to open a few dozen stores annually for the next several years in a roughly equal mix of new and existing markets. About half of the company’s stores have opened in the past three years. It is easy to understand why when new stores are typically profitable within three months and have returned the initial cash investment within a year. But while a rapidly expanding store base has produced revenue expansion throughout the housing bust, same store sales fell off a cliff during this period.
We wonder how quickly bullish optimism over new store growth might turn into concerns for cannibalization as comps at mature stores continue to deteriorate. As we discuss in detail below, we believe demand for LL’s core products are set to decline next year as the foreclosure moratorium and expiration of homebuyer tax credits will have a meaningfully negative impact on existing home sales. With “the street” forecasting a much stronger outlook for home prices (we struggle to find anyone calling for a decline more than 0% – 5%), investors in LL shares are set up for a major disappointment.
Wall Street claims that LL’s low cost advantage provides the company with a market niche that is difficult to lose. Bulls point to its focused product assortment, direct sourcing and “good customer service” as core competitive advantages over “big box” retailers. We think “the street” is missing several key issues that are likely to present major challenges in the year ahead.
First, gross margins are likely to come down more than expected due to rising energy and transportation costs and increasing wage pressures in China. Because labor is a greater percentage of the total cost for engineered wood flooring, increasing Chinese labor inflation would quickly put a big dent in any “cost advantage” assumed by the bulls. In addition to downward pressure on gross margins, we also anticipate upward pressure on SG&A due to continued difficulties with the implementation of SAP into next year.
Management guidance and “the street’s” acceptance that this is a one or two quarter blip runs contrary to past experience. Last but certainly not least, we are shocked by investors’ total and complete disregard for the pending US International Trade Commission investigation into Multilayered Wood Flooring [MLWF] imports from China. At best, this investigation introduces substantial uncertainty into the business and serves as a distraction to management’s limited time and resources. At worst, if the ITC were to set a tariff anywhere near the maximum level requested, we believe LL’s business model and “cost advantage” would be severely challenged.
Shares of LL rose 375% from a low of $7.02 in March 2009 to a high of $33.41 earlier this year. It’s worth noting that Tom Sullivan has sold roughly five million shares since the March lows with the great majority of sales at prices north of $20. At last week’s closing price of $23.42, the stock changed hands at 24x and 18x 2010 and 2011 consensus earnings expectations, respectively. Analysts are looking for 30% earnings growth next year driven by new store openings, operating leverage, and stabilization in the domestic housing market.
We have our doubts. Taking management at their word that MLWF only represents 10% – 11% of total sales, we estimate that a 50% tariff on Chinese imports would reduce next year’s earnings to $0.94, other things being equal. An earnings miss of this magnitude would likely result in multiple compression, as valuations of “high growth” retailers are inherently unstable. For perspective, note that LL has traded as low as 8.6x and as high as 27.6x forward earnings since the company went public.
Even giving the company the benefit of the doubt, and maintaining the stock’s current forward multiple, shares could easily trade down toward the $11 to $16 range based on the midpoint of our estimates highlighted in this report. If our estimation that LL’s exposure to MLWF represents a much larger share of the hardwood segment is correct (our research points to anywhere from one half to two thirds of segment sales), the impact would be much, much greater. And a higher tariff (potentially north of 200 percent), when combined with greater exposure to engineered flooring (as we believe), could present a disaster scenario for LL shares.
Disclosure: At the time of publication, the author was short Lumber Liquidators (LL), although positions may change at any time.
Disclosure: Short Lumber Liquidators