Lumber Liquidators is a short due to lack of inventory control and balance sheet discipline.
Lumber Liquidators (LL), located in Toano, VA, is a specialty retailer of hardwood flooring and accessories. The products are mostly sold under private label brands, including the premium Bellawood brand. LL primarily sells to contractors or to homeowners through a network of 213 stores located in 46 states. Customers can also order product through the company website.
Sales for the most recent quarter of $153.2 mm, December 2010 were up 10.5% over $137 mm December 2009 and for the year ended December 2010 sales of $620.2mm were up 12.2% over the prior year sales of $544.5mm. Net income for the most recent quarter was $5.9mm compared to $7.1mm for the quarter ended December 2009. For the year ended December 2010 the company had net income of $26.2 million down from 2009 net income of $26.9million.
We have identified a number of disturbing trends over the last several quarters and for that matter the last two years. Inventory at year end 2010 was $155.1 million increasing from $133.3 million for the year ended 2009. The increase in inventory has been persistent over the year and represents an increase of 14.4% for the year which outpaced sales growth of 12.2% for the year. Days inventory was 132 days for the December 2010 quarter which was slightly higher than the 131 days for the September quarter. Overall days inventory have increased roughly 15 days since December 2009. This is a particularly disturbing trend given the company has a slogan of "never out of stock" and they feel this is a competitive advantage over their competition, which are mostly HD and LOW.
There are a number of problems that are posed by the increase in inventories. First of all gross margins have fallen to 33.9% which is the lowest they have been in the last 4 years. While the company claims to have operating leverage we see things a bit differently by looking at the sales to net fixed assets. The quarter ended December 2010 sales to net fixed assets were 20.9 down from the previous year of 31.2. Sales to net fixed assets have fallen every quarter for the last 2.5 years. The company also has very weak cash flow which has primarily been impaired by the increases in inventory. We feel a major red flag is the fact that cash flow has been lower than net income consistently for the last four years and hasn’t shown any sign of turning. All of this has continued to put pressure on operating margins of LL for the past several years. We have seen operating margins fall to 6.8% for the year end December 2010 down from 8% for the year end December 2009.
Operating margins got crushed in the September quarter due to the failed implementation of SAP software implementation negatively impacted earnings for the quarter. Rarely does a company come out and put down a software provider that is supposed to make the company more efficient. We think this is not an SAP problem but more of a management issue. Competition is intense with Home Depot (HD) and Lowe’s (LOW) taking mindshare from contractors and individuals looking for more than just lumber. We feel that LL is losing customers to competition.
Their inventory is a trend in my opinion and negatively impacting the company even if it isn’t a long term trend the company has not been able to leverage their new fixed costs and fixed assets. It is pretty clear to us that the company has limited operating leverage. In fact on the most recent call the company speaks of adding new managerial staff to better facilitate their "never out of stock" slogan. Another key point in our short thesis is the fact that the housing market doesn’t appear to making a turnaround anytime in the near future and employment and spending does not appearing to be picking up.
We would short the stock before the release of earnings on April 27 and think the stock should ultimately trade into the mid teens over the next 6 months. We think the company is at best a 10% growth company and doesn’t deserve to trade at a premium.