Lumber Liquidators Holdings Should Start Liquidating Inventory

| About: Lumber Liquidators (LL)

Lumber Liquidators Holdings, Inc (NYSE:LL) is a specialty retailer of hardwood flooring products via its website and 250 locations across the United States and in Toronto, Ontario, Canada. A reader passed this along to me, suggesting that it is a similar to hhgregg (NYSE:HGG).

How so? Both companies operate in relatively mature industries. Both have far larger, better funded and well-established competitors (in LL’s case, Lowe’s (NYSE:LOW) and The Home Depot (NYSE:HD)). Both have enjoyed significant revenue growth over the last few years, the result of (unlike their competitors) significant expansion opportunity as their primary markets are far from saturated. Neither have any debt, and both have a large stockpile of cash to help fund growth.

Let’s take a closer look. First, the revenue growth.

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Lumber Liquidators Holdings, Inc. - Revenue and Margins, 2002 - 2Q 2011

Revenue and Margins, 2002 - 2Q 2011

The company certainly has experienced significant revenue growth. Further, the company’s margins have stayed relatively stable, despite the recession. One would expect this company, operating in the home renovation market, would have experienced exceptional revenue disruption, but this does not appear to be the case here.

An inquiry into retailer revenues has to go beyond total revenues to also look at same store sales and (if available) sales per square foot. Total revenues as a metric can mask the underlying performance of individual stores where the store count is changing, which is the case with LL. The company reports comparable store net sales increased 1.6% in 2008, were flat in 2009, and increased 2.1% in 2010, and it appears the company has held its definition of comparable stores steady throughout the period. On its face, the company’s store-level sales seem to have held up.

So far, so good. Let’s take a look at returns, which give us an idea of whether the management has been a good steward of shareholder capital.

Lumber Liquidators Holdings, Inc. - Returns, 2002 - 2Q 2011

Returns, 2002 - 2Q 2011

The ROE line disappeared from 2004 to 2006 because equity was negative. Also, this was before the company went public, and I relied on unaudited figures. Overall, the company’s returns have been quite good, in the high teens and above, despite the recession hitting this industry hard. There is a downward trend to the company’s returns, but the company was rapidly deleveraging throughout this period, so I have little concern about the apparent trend. The last four years should probably be our focus, with the prior periods taken with a grain of salt. The conclusion I would draw is that the company appears to have done a good job with shareholder capital.

Speaking of shareholder capital, the company’s founder and chairman of the board Thomas Sullivan still owns 12.2% of the company. It is good that a large shareholder is on the board ensuring the company continues to act as a responsible steward of shareholder capital. The rest of management and directors combined own just a hair over 1 million shares, or another 3.6% of shares outstanding. This is a good amount of investment, so shareholder interests should be well represented.

Speaking of Sullivan, the company leases 27 of its locations from a group of companies that Sullivan has a stake in. This represented $2.635 million of lease payments in 2010. Generally, I don’t like these kinds of related party transactions. The company does not disclose enough information to determine whether these represent reasonable market rates.

Let’s look at cash and debt levels.

Lumber Liquidators Holdings, Inc. - Cash and Debt Levels, 2002 - 2Q 2011

Cash and Debt Levels, 2002 - 2Q 2011

I have included total debt the company’s redeemable preferred shares that were outstanding from 2004 to 2006, before the company went public. This chart reinforces the idea that we are dealing with prudent management. the company has had no debt since it went public, and has maintained a decent cushion of cash.

Let’s look at free cash flows.

Lumber Liquidators Holdings, Inc. - Free Cash Flows, 2002 - 2Q 2011

Free Cash Flows, 2006 - 2Q 2011

This is where the story takes a turn for the worse. As you can see, the company’s free cash flows have been, to say the least, weak. This isn’t exactly unexpected given the company’s growth, but it doesn’t help a value investor who wants a long track record of strong free cash flows, and is less enthralled by growth than most investors.

Unfortunately, the story gets worse. Much worse. Let’s look at the company’s cash conversion cycle.

Lumber Liquidators Holdings, Inc. - Cash Conversion Cycle, 2006 - 2Q 2011

Cash Conversion Cycle, 2006 - 2Q 2011

There is a definite trend here and it goes in the wrong direction. I think the chart masks the alarming growth in the company’s cash conversion cycle, which has increased from 62 days in 2007 to 100 days in 2010 -- and, on an annualized basis, has become even worse in Q1 and Q2 of 2011. The clear driver of this is the rapid rise in the company’s inventory levels, which have increased from a respectable 45 days in 2006 to a ridiculous 130 days in 2010 -- and 142 days this last quarter.

This kind of growth in days of inventory is a red flag that demands further inquiry. Here’s what the company says about its inventory in its recent 10-K:

Our most significant asset is our merchandise inventory. Merchandise inventory is considered either “available for sale” or “inbound in-transit,” based on whether we have physically received and inspected the products. We launched our initiative to strengthen our in-stock commitment to our top selling products in the fourth quarter of 2009. The increase in 2010 available inventory per store is primarily a result of the adverse impact of our reduced productivity.

Lumber Liquidators Holdings, Inc. - Inventory, 2008 - 2010 (source: Company 10-K)

Inventory, 2008 - 2010 (source: Company 10-K)

Over three years, the company has increased its inventory per store by 21.5%, so as to fulfill a commitment to being in-stock. This equates to a $32.3 million additional investment (a little over $1 per share) in inventory using most recent figures so this is hardly an academic inquiry. This comes at an opportunity cost for the company (opening new stores), but more importantly it comes at an opportunity cost for shareholders who could have invested the money elsewhere. It is impossible to know how much this investment helped the company’s earnings over the period, but assuming the company’s 4.6% historical profit margin continues, for a 10% ROI revenues would have to increase by $70.2 million to justify the investment – a high hurdle.

Let’s briefly discuss valuation. As usual, I looked at a variety of scenarios in calculating a valuation range based on earnings power and residual earnings. I concluded that, even in the most bullish of scenarios, the company is overvalued, suggesting that even my most bullish scenarios are not bullish enough for current LL investors. It appears to me that the company is priced for perfection, and then some. An investor at these prices has to be highly confident that growth will be strong and consistent, as there is little room for error.

Disclosure: No position