Should You Liquidate Lumber Liquidators?

| About: Lumber Liquidators (LL)

Lumber Liquidators Holdings, Inc. (NYSE:LL) is a leading retailer of hardwood flooring with an excellent operating history. The company has no debt and a historical growth rate of 20% per annum. Moreover, it is expected to have an exceptional year in fiscal 2012 as earnings accelerate off of a flat base in 2011. However, we believe that short-term optimism has driven the stock to an unjustified high valuation. Business is good, and should continue to be good, but nowhere near as good as today's valuation indicates.

Growth stocks are defined as companies with high rates of change of earnings growth of 15% to 20% or better. Growth stocks offer the potential for share prices to rise in lockstep with their profit growth in the long run. Therefore, the PEG ratio formula (price equals growth rate) tends to be the most appropriate formula used to value growth stocks. However, due to the exponential nature of compounding large numbers, PEG ratio forecasts are capped at 40%.

Because of the higher valuation typically awarded to fast growth, growth stocks offer the potential for greater capital appreciation. On the other hand, they also offer higher risk. First, they tend to command much higher-than-average P/E ratios, and second, achieving very high levels of growth is very difficult to sustain. Consequently, forecasting future earnings growth is more important with high-growth stocks than any other class of stock. Also, the average growth stock typically puts all of its profits back into the company to fund its future growth, instead of paying dividends.

About Lumber Liquidators, taken directly from its website:

With over 280 locations, Lumber Liquidators is North America's largest specialty retailer of hardwood flooring. The company features more than 340 first quality flooring varieties, including solid and engineered hardwood, bamboo, cork, laminate and resilient vinyl. Every location is staffed with flooring experts who can provide advice and useful information about Lumber Liquidators' low priced product, much of which is in stock and ready for delivery.

Earnings Determine Market Price

The following earnings and price correlated F.A.S.T. Graphs™ clearly illustrates the importance of earnings. The Earnings Growth Rate Line or True Worth™ Line (orange line with white triangles) is correlated with the historical stock price line. On graph after graph, the lines will move in tandem. If the stock price strays away from the earnings line (over or under), inevitably it will come back to earnings.

Lumber Liquidators: Historical Earnings, Price, Dividends and Normal P/E Since 2007

Click to enlarge images.

The Two Keys to Long-Term Performance

Years of research and experience have taught us that there are two critically important keys to achieving above-average, long-term shareholder returns at reasonably controlled levels of risk. The first key is earnings growth, or what we like to call the rate of change of earnings growth. The faster a company can grow its business (i.e., earnings), the larger the income stream it can produce with which to reward shareholders. This is because of the power of compounding, which Albert Einstein was alleged to have called "the most powerful force on earth." Ultimately, both capital appreciation and dividend income will be a function of a company's ability to grow its profits.

The second key is valuation. When a company can be purchased at its intrinsic value based on earnings and cash flow generation, the shareholders' rate of return or long-term capital appreciation will inevitably correlate to and/or equal its earnings growth rate. Overvaluation will lower that rate of return and, conversely, undervaluation will increase it. Consequently, paying strict attention to the valuation you pay to buy a stock is a critical component of both greater return and taking lower risk to achieve it. Because, ironically, when you overpay for even the best business, you simultaneously lower your return potential while increasing your risk of achieving the lower return.

The associated performance results with the earnings and price correlated graph, validates the above discussion regarding the two keys to long-term performance. Notice the impact that valuation (black line above or below orange earnings justified valuation line) had on the following performance results.

The following graph plots the historically normal P/E ratio (the dark blue line) in conjunction with 10-year Treasury note interest. Notice that the current P/E ratio on this quality company is as high as it has been since 2007.

A further indication of valuation can be seen by examining a company's current price-to-sales ratio relative to its historical price-to-sales ratio. The current price-to0sales ratio for Lumber Liquidators is 1.78, which is historically high.

Looking to the Future

Extensive research has provided a preponderance of conclusive evidence that future long-term returns are a function of two critical determinants:

1. The rate of change (growth rate) of the company's earnings

2. The price or valuation you pay to buy those earnings

Forecasting future earnings growth, bought at sound valuations, is the key to safe, sound, and profitable performance. Therefore, it logically follows that measuring performance without simultaneously measuring valuation is a job half done. Lumber Liquidators is clearly an industry leading superior business, which based on the consensus estimates from leading analysts, appears to be capable of growing earnings at an above-average rate for the foreseeable future. At its current price, Lumber Liquidators is significantly overvalued relative to its past, present and future fundamentals. It currently offers a meager 3% earnings yield, which hardly compensates investors for the risk they are taking.

With most stocks trading at very modest valuations, it seems hard to justify today's lofty P/E ratio of 37.9. We believe this is more than likely driven by the high expectations for 2012 earnings growth of 50%. However, logic would dictate that this growth rate is unsustainable, and this view is corroborated by the consensus of leading analysts' forecast for long-term growth of 20%. Consequently, we believe that Lumber Liquidators' price is poised to come back to earth as earnings growth rates normalize.

The Estimated Earnings and Return Calculator Tool is a simple yet powerful resource that empowers the user to calculate and run various investing scenarios that generate precise rate of return potentialities. Thinking the investment through to its logical conclusion is an important component toward making sound and prudent commonsense investing decisions.

The consensus of 11 leading analysts reporting to Capital IQ forecast Lumber Liquidators' long-term earnings growth at 20% (orange circle). Lumber Liquidators has no debt of capital (red circle). It is currently trading at a P/E of 37.9 (blue circle), which is above the value corridor (defined by the five orange lines) of a maximum P/E of 24. If the earnings materialize as forecast, Lumber Liquidators' True Worth™ valuation would be $72.58 (Brown circle on EYE chart below) at the end of 2017, which would be a 7.7% (yellow highlighting) annual rate of return from the current price.

Earnings Yield Estimates

Discounted Future Cash Flows: All companies derive their value from the future cash flows (earnings) they are capable of generating for their stake holders over time. Therefore, because earnings determine market price in the long run, we expect the future earnings of a company to justify the price we pay.

Since all investments potentially compete with all other investments, it is useful to compare investing in any perspective company to that of a comparable investment in low risk Treasury bonds. Comparing an investment in Lumber Liquidators to an equal investment in 10-year Treasury bonds, illustrates that the company's expected earnings would be 4.8 times (purple circle) that of the 10-Year T-Bond Interest (see EYE chart below). This is the essence of the importance of proper valuation as a critical investing component.

Summary and Conclusions

This report presented essential "fundamentals at a glance" illustrating the past and present valuation based on earnings achievements as reported. Future forecasts for earnings growth are based on the consensus of leading analysts. Although with just a quick glance you can know a lot about the company, it's imperative that the reader conducts their own due diligence in order to validate whether the consensus estimates seem reasonable or not.

We think Lumber Liquidators is an exceptional retailer where, through no fault of its own, the market has driven its shares to nose-bleed valuations. Consequently, we believe it would be a good time to take some profits or even close out the position entirely. Even though housing is expected to rebound, it appears that Lumber Liquidators already has. Prospective short sellers may want to take a look as well, although momentum could continue to carry shares higher in the short run. On the other hand, we believe the long-term risk is high at these levels.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation. A comprehensive due diligence effort is recommended.