I was reading a Lumber Liquidators-focused article by Seeking Alpha author Elephant Analytics where he/she provides a potential valuation range of $10-20/share. I've found this author to be a fairly neutral arbiter of this company despite the fact the accusations made against Lumber Liquidators have made it a polarizing company to follow. I've written a couple of articles in the past delving into the weeds of formaldehyde testing and compliance, and recent regulatory and legal decisions have validated my assertion that there never was any evidence that Lumber Liquidators was not CARB-compliant, let alone poisoning people. With the regulatory and legal clouds lifting, I take my own look at the valuations of a "normalized" business.
I am fully aware that "normalized" is a subjective word. For the purpose of this article, I characterize normal by two distinct eras in the company's history. Obviously, pre- and post-formaldehyde poisoning accusations. However, it's also characterized by the eras before and during CEO Robert Lynch's tenure (January 2011 to May 2015).
I'm posting 10 years of Lumber Liquidators' financials below to get a sense of the company's performance up to the recent formaldehyde scare, however, of particular note is the marked improvement in gross margins over the Lynch era, going from ~35% to 40% in short order. Many have argued this remarkable increase was not sustainable, and the fact the company chose to stop selling the cheap Chinese laminates is used as evidence those margins were indeed unsustainable.
However, Lumber Liquidators has stated the Chinese laminates were only 10% cheaper than other sources. I believe the Chinese laminates accounted for 15% of sales although it might have been 20%. If I did the math right, I come up with the Chinese laminates accounting for about one percentage point of gross margin, i.e. the 40% gross margin would only be 39% without the 10% cheaper Chinese laminates.
10 Years Of LL Financials
|Revenue $US M||332||405||482||545||620||682||813||1,000||1,047||979|
|Cost $US M||222||270||315||350||404||441||505||589||629||700|
|Gross Profit $US M||110||135||168||195||216||241||309||411||418||279|
|Op Ex $US M||89||116||131||151||174||198||230||285||314||362|
|Op Inc $US M||21||19||37||44||42||42||78||126||104||(83)|
As you can see from the table above, even before Robert Lynch took over as CEO in 2011 revenues and profits had doubled over a four-year period and gross margins had improved from ~33% to ~35%. In other words, Lumber Liquidators' pre-formaldehyde scare success was not solely attributable to Lynch's tenure.
Elephant Analytics' valuation uses a revenue range from the current run rate of ~$940M to 2015 (formaldehyde tainted) revenues of $975M. Gross margins range from current (less one-time expenses) of 33% to pre Lynch high 35% for the $10-20 fair value range.
This is what got me to start looking at valuation myself. For my valuation, however, I don't completely discount the improvements in the Lynch era, and I assume the company can eventually get back to same-store sales levels on par with the pre-formaldehyde scare levels. Make no mistake about it, current same-store sales are abysmal, and getting back to pre-scare levels is going to take significant time. However, this isn't the first company tainted by controversy, and time has healed many other wounded companies in the past. Eventually, consumers forget and move on.
One caveat, as I note in my profile, I have no formal financial background. I am self taught with a healthy dose of help from the good folks at TMF when I was a TMF Hidden Gems sub. Tom Gardener put out a valuation metric he terms "Owner Earnings" that is popular among TMF subs and one I like to use. I'm going by memory (I may make a mistake), however, it's net income adjusted to a 36% tax rate, plus depreciation and amortization and less maintenance Cap Ex.
I'm going to tie this all into a table with a range of valuations, however, here are the parameters of the table. I use pre-formaldehyde scare 2014 revenues of $1,047M, assuming these represent normalized same-store sales levels. Lumber Liquidators added new stores in 2015 and will continue to do so going forward. That said, ball-parking same-store sales will normalize in maybe 2017 or 2018, there is a factor of safety built in with more stores contributing to the $1,047M revenues.
As I noted earlier in this article, I do agree that 40% gross margins were likely not sustainable, however, I don't necessarily agree that all of the improvement under CEO Lynch was unsustainable. One credible article I saw in the past ball-parked sustainable normalized margins at 36-38%. For the purpose of my valuation, I start with the pre-Lynch gross margin of 35% and work my way up to 38%. One last tidbit regarding Lynch era performance, it took place at a time when new home starts were at an all-time historic low about 1/3 of the long-term 50+ year average and about 1/2 the lows of any previous recession. An even more remarkable or unbelievable performance depending on how you choose to look at it.
I was going to include depreciation and amortization as well as Cap Ex in the financial table I added earlier in the article, however, I thought it might be confusing, so I will just note that depreciation and amortization went from $3M to $17M from '06 to '15 and Cap Ex went from $3M to $22M from '06 to '15. For my valuation, I use 2014 depreciation and amortization of $15M. Maintenance Cap Ex is hard to quantify. Given LL is in growth mode, it makes sense most of the Cap Ex is for growth, however, I ballpark $5M as maintenance, and for my valuation, I combine the +$15M depreciation and amortization with the -$5M maintenance Cap Ex for a $+$10M combined total.
|Revenue $US M||1,047||1,047||1,047||1,047|
|Gross Profit $US M||366||377||387||398|
|Op Ex $US M||314||314||314||314|
|Op Inc $US M||52||63||73||84|
|Net 36% Tax||33||40||47||24|
|Dep-Am; Cap Ex $US M||10||10||10||10|
|Owner Earnings $US M||43||50||57||64|
|Owner EPS $US||1.59||1.85||2.11||2.37|
A bit of housekeeping, the $314M Op Ex in the table is the 2014 operating expense. For owner EPS, I use the current 27M share count. I also like to add (subtract) net cash or cash less debt, however, they are about the same for Lumber Liquidators so they cancel out.
In regard to the comparisons to Elephant Analytics' valuation, I fully concede the author as a much more sophisticated investor than I am, and I am not criticizing this person's work. I believe the author is using conservative numbers and a shorter-term outlook for a company with a lot of unknowns right now in order to incorporate a significant factor of safety. There is nothing wrong with this approach, and it is a prudent way to mitigate losing money. The one drawback is by the time the unknowns are clear, a large part of the upside will be gone as well. That said, I'm sitting on losses in Lumber Liquidators right now, and based on the trading pattern noted in Elephant Analytics' articles, there's a good chance this person is sitting on a net gain.
While I do not believe in technical analysis, I do think an investor can gain some insights into the valuation from trading ranges in the context of fundamental analysis. Looking at LL's price chart over the Lynch era, as expected, animal spirits took over as gross margins rapidly improved with a high of ~$119/share going into 2014. I did not follow the company at this time, however, the stock rapidly comes back to earth with some sort of news in July 2014, causing it to fall to a range of ~$55-~$65 until the bottom fell out six months later when the 60 Minutes hit piece was first aired.
Given gross margins went from 41% in 2013 to 40% in 2014, I suspect the rapid decline in July 2014 was based on news that gross margin was going to decline in 2014. I bring this up because the trading range it settled into was not too far from the high end of my valuation and might be an indication that my valuation range could be valid; assuming LL can get back to pre-scare same-store sales levels and at least some of the Lynch era improvements in gross margin are sustainable.
Whether LL can get back to pre-scare same-store sales is the biggest unknown at this point. Sales trends since the hit piece was aired over a year ago have been horrendous and have yet to show signs of a turnaround. I don't watch 60 Minutes, however, I believe the piece on LL was aired two more times after the initial airing, and from comments on message boards, it sounds like they periodically update the story with any news that supports the conclusion of the original piece. Given this recurring headwind, it's not hard to understand why Lumber Liquidators has yet to show signs of a turnaround in sales.
Given the current performance of LL, it's hard to fault anyone for being pessimistic about getting back to pre-scare same-store sales levels. It's hard for me to be confident it will happen even though I've seen other companies weather the "bad actor" storm and eventually get back to normal. Given that there is no reason to expect significant improvement in sales any time soon, however, the stock has moved significantly off of its recent lows; it looks to me like Mr. Market is starting to look forward to when sales do eventually turn around. Elephant Analytics seems to see this as irrational exuberance and a chance to short LL; I see it as a sign that maybe I'm not alone in thinking "this too shall pass". Time will tell who is right, although we may both be right in different time frames.
Disclosure: I am/we are long LL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.