Another Company Benefitting from the Housing Renaissance

William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Housing starts (new construction) rose to a five year high of 872,000 according to an Oct. 17 article,. Stocks associated with building, repairing and remodeling homes are also hitting new highs. Hardwood flooring is a popular choice in newly built or renovated homes. With the arrival of the housing renaissance, Lumber Liquidators (NYSE: LL), a retailer specializing in hardwood floors, stands to benefit.

Qualitative Elements

Lumber Liquidators recently laid the foundation for future success in the form of infrastructure investment, strategic real estate purchases, and building productive relationships with suppliers and customers.

In 2010 and 2011 Lumber Liquidators invested heavily in an information technology system that put a temporary burden on sales, gross margins, and free cash flow; a necessary move to keep track of costs and customer preferences. Other moves to improve infrastructure included building and supplying new distribution centers and stores.

The company employs strategic thinking in real estate when opening a new store by looking for areas accessible from main roads and in areas with lower rent. It adapts to existing buildings and enters shorter lease terms. If a more optimal setting becomes available Lumber Liquidators can take advantage of it.

Lumber Liquidators’ commitment to superior quality and low price stems from its relationship with mills. It sets the qualitative standards by which the mills have to abide. If the mills aren’t up to snuff, Lumber Liquidators moves on to someone else. Lumber Liquidators also ships directly from the mills to the stores to save on handling costs whenever possible.

Lumber Liquidators maintains good customer relationships with a call center, employing people knowledgeable about flooring to answer questions by e-mail and telephone.

Fundamentals

Lumber Liquidator's revenue increased 92% over the past five years (see chart below).

The implementation of the integrated information technology system mentioned above and the opening of new stores near established ones put a friction on growth over the past couple of years. As the company grappled with the implementation of the new system, product delays ensued, costing the company business. The opening of new stores in close proximity to established ones resulted in a comparable stores decrease of 2% in 2011. However, in the most recent quarter Lumber Liquidators’ sales increased 19%.

With the implementation of the new information system complete, the company should see less product delivery disruptions and loss of business. Lumber Liquidators saw a higher number of invoiced customers with more sales per invoice. A higher number of established stores, combined with increased sales of molding also helped drive the sales increase. Comparable store (a store open longer than a year) sales increased 12% in the most recent quarter.

<img src="http://media.ycharts.com/charts/f63bff6095aa7697f6dbb113e0aca661.png" />

LL Revenue TTM data by YCharts

As you can see in the chart below, gross margins (gross profit divided by sales expressed as a percentage) remained relatively low for the past couple of years. Margins were held low by transportation costs, expenses related to the information technology system, and underperforming products.

According to the latest earnings report, gross margin increased 250 basis points. Buying directly from mills, especially in lower cost regions such as Asia, drove the cost of merchandise lower. The optimal cost of merchandise occurs when the company bypasses warehouses and ships straight from the mills to the stores.

<img src="http://media.ycharts.com/charts/7451f581f43229154a977e86447c2448.png" />

LL Gross Profit Margin TTM data by YCharts

Free cash flow (operating cash minus capital expenditures) dipped into the negative for the past couple of years (shown in the chart below). Investment in store infrastructure such as the information technology system, new stores, and warehouses contributed to capital expenditures.

In 2012, with the infrastructure firmly in place and fewer capital expenditures, free cash flow expanded 68%.  Of course, increased foot traffic had something to do with this as well. Inventory buildup in anticipation of higher demand will produce temporary friction on cash flow.

<img src="http://media.ycharts.com/charts/8a1e139fe4da8cfcfc81e12f5a05d7d3.png" />

LL Free Cash Flow TTM data by YCharts

Lumber Liquidators possesses a good balance sheet. Cash to stockholder’s equity stands at reasonable 18%. It possesses no long-term interest bearing debt. Total debt to equity stands at 38%, below my personal threshold of 85%.

Management-Ownership

I always like to invest in companies in which management owns a great deal of stock. Management with a significant stake in the enterprise will take better care of it and try to make it as successful as possible. The founder and chairman of the board, Tom Sullivan, owns 4.5% of the company’s stock.

Competition

Lumber Liquidators competes in a highly fragmented market. According to Lumber Liquidator's 2011 10-K, Lowe’s (NYSE: LOW), Home Depot (NYSE: HD) and Lumber Liquidators together made up 37% of hardwood flooring sales. The remainder of the market includes independent retailers and smaller chains that offer other types of flooring and home improvement solutions.

Home Depot and Lowe’s don’t specialize in just hardwood flooring, so they may not be able to offer the variety of Lumber Liquidators, and their employees may not be as knowledgeable with so many products on their shelves. Also, the big box retailers don’t buy straight from the mills, which increases their merchandise cost.

Lumber Liquidator's market share continues to increase due to the decline in the number of independent retailers under difficult macroeconomic conditions. Independent retailers purchase merchandise on an intermittent basis, which prevents them from offering the steady business that suppliers crave compelling them not to offer price breaks. Small retailers also buy from local mills and distributors, which increases cost.

Weighing the Risks

Lumber Liquidators’ meteoric 205% rise in stock price year to date has resulted in a higher valuation. The P/E ratio of this company stands at 36. Any future earnings disappointments would butcher its stock price.

Political risk for Lumber Liquidators resides in the high range, with 42% of the company's products sourced from Asia. Currency fluctuations and possible civil unrest in the region could disrupt it’s supply chain.

The company’s prospects due to housing growth and an excellent balance sheet compel me to give Lumber Liquidators a low fundamental risk rating.

Conclusion

Lumber Liquidators will continue to deliver a high quality product at a low price. Good standing with suppliers will ensure that prices stay low. Keeping customers happy will compel them to come back. The housing recovery, good financials, management ownership, and greater market share will move the stock price forward.


stockdissector has no positions in the stocks mentioned above. The Motley Fool owns shares of Lumber Liquidators. Motley Fool newsletter services recommend The Home Depot, Lumber Liquidators, and Lowe's Companies. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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