Editor's Choice

Will Lumber Liquidators Walk the Plank in 2013?

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

As Foolish long-term investors, we should delight in finding responsible, growing companies which are built to last a lifetime.  After all, as Warren Buffett wrote in his 1989 letter to Berkshire Hathaway shareholders, "Time is the friend of the wonderful business, the enemy of the mediocre."

However, this doesn't mean we should be willing to pay any price to invest in otherwise-great businesses.

The Stock

This in mind, Lumber Liquidators (NYSE: LL) has finally piqued my interest.  Following a gut-wrenching 29% loss in 2011, shares of the hardwood flooring specialist went through the roof in 2012, gaining 199% after exceeding analysts' expectations for three consecutive quarters.

To its credit, Lumber Liquidators didn't soar without reason; thanks in part to sourcing initiatives and a concerted effort by management to optimize their supply chain, the company's previous margin issues have largely disappeared.  In addition, as Fool contributor Rick Aristotle Munarriz wrote last week, with home prices finally on the rise again, Lumber Liquidators' revenues have grown as "folks hoping to improve the quality of their homes through hardwood [...] no longer have to worry about freefalling home prices taking their mortgages underwater."

Lumber Liquidators has also benefited from stagnant commercial real estate prices which have helped it maintain a comfortable rate of revenue growth through new store openings.  While the company is smart to avoid using leverage to finance expansion, that made it difficult to achieve its previous goal of opening 30 to 40 stores per year.  Still, as of the end of the third quarter, it remained on track to increase its store count by more than 9% with as many as 25 new locations by the end 2012.  

The Valuation

Despite these strengths, with the stock trading near 52-week-highs and its next quarterly earnings announcement fast-approaching, has Lumber Liquidators risen too far, too fast?  To help us find out, let's take a look at some of the company's key metrics next to two of its publicly-traded competitors:

<table> <tbody> <tr> <td> </td> <td>Lumber Liquidators</td> <td><strong>Home Depot</strong> <span class="ticker" data-id="203819">(NYSE: <a href="http://caps.fool.com/Ticker/HD.aspx">HD</a>)</span></td> <td><strong>Lowes</strong> <span class="ticker" data-id="204349">(NYSE: <a href="http://caps.fool.com/Ticker/LOW.aspx">LOW</a>)</span></td> </tr> <tr> <td><strong> Market Capitalization </strong></td> <td> $1.45 billion</td> <td> $94.48 billion</td> <td> $40.02 billion</td> </tr> <tr> <td><strong> Debt-to-Equity Ratio </strong></td> <td> 0.00</td> <td> 0.61</td> <td> 0.63</td> </tr> <tr> <td><strong> Current Ratio</strong></td> <td> 3.30 </td> <td> 1.50 </td> <td> 1.30 </td> </tr> <tr> <td><strong> Trailing P/E Ratio</strong></td> <td> 36.17</td> <td> 22.45 </td> <td> 21.36</td> </tr> <tr> <td><strong> Est. Forward P/E Ratio</strong></td> <td> 26.48</td> <td> 18.21 </td> <td> 17.11</td> </tr> <tr> <td><strong> Dividend Yield</strong></td> <td> N.A. </td> <td> 1.80% </td> <td> 1.80%</td> </tr> <tr> <td><strong> Payout Ratio</strong></td> <td> N.A. </td> <td> 41.00%</td> <td> 36.00% </td> </tr> <tr> <td><strong> Return on Invested Capital</strong></td> <td> 18.70%</td> <td> 15.00%</td> <td> 8.60%</td> </tr> <tr> <td><strong> PEG Ratio (5 yr expected)</strong></td> <td> 2.19</td> <td> 1.28</td> <td> 1.35</td> </tr> </tbody> </table>

Lumber Liquidators' balance sheet remains strong with more than $40 million in cash and no debt.  In addition, while the company doesn't pay a dividend, its impressive ROIC of 18.7% shows a knack for creating shareholder value by reinvesting capital in its business.

At first glance, however, Lumber Liquidators looks expensive, trading for 36.17 times trailing earnings and 26.48 times next year's estimates.  When measured against analysts' long-term growth estimates of 12.6%, LL has a PEG ratio of 2.19 -- a considerably-higher premium on growth compared to both Home Depot and Lowes.

On one hand, it's tempting to think this premium is well-deserved considering Lumber Liquidators has managed to grow revenues by more than 13% for each of the past five years, all while maintaining an impressive annual EPS growth rate of 18.87%.  On the other hand, LL's current trailing P/E ratio still looks uncharacteristically-high when compared to its five-year average at 23.67.  In fact, going back even further, note Lumber Liquidators current trailing P/E is the highest the company has seen since going public in 2007.

Despite my concern, Lumber Liquidators may yet find a way to grow into its outsized valuation. Management has, after all, stated they expect fourth quarter gross margin to "continue its cumulative, multiyear expansion," albeit at a slower pace than the 250 basis point increase we saw in the third quarter.

The Foolish Bottom Line

To be sure, Lumber Liquidators is a solid business with a sterling balance sheet and enviable future growth prospects.

That said, I'm convinced this is a perfect example of a great company whose stock has simply gotten ahead of itself.  If margins or revenue show any signs of slipping, shares of Lumber Liquidators could face an intolerant buzzsaw in the form of our overactive stock market.  

In the end, while I'll readily admit the stock could go higher from here, its current valuation remains too high for me to comfortably jump on board.

Steve Symington has no position in any stocks mentioned. The Motley Fool recommends Lowe's Companies, Inc., Lumber Liquidators, and The Home Depot, Inc.. The Motley Fool owns shares of Lumber Liquidators. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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