LL isn’t a big position for me, so I hadn’t done a deeper dive until now. Below are my notes based on the company’s 10k, recent conference call, and some historical data points (based on SSGPlus data points).
Overall, after going through all the information at hand, I feel LL is potentially a solid market beater from its current prices. The 60 Minutes expose will likely only have a short-term impact; the fundamentals of the company look solid and it’s nicely setup for long-term growth.
I 'm planning to increase my stock position.
Earnings Release: http://investors.lumberliquidators.com/2015-02-25-Lumber-Liq…
Lumber Liquidators is the largest North American speciality retailer of hardwood flooring products. As of 31 December 2014, LL operated 352 retail stores across North America, with all but nine stores located in the US. LL currently has 9 stores in Ontario Canada. Lumber Liquidators was founded in 1994 and they IPO’ed in 2007. Some other key points about Lumber Liquidators:
o They operate with a direct sourcing model and currently have relationship with 130 national and international mills
o They seek long-term, core relationships with mills committed to their product specifications, sustainable supply and regulatory compliance standards. In 2014, top 20 suppliers accounted for approximately 62% of the supply purchases; largest mill partner represented 7% of the supply. One advantage of having an extensive and stable network of supplier is the ability to get better pricing. As Lumber Liquidators footprint and product sales increase, having a stable supply system ensure quality products, without bottlenecks and good prices.
o Lumber Liquidators appear to be doing a fair bit to stay ahead in terms of regulatory requirements, although this has been a point of contention among naysayers and short sellers. In their 10K, they note the following:
In the first quarter of 2015, we expect to begin operating a 1,500 square foot lab within our new East Coast distribution facility. The lab will feature two temperature and humidity controlled conditioning rooms and two emission chambers correlated to a California Air Resources Board (“CARB”)-approved Third Party Certifier. This equipment mirrors the capabilities of CARB and other state-of-the-art emission testing facilities. We believe no other flooring retailer has comparable facilities. This new lab will complement and augment the capabilities of the facilities we operate in Toano, Virginia and in Shanghai, China, as well as those utilized by our suppliers.
o Their typical sales mix consists of solid & engineered hardwood products (40%), laminate, bamboo & vinyl plank (40%), and moldings & accessories (20%). This varies a bit year to year but seems to be more or less along this distribution for the past 3-years.
o Product sourcing mix in 2014 was 49% North America, 40% Asia, 6% South America, and 5% Europe & Australia.
o Bellawood is their flagship brand. It is a collection of solid and engineered hardwood flooring, bamboo flooring, moldings and accessories. These products come with a transferable 100-year warranty. Bellawood brands were 16.3% of the flooring sales mix in 2014, up from 15.9% in 2013. The following is from the 10K about investments in Bellawood product line:
In order to control the quality of our Bellawood brand, we maintain a finishing facility in Toano, Virginia. In 2014, we finished more than 28 million square feet of flooring, including approximately 92% of the Bellawood demand. To supplement the Bellawood production needed, we utilize, certify and continually monitor the finishing processes of certain mills in both North America and South America. In 2014, we invested in a second finishing line at our Toano facility to more than double our finishing capacity. We have planned a total investment of approximately $5.1 million in connection with this project, with $4.3 million expended in 2014, and expect the second line to be operational in the first quarter of 2015.
o LL is currently upgrading their retail store model, with the new model allocating more space for the ‘showroom’.
o LL’s 10K puts the 2014 retail value of the U.S. hardwood and laminate flooring markets were approximately $4.8 billion and $1.9 billion, respectively. These are based on industry estimates. LL estimates a 9% share of this market. The market is expected to grow at 4-5% rate over the long-term and LL can gain market share by capturing sales from the small mom & pop stores. The hardwood flooring market is highly fragmented.
Risks & Issues
Government investigation into importation of wood:
On Sept 26, 2013, US government officials raided LL’s corporate headquarters for important documents pertaining to imported wood. It appears DoJ is contemplating criminal action against LL under the Lacey act.
Various California-based Litigations
o The Prop 65 allegation involves potential violation of California’s Safe Drinking Water and Toxic Enforcement Act; the Prop 65 Plaintiffs allege that LL failed to warn consumers in California that certain of our products (collectively, the “Products”) emit formaldehyde in excess of the applicable safe harbor limits.
o The Balero matter alleges unlawful and fraudulent business practices by selling certain products in California that do not comply with California’s Airborne Toxic Control Measure to Reduce Formaldehyde Emissions from Composite Wood Products (the “CARB Standards”) and by falsely advertising and representing that such products meet the CARB standards.
The 60 Minutes Expose
This apparently looking at a combination of issues noted above. This is what Lynch noted in the conference call:
I want to also reiterate our position of product safety. We now believe the news program 60 Minutes will feature our company in an unfavorable light with regard to our sourcing and product quality, specifically related to laminates. We believe this story will be a derivative of Prop 65 matter and Balero [ph] matter disclosed in our 10-K. We have not factored any adverse impact on customer demand into our 2015 outlook but we will vigorously challenge any false allegations or factual incorrect presentations.
Financials and 2014 Results
Revenues: $1.05B (2014), $1B (2013), $813M (2012)
Comparable store sales: -4.3%, 15.8%, 11.4%
Net income: $66.3M, $77.4M, $47.1M
EPS: 2.31, 2.77, 1.68
Diluted shares out: 27.5M, 27.9M, 28M
Some discussion points:
o The 2014 financial results were generally below expectations but it’s worth noting that these results had pretty though compares because of two sequential years of double-digit increases in comparable store net sales and 640 basis points of operating margin expansion. The 2014 sales were impacted by several factors, including:
- Weakness in the number of customers invoiced
- Slowdown in the aggregate sales of single family homes, which were negative on a year-over-year basis through September 2014.
- Constrained inventory levels on certain products also impacted sales.
o Gross profit margin for 2014 was 39.9%. This compares with 41.1% in 2013 and 38% in 2012. Profit margins of this business are strong. Management explains the 120 basis points reduction in gross margin by ad-hoc discounting at point of sales, net shift in sales mix, and changes in sourcing mix. These costs were offset a little bit (10 bps) by reduction in transportation costs.
o Management claims that new marketing campaigns started in November 2014 are producing results. For example,
- In December 2014, they observed a 8.1% increase in the number of customers invoiced
- At December 31, 2014, open orders (customer orders awaiting pickup or delivery) had increased $18 million, or 69.0% in comparison to December 31, 2013.
Note, however, that this could also be attributed to weak comparable numbers and improving sentiment.
o 2014 was a year of significant capital investments. Management claims the following:
- Completed a significant optimization of supply chain, including implementation of product allocation intelligence, operation of a second major distribution center on the West Coast, and construction of a million square foot facility on the East Coast, which was fully operational in January 2015;
- Improved the finish and expanded the assortment of the flagship brand Bellawood;
- Purchased a second line for finishing, which is expected to be fully operational in the first quarter of 2015;
- Invested in the initial steps to vertically integrate the supply of domestic hardwood;
- Opened 34 new store locations in the expanded showroom format and remodeled 17 existing stores, including 13 relocated within the primary trade area.
o The balance sheet is strong with no debt. They have $20M in cash & cash equivalents. They produce healthy cash flow from the operation and this should be enough to fund growth initiatives. Note that the company has been buying back stock:
In 2014, cash and cash equivalents decreased $60.3 million to $20.3 million. The decrease of cash and cash equivalents was primarily due to $53.3 million of net cash used to repurchase common stock and $71.1 million for capital expenditures partially offset by net cash provided by operating activities of $57.1 million.
2015 Guidance and Valuation
o Capital expenditure between $25 and $35M.
o Open between 30 to 35 new stores using up about $10M cash.
o Remodel/renovate about 15 to 20 stores for about $5M cash.
o Currently 85 stores provide installation services. They want to increase this to 150 by end of 2015.
o Complete East Coast distribution centre, continue vertical integration initiatives, and continue some of the new promotional activities.
o They have seen strong customer demand since the beginning of the year in comparison to 2014. Note that beginning of 2014 was impacted by severe weather. They noted the following in the conference call:
Net sales through February 23rd were up 21.4% with comparable stores up 12.1% driven by a 16.8% increase in the number of customers invoiced and partially offset by our lower average sales. Further, open orders have increased 24.5% over the balance of February 23, 2014.
However, they also noted that the new promotional campaign, which appears to be aggressive with respect to pricing (potentially to get market share), along with shifts in the sales mix are going to impact gross margins. They expect Q1 gross margins to be around 38 - 38.5% versus 39.9% reported for FY 2014.
o Management is guiding for Net Sales b/w $1.14B and $1.21B; comparable sales increases b/w 3 - 9%; EPS b/w $2.50 - $3.00. EPS estimates don’t consider impact of share repurchases.
There’s a fair amount of pessimism baked into LL’s stock. The stock took a big tumble, potentially because of the weak results and also because of the impending 60 minutes expose. Now, some of these matters have been around for a while and it appears that LL has made amends to address various issues. I doubt the 60 minutes program will have any long-term impact on the company. I ‘m encouraged by a few factors:
- The comparisons for 2014 were though as the company was up against superb comps in the prior year.
- Management stated that the beginning of 2015 is looking good.
- The company is debt free, founder led, and has put in solid infrastructure investments in the prior years, which should help in the years ahead.
- It’s the leader in the Wooden Flooring space and can continue to grab market share by aggressive marketing and pricing, which will impact gross margins in the short-term but will enable it to expand and grab market share over the long-term.
- The balance sheet is strong the company generates good cash flow.
- With so much pessimism, a positive Q1 outcome can give the shares a boast in the near future. With shares priced around $49, and looking at the guidance, and taking the mid-point (of a wide estimate), we get:
P/E (TTM): 21.23
P/E (NTM): 17.9
Note that at the mid-point, management is guiding for about 18% YoY EPS, so PEG (using PE, trailing twelve months) is about 1.16. Also, looking at historical data, it appears PE has been b/w 43 and 19 in 2013, 35 and 10 in 2012, and 35 and 15 in 2012.
Looking at these data points, managements execution and the company’s market positioning, I thinking a 15% eps growth over the next 5-years is quite possible. Assuming a PE of 20, I can estimate a price around $110 in this time frame.