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Today's Buy Opportunity: Lumber Liquidators

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When I first began researching Lumber Liquidators (NYSE: LL  ) , I joked with a few of my Foolish colleagues that it's a good thing that the company didn't franchise their stores, because if they did I wouldn't be working at The Motley Fool. Was I exaggerating? Maybe a little, but Lumber Liquidators has one of the most profitable business models that I have come across in any retailer.

What they do
Lumber Liquidators is the largest specialty retailer of hardwood flooring in the country.  While Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) are notable competitors, this industry is highly fragmented, with about 60% of market share being held by smaller independent flooring shops that sell mainly carpet. By focusing solely on hardwood, Lumber Liquidators is able to sell its flooring around 20% to 30% below the industry average. As a result, its primary customers are value-oriented, do-it-yourself homeowners who are renovating their homes and looking for a deal.

Why they're winning
Lumber Liquidators' store-level economics are simply remarkable. The company's primary strategy is to locate its stores in out-of-the-way industrial parks with low rents while promoting its brand through heavy advertising -- like the bright yellow signs you see behind home plate during Major League Baseball games. The average store costs only $300,000 to open, $225,000 of which is inventory. After one year, the average store has completely paid back the initial investment, and after three years, is producing average sales of $3.1 million and a return on invested capital of 140%. This level of profitability has allowed Lumber Liquidators to expand entirely from its own operating cash flow, thus having little need for debt -- of which it has none.

And speaking of expansion, Lumber Liquidators is only halfway to its goal of 400 stores in the U.S. The company plans to open 30 to 40 stores per year over the next several years and began international expansion into Canada in the second half of this year. Management has also been considering a move into Europe and believes that the Lumber Liquidators model would translate well.  

But, the most exciting part of Lumber Liquidators' store growth is the ability to spread operating costs over a larger store base, which should improve margins. Management believes the company will achieve about 0.6% to 0.8% of operating margin expansion annually on advertising and administrative costs. Additionally, recent investments in the company's enterprise software and distribution center should improve efficiency and add to profitability as well.

Now, I'm not the only one who has identified the cash-generating ability of Lumber Liquidators. In fact, the company has been a growth investor darling over the past few years, so the stock often trades at a premium to its peers. Fortunately for investors, the housing market malaise following the expiration of the homebuyer tax credit has knocked the stock (in blue in the chart below) down 27% from its April peak, which also trails the performance of the company's closest peers, Home Depot (gray) and Lowe's (yellow).

Source: Capital IQ, a division of Standard & Poor's (4/23 peak to present).

Source: Capital IQ, a division of Standard & Poor's (4/23 peak to present).

What to watch
One concern I have about Lumber Liquidators is the characteristic that makes hardwood floors so appealing to homeowners: the high durability of its product. Many of their floors come with warranties of up to 50 years and have the ability to be refinished multiple times, so a lack of return customers could be an issue. However, the average ticket of $1,500 equates to about 400 to 500 square feet, or about one to two average-sized rooms. That means there're still plenty of rooms left for loyal customers to furnish.

Additionally, the U.S. has averaged almost 1.5 million new home starts over the past two decades. Only about 15% of those homes have hardwood floors, so that remaining 85% are all potential customers down the road when the carpet needs to be replaced. Also, as Lumber Liquidators expands into new geographic regions, it should be able to attract more of those local homeowners looking for an upgrade.

The Foolish bottom line
If you're looking for a beaten-down growth stock with a lot of room left to run, Lumber Liquidators is worth a look. The company has a strong brand in a niche market that is ripe for consolidation. While it may be hard to get excited about the company's core product, it's definitely easy to get pumped about its ability to generate cash.

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The Motley Fool will wait at least 24 hours after this publication before buying shares of Lumber Liquidators. To see an FAQ on the "11 O'Clock Stock," click here.

Jeremy Myers owns shares of Lowe's. Home Depot and Lowe's are Motley Fool Inside Value picks. Lumber Liquidators is a Motley Fool Rule Breakers recommendation. The Fool owns shares of Lowe's. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 22, 2010, at 11:14 AM, prginww wrote:

    LOVE lumber liquidators...both the stock and the product.

  • Report this Comment On September 22, 2010, at 11:44 AM, prginww wrote:

    Good Morning Fools,

    I'd love to hear your response to my 11 O'Clock Stock selection. I'll be available today to respond to question or comments on my favorite hardwood flooring purveyor.

  • Report this Comment On September 22, 2010, at 11:46 AM, prginww wrote:

    @biolasteve - It's great when you can find the best of both worlds. My parents bought their flooring from LL a few years back and had a great experience. I wish I had paid more attention to the stock back then.

  • Report this Comment On September 22, 2010, at 1:05 PM, prginww wrote:

    It seems that they started selling excess lumber (liquidators) but now sell directly from mills, cutting out the middle man to save $. However, I couldn't find anything, even a wimpy statement, on their website about sustainable harvesting of forests. Did I miss something? Does anyone know about their policy re chopping down primary forests?

  • Report this Comment On September 22, 2010, at 2:00 PM, prginww wrote:

    The sponsor the PBA tour. Not sure if that is a good or bad thing. Denny's did it for a few years until they gave up.

  • Report this Comment On September 22, 2010, at 2:17 PM, prginww wrote:

    @SocialRespInvest - I think this statement from the company's website should address your concern-

    "The environmentally conscientious company only purchases from suppliers who practice sustainable harvesting, which allows forests to heal and re-grow faster."

  • Report this Comment On September 22, 2010, at 2:22 PM, prginww wrote:

    @mikecart1 -

    I was thinking the same thing about the PBA. I'm not sure what the target demographic is there. It seems like the company has been pulling back on some of its advertising spend as the company achieves better brand recognition. I guess the obnoxious yellow signs work afterall.

  • Report this Comment On September 23, 2010, at 12:43 AM, prginww wrote:

    The funniest thing from my POV is that _just this weekend_ my wife and I went around stores shopping for hardwood for the floor of the "bar room" we're adding to our new home, and ended up picking... Lumber Liquidators (!), which we'd never heard of but was the one highly recommended by our usual and highly-trusted contractor; we just loved the price, courtesy and promptness of service, quality of the materials, easy availability of small free samples so we could take them home and compare them in the natural settings (including the "bar" itself, which we already bought!)... and we already have everything delivered and resting-in-place for a few days (as our contractor says is indispensable before actual installation, esp. for actual solid planks of wood rather than the typical modern laminated, oops I mean "engineered hardwood", materials;-). The coincidence in seeing it recommended as today's stock pick almost sent me (after due diligence of course) to hit a market order...!-) (though in the end, with my typical skinflint, oops I mean "value investor" approach, I ended up instead just putting it on my highly-watched list to wait out the current overall surge in the market, which after all IS due for a little correction any time soon after 3+ weeks of rallying, innit now...?-) -- I really do love the stock as well as the company, just hope I can get it a little wee bit _below_ $24 a pop...!-).

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