Usually when the Feds storm a large publicly traded company's headquarters, they have good reason. In the case of Lumber Liquidators (NYSE:LL), this action is pushing shares significantly lower on Friday. While this may be discouraging, and a sign to sell, investors can still find value in the home improvement space.
What's going on?
Trading in Lumber Liquidators' shares were halted early Friday morning as reports rolled in of a federal raid at the company's headquarters and storage facilities. Reportedly, the Fed is investigating the company's importation of certain products, which could spell trouble for Lumber Liquidators.
Back on June 20, blogger Xuhua Zhou uncovered that products sold in the state of California were in gross violation of the emission standards in the state (and also the country). The company has long attributed its rise in gross margin, from 34.8% (2010) to over 40%, to efficient Chinese sourcing. However, Zhou notes that this improvement came at a cost of safety.
Reportedly, engineered and laminated wood flooring products lowered costs, but included toxic levels of a known carcinogen called formaldehyde, which is linked to childhood asthma and female reproductive issues.
Just to be fair, there is no proof that Feds are investigating this specific claim, but since we know it has something to do with imports one has to draw the connection to this prior research. Clearly, there is some concern of harmful products, which could eventually lead to government enforcement, class action lawsuits, and possibly a change in company perception that hinders growth.
Like I said, it's never a good idea when the Feds knock on your door, and in this case, I don't think they came to say "hi."
What to do
Lumber Liquidators has been an absolutely fantastic stock since the start of 2012. During this period, it has returned gains of nearly 500% as a boom in housing, coupled with rising margins, led to improved fundamentals. Thus, some might categorize Lumber Liquidators as a cult stock – trading at 46 times earnings – and in that case, it doesn't take a lot to reverse the trend of such a company.
Most recently, we can reminisce on the situation surrounding Intuitive Surgical (NASDAQ:ISRG). Intuitive had traded in a bullish trend for over a decade, but then claims from the likes of Citron Research and CNBC's Herb Greenberg of marketing violations laid the groundwork for a massive decline.
Soon after, reports that the company was being probed by U.S. regulators regarding the safety of its robots pushed shares even lower. Finally, in the latest developments, the FDA issued a warning letter requesting insight into both product recalls and user input. This news came just one week after the company revised earnings guidance downward, and as a result Intuitive has lost over 35% of its value in just eight months.
Now I am not suggesting that such an event will play out in shares of Lumber Liquidators. But given its stock performance and the nature of Friday's news, I'd pay close attention to all potential rumors, as future losses could come with the emergence of new developments.
There's value elsewhere
Lumber Liquidators, with $902 million in trailing 12 month revenue, is very small relative to the home improvement space. Therefore, any fundamental declines that the company may experience will be minimally noticed on the income statements of juggernauts like Home Depot (NYSE:HD) or Lowe's (NYSE:LOW).
With that said, there are good places to invest within this space. Lowe's significantly lagged Home Depot between 2009 and 2013. Yet, in 2013, Lowe's is outperforming Home Depot with stock gains of 35%, compared to Home Depot's gains of 23%.
The reason for this has been Lowe's sudden boost in growth. During its last quarter, revenue grew 10% year-over-year – Home Depot grew 9.5%. In addition, Lowe's is projecting full-year top line growth of 4 % -- Home Depot is projecting growth of 2.8 %.
Moreover, at one times sales and 18 times next year's earnings, Lowe's is cheaper than Home Depot at 1.4 times sales and 18 times next year's earnings. Therefore, investors might find a safe and rewarding long-term play in Lowe's.
But if you're looking for a strong growth play, then Restoration Hardware (NYSE:RH) is your stock. The company is a home improvement store for the wealthy, and is guiding for revenue growth of 32% in 2013 – Lumber Liquidators current guidance is for top-line growth of 17%.
In addition, Restoration Hardware is larger than Lumber Liquidators, with 40% more revenue, but Lumber Liquidator's market cap is greater by nearly $500 million. With greater growth, a cheaper stock, and less drama, Restoration is a company that could benefit if Lumber Liquidator declines.
For a more comprehensive look at Restoration compared to Lumber Liquidators, you can read this .
The key takeaway from the Fed's interest in Lumber Liquidators is that nothing good can come from this news. As an investor, you have to be pretty gutsy to hold Lumber Liquidators given the latest developments, but this fact doesn't mean that you can't find value in the home improvement space. Because, simply put, there is value scattered throughout this space, just not in Lumber Liquidators.
Brian Nichols owns Restoration Hardware. The Motley Fool recommends Home Depot and Intuitive Surgical. The Motley Fool owns shares of Intuitive Surgical. 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.