Is Lumber Liquidators Still a Good Buy?

Niche home improvement retailer Lumber Liquidators (NYSE: LL  ) has been riding the improving domestic housing market to new highs, nearly doubling its share price over the past twelve months. According to the National Association of Realtors (NAR), existing home sales jumped 13.2% in August 2013 to a seasonally adjusted 5.5 million, while prices increased 14.7%. However, Lumber Liquidators' share price took a hit in late September due to the disclosure of a search of the company's facilities by the Department of Homeland Security. The search was looking for possible violations of the Lacey Act, which prohibits trade in protected plant species. After this, is it time for investors to take their money off the table?

What's the value?
Lumber Liquidators has built a formidable franchise in the flooring category over the past two decades by providing a wide selection of products at discount prices with a focus on customer service. To offset the volume buying power of the industry giants, Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) , Lumber Liquidators has formed tight relationships with approximately 110 mills in Asia and North America. This has allowed it to share costs and maintain its price competitiveness. It has also been going high-tech in its operations with a floor finder mobile application that allows customers to view digital samples and visualize the finished product.

In the 2013 fiscal year, Lumber Liquidators has maintained its growth trajectory. Revenue has gained 22.4% thanks to a strong, double-digit comparable-store sales gain and continued expansion of its store network. The company has benefited from solid activity and higher prices in the domestic existing home market, the source of 90% of its sales. In addition, Lumber Liquidators has enjoyed a wider operating margin (12% versus 8.3% in the prior-year period) due its greater success rate at up-selling its customers into its premium Bellawood product line.

Barbarians knocking
While Lumber Liquidators has been growing its store network with 300 stores at last count, it has an obvious size disadvantage to the industry giants. Home Depot and Lowe's may have temporarily lost sight of the customer in their cavernous warehouse-style stores, but they are both engaged in productivity-enhancing initiatives that aim to increase the customer-facing time of their employees. Both companies are also working to integrate online capabilities with their physical store bases in order to get online customers into the stores for ancillary purchases.

Like Lumber Liquidators, industry leader Home Depot has gained from rising domestic real estate activity in the 2013 fiscal year. An 8.5% increase in revenues was aided by positive comparable-store sales across most product categories. More importantly, the company's profitability has been enhanced by its process initiatives which aim to have 60% of total per-store labor hours spent on customer service duties. While Home Depot has seemingly tapped out its domestic store growth, it sees opportunities in Canada and Mexico that only account for roughly 12% of its total store base.

Similarly, no. 2 industry player Lowe's has generated top-line growth from the positive industry trends. The company reported a 5.1% increase in revenues and positive comparable-store sales in the 2013 fiscal year. It has also enjoyed operating margin expansion, although its profitability trails that of its larger peer due in part to the costs of its proprietary credit program that offers a 5% purchase discount to certain customer segments. On the upside, the company's smaller size affords it more room for expansion, exemplified by its August 2013 acquisition of 72 stores from the Orchard hardware chain. Lowe's is also positioning itself for a greater share of the installation market with its online tools, a segment that the company estimates accounted for 22% of the home improvement industry's $645 billion in sales in 2012.

The bottom line
Lumber Liquidators broke Warren Buffett's maxim of never doing something that would land you on the front page of tomorrow's paper in a negative light. While only time will tell what the ramifications of the company's business practices are, a likely outcome is a settlement that includes a fine and a requirement to improve internal control processes. In the meantime, Lumber Liquidators' story seems intact. It seeks to build out more locations in its markets and continues to enhance the customer experience with more store remodels to its larger, future store format. Until the dust settles, though, investors might want to keep this retailer on the watchlist.

Beyond the watchlist
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