Does It Make Sense for Home Depot or Lowe's to Buy Lumber Liquidators?

The home improvement industry isn't exactly what analysts would call a "high growth" industry. To illustrate this, you only need to look at how Home Depot (NYSE: HD  ) and Lowe's  (NYSE: LOW  ) have performed over the past few years. Analyzing this timeframe, investors would see that revenue grew less than 5%, in aggregate, for both of these industry giants. This has left their management trying to find ways to grow, but could the greatest opportunity for them be sitting right beneath their noses?

Lumber Liquidators might be a layup
One of the best growth stories in home improvement has been Lumber Liquidators (NYSE: LL  ) . The $2.5 billion retailer that specializes in hardwood flooring has experienced explosive revenue growth over the past five years. Between 2008 and 2012, revenue jumped 68.7% from $482.2 million to $813.3 million, while net income has risen an impressive 131.1% from $22.1 million to $47.1 million.

In all fairness, Lumber Liquidators is only a fraction of the size of Lowe's and Home Depot, which have market caps of $49.3 billion and $111.3 billion, respectively. For this very reason alone, it's understandable that the company could grow so much. What's most impressive though is not just Lumber Liquidators' growth; it's also the margins seen during this growth spurt.

Usually, when management seeks to grow sales in a highly saturated and competitive environment, it must do so at the cost of lower margins. Probably the best example of this kind of situation taking place today involves Costco, which has seen return on equity and net profit margin fall far short of competitors like Wal-Mart and Target. However, this doesn't seem to be the case for Lumber Liquidators. Between 2008 and 2012, Lumber Liquidators has clocked a net profit margin of 4.7%.

Although this doesn't appear all that great, it's quite impressive when you look at Home Depot and Lowe's. Over the past five years, Home Depot's net profit margin has matched the 4.7% of Lumber Liquidators (albeit with consistent improvements annually, while Lumber Liquidators has been unpredictable). Meanwhile, Lowe's has lagged its competitors with a net profit margin of 4% as its selling, general, and administrative expense, as well as its interest expenses, have ballooned over the years.

Based on this data, it appears as though Lumber Liquidators is a no-brainer. The company has found a way to grow significantly in size while maintaining margins that its largest peers have had difficulty matching. Furthermore, Home Depot and Lowe's may be up for the challenge. Over the past two years, Home Depot has spent $235 million on acquiring other businesses, and Lowe's bought bankrupt specialty retailer Orchard Supply Hardware for $205 million this past August. While these expenditures each make up less than 10% of the market cap of Lumber Liquidators, it demonstrates that both businesses are intent on finding ways to grow.

Or maybe it's not after all
There is one downside to a potential Lumber Liquidators acquisition; it would be pricey. Currently, Lowe's trades at 3.9 times book value and 13.1 times cash flow from operating activities. Home Depot is even cheaper at 3.6 times book value, but more expensive when valued by cash flow from operating activities at 15.9 times.

In juxtaposition, Lumber Liquidators costs a fortune. Lumber Liquidators is trading for 6.7 times book value and a whopping 52.2 times cash flow from operating activities, using the numbers from its most recent quarter. On top of this valuation, it's highly likely that acquiring Lumber Liquidators would involve a substantial premium, potentially serving as a barrier to either business making a bid for it.

Add to this the fact that Lowe's has a long-term debt/equity ratio of 0.8 and cash of only $1.2 billion, and it might be borderline impossible for Lowe's to buy up the company. Home Depot, on the other hand, might be a different story. As of its most recent quarterly report, Home Depot had a long-term debt/equity ratio of 0.47 and cash on hand of $4.9 billion. This implies that, even at $3 billion, buying up Lumber Liquidators might be doable. The real question that remains, though, is if Home Depot has the sense or courage to make such a move.

Foolish takeaway
So there you have it! Right now, Lumber Liquidators is growing extremely fast and doing so without saying goodbye to profitability. Based on this alone, the company is a very attractive takeover target for a bigger player like Home Depot or Lowe's. The downside to this, though, is that any sort of purchase would demand a large premium to what Lumber Liquidators might be worth.

This reality should discourage investors from buying into the business with the hopes that it will be bought out this month, next month, or even within the next year. However, this doesn't mean that it doesn't make sense to buy into the business with the expectation that its high growth and relatively attractive margins could pay off over time. In fact, unless the business deteriorates, this possibility looks to be quite strong.

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