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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).

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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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.