This 500% Gainer Could be About to Take a Double-Digit Dive

StreetAuthority Network

As the housing market showed tentative signs of a recovery in the summer of 2011, many investors assumed that buying shares of homebuilders would lead to considerable profits. These stocks have indeed rallied nicely in the past two years, but have been outpaced by a more stealthy housing play, Lumber Liquidators (LL)

In the past 24 months, this stock has risen more than 500%. Trouble is, the stock is now disconnected from the fundamentals, and a sharp reversal may soon be at hand.

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LL Stock Chart

Lumber Liquidators sells a wide range of flooring materials through a network of more than 300 stores. Through much of the past decade, when the housing market was still going strong, the company posted solid growth.

Sales grew at least 20% a year from 2004 through 2007. Even the housing bust couldn't slow this company down, as sales have continued to grow at a 10% to 20% annual pace since 2008. Analysts look for continued gains both this year and next. In fact, recently released Q2 sales grew a solid 22%, highlighting this company's ongoing momentum.

Many other companies are in the midst of similar solid growth trajectories, but few can boast such an amazing stock price move. So what explains the appeal behind Lumber Liquidators?

The bottom line: metrics. The company's gross margins typically hovered in the mid-30s, though thanks to economies of scale of a larger retail store base, coupled with benign lumber prices, that metric now exceeds 40%. Operating margins have typically hovered in the 6% to 8% range, but that metric should push above 10% this year.

And a company that never earned even a $1 a share in its history, earned $1.68 a share in 2012, and is on track for more than $3 in per-share profits by next year, according to consensus forecasts. In sum, a steadily expanding store base, coupled with solid same-store sales gains, has led to even more robust profit growth.

Yet, as is the case with many other great retail growth stories, Lumber Liquidators is about to hit stiffer headwinds. For starters, the company is on the cusp of adding roughly 10% more stores to its existing store base count this year.

Management has presumably already picked the "low-hanging fruit" in terms of ideal locations, and it's unclear if the next wave of stores will start to cannibalize existing locations or will generate as much foot traffic as previously opened stores. Such a trend has tripped up The Gap (GPS), Abercrombie & Fitch (ANF) and many others in the past, and Lumber Liquidators may be closer to market saturation than many suspect.

Second, and more importantly, Lumber Liquidators appears to have been a prime beneficiary of the housing bust, as homeowners chose to re-do floors in existing homes to spruce them up for sale. It's hard to know how long this remodeling cycle can last, but it's been under way for nearly a half decade. As new home construction starts to take off, builders install their own flooring and don't tend to purchase more expensive ready-made flooring.

Third, the company is heavily exposed to lumber prices, and if new home building picks up in 2014, as many expect, then a key raw material will start to create a drag on margins.

Finally, the company's competitive pricing compared to rivals such as Lowe's (LOW) and Home Depot (HD) appears to have come at the expense of quality. Contractors give the firm very low ratings. That bodes poorly in terms of repeat business.

Meanwhile, nosebleed valuations for this stock imply it cannot afford to stumble in the quarter ahead. Lumber Liquidators has exceeded profit forecasts by an average of 28% over the past four quarters. Investors are now conditioned to expect such outperformance in the third and fourth quarters as well. Analysts have recently sharply raised their forecasts, making it much harder to exceed what had been a low bar of expectations.

Let's take a closer look at those valuations. Shares trade for 57 times trailing 2012 profits, and 36 times projected 2013 profits. To put that in perspective, Lowe's and Home Depot trade for roughly 20 times projected profits for the current year. Said another way, Home Depot's price-to-sales ratio is about 1.5, and that metric is around 1 for Lowe's. Lumber Liquidators trades for nearly 3 times sales.

Add it up, and Lumber Liquidators has proven to be a solid growth story with eye-popping valuations to show for it, but clouds are emerging. And, perhaps as soon as the next quarter, the stock could hit an air pocket if:

1. The company fails to deliver better-than-expected results as it has recently done.

2. Management more candidly discusses the challenges facing the same-store sales opportunities at its newest, second-tier sites.

3. Management notes that the recent renovation boom associated with the foreclosure mess is starting to peter out.

It's only a matter of time before investors realize that this stock's valuation reflects a long-term growth opportunity that doesn't exist anymore. When that happens, LL could make a quick move back to the $65 area or perhaps even lower.

Recommended Trade Setup:

-- Sell LL short at $88 or above
-- Set stop-loss at $105
-- Set initial price target at $65 for a potential 26% gain in eight week

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