Lumber Liquidators Looks Ready to Rebound

If a lumber company falls during a stock market rally, does it make a sound? This philosophical puzzle refers to what happened last Thursday to the nation's largest hardwood flooring specialist, Lumber Liquidators (LL), which operates 250 stores in 46 states and Canada.

After the company cut its full-year revenue forecast in an impromptu business update Thursday, investors took Lumber Liquidators to the woodshed, sawing 28.5% off its share price. But while the short-term macroeconomic headwinds will undoubtedly be challenging, this highly profitable company still has a strong competitive position and ample room to expand, which is why I think this flooring retailer is a good prospect for investors' portfolios right now.

The lowdown on low-cost flooring

Lumber Liquidators provides its customers the widest range of hardwood flooring options in the industry at prices lower than its competitors can offer. What makes this possible is the company's uber-low-cost store format: bare-bones warehouses in low-rent areas and just a store manager and two or three sales associates running the show. By ordering its inventory in bulk, Lumber Liquidators is able to keep its merchandise costs low.

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The company's streamlined format produces phenomenal returns on capital. It costs Lumber Liquidators $300,000 to open a new store -- and all but $75,000 of that amount accounts for the inventory. The average new store is profitable within three months and returns its initial cash investment in less than a year. And because it's so cheap to build a new store, Lumber Liquidators has been able to grow at a breakneck pace. The company has expanded from 57 locations at the beginning of 2005 to 250 today, and management has set an eventual target of 400 stores.

But won't the big-box stores snap Lumber Liquidators like a twig? Don't count on it. Lumber Liquidators' locations may not be as convenient as competitors' such as Lowe's (LOW) and Home Depot (HD) or even your local mom-and-pop flooring shop, but customers are happy to drive a few miles out of their way to save hundreds of dollars on a new floor or browse a wider selection. In fact, it's the local flooring stores that should be concerned in this equation. These inefficient operators currently control about two-thirds of the market, but I expect Lumber Liquidators and the big-box stores to continue to steal those sales over time.

Why Wall Street pulled the rug out from under Lumber Liquidators

As you might imagine, this economy is a difficult environment for a company that sells big-ticket, discretionary, housing-related products. With the housing market and economy hurting, Lumber Liquidators' customer base has become much more price sensitive. While this trend should actually play to Lumber Liquidators' strengths, the company was caught off-guard this quarter and could not rein in its expense structure in time.

Part of the problem is Lumber Liquidators' fault. The company's botched implementation of a business software package last year has dragged on results for the last three quarters. While the company insists that the software issues are in the rearview mirror, last week's near-30% scalping indicates that the investment community has lost patience with Lumber Liquidators.

Opportunity knocks, investors

The market's knee-jerk reaction suggests to me that many investors are focused on the wrong metrics. While Lumber Liquidators' reduced revenue guidance was disappointing, it's clear that new Chief Operating Officer Rob Lynch's margin improvement initiatives are already bearing fruit. By renegotiating contracts with vendors and diversifying the company's supplier base, Lynch has Lumber Liquidators poised to post record-high margins by the fourth quarter.

Despite the dour macroeconomic climate and subpar first-half performance, Lumber Liquidators still expects to earn between $1.00 and $1.15 per share this year. At $18.50 per share, the market is pricing the company as if its sales trends and margins will never improve. But if Lumber Liquidators can generate a slight improvement in either category, I believe shares should be worth about $28 -- and if the housing market recovers, that estimate will likely prove conservative.

The bottom line

It's not often that one gets a chance to buy a fast-growing, highly profitable business at a bargain basement price. Take advantage of the stock market's short-term mindset and open up a position in this long-term winner today.

Senior Motley Fool analyst Rich Greifner does not own shares of any company mentioned in this article. The Motley Fool owns shares of Lumber Liquidators.