Our differentiated short thesis is predicated on the following attributes, which make the Company a highly attractive short at current prices:
Unattractive Valuation Priced for Perfection: At current prices, LL's current valuation implies absolutely no margin of safety, as the business trades at a drastic 26.4x TTM EV/EBITDA, 47.4x earnings and a miniscule 1.9% FCF yield. Current metrics are very similar to that of companies in the tech boom, albeit the biggest difference is that Lumber Liquidators operates in a mature, low barriers to entry, highly competitive business. Importantly, well-positioned peers such as Home Depot (HD) and Lowe's (LOW) are priced at drastically lower multiples, roughly ~11x EBITDA, and are diversified businesses with higher or similar margin profile and a leading combined market share. At most, LL's business is worth 11x - 13x EBITDA, if not lower.
Rampant Insider Selling: Insiders such as the Chairman have sold over $39MM in shares over the past year (not including option exercises and dispositions). Businesses with strong prospects tend to have "higher" insider ownership, which obviously is not the case with LL. Further, the insider sales go contrary with the bull story, as if the business had a clear runway for growth in profitability, why would the Management team want to sell out? Additionally, it is important to note that the Board and Management team have a clearer understanding of the business versus outside passive shareholders.
Non-Differentiated Business: The Company operates in a highly fragmented industry, in which small mom and pop operators control 60% of the industry and the two largest, Home Depot and Lowe's control a combined ~27%. Additionally, the Company also faces stiff competition from Home Depot and Lowe's, two competitors with scale and a greater store base. Further, the business has no barriers to entry, as competitors can easily build-out a new store base and source product from China.
Potential Lacey Act Violation and Sourcing Issues: On September 26th, 2013, Lumber Liquidators' Toano, VA headquarters were raided by federal agents on the suspicion that the Company has been importing protected wood products into the states. Further, other issues have been raised such as high formaldehyde levels in their products.
Rampant Customer Complaints and Quality Issues: Simple scuttlebutt research suggests that Lumber Liquidators' products are of low quality compared to its competition and has disgruntled its customer base, which comprises both DIY users and contractors.
Reversion to Mean: The Company's gross and EBITDA margins have expanded 450 bps and 510 bps, respectively, since FY2011. The Company's sourcing initiatives are behind a majority of the margin expansion; however, evidence suggests that margins are unsustainable given the quality and sourcing issues that are now evident (i.e. recent government intervention, poor quality and potential illegal formaldehyde levels). If margins return to FY2011 levels, the Company trades at an even more unsustainable EV/EBITDA multiple of 44.4x.