LL - Mama Said Knock You Out

8/8/2019 LL - Mama Said Knock You Out

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Lumber Liquidators Holdings, Inc.

(NYSE: LL)

Prepared by:

800 Golfview Park

Lenoir, NC 28645

(828) 758 6100

www.broyhillasset.com

December 2010

B ROYHILL A F F I N I T Y FUND
http://www.broyhillasset.com/http://www.broyhillasset.com/http://www.broyhillasset.com/


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DISCLAIMER

The analyses and conclusions of Broyhill Affinity Fund LLC (Broyhill) contained in this presentation

are based on publicly available information including SEC filings and numerous other public sources

that we believe to be reliable. We recognize that there may be confidential information in thepossession of the companies discussed in this presentation that could lead these companies to

disagree with our conclusions. If we have made any errors or if any readers have additional facts or

corrections, we welcome hearing from you. This presentation and the information contained herein is

not a recommendation or solicitation to buy or sell any securities.

Our purpose is to disseminate publicly available information that we believe has not been made

readily available to the investing public but is critical to an evaluation of the company. The analyses

provided may include certain statements, estimates, and projections prepared with respect to the

historical and anticipated operating performance of the company. Such statements, estimates, and

projections reflect various assumptions by Broyhill concerning anticipated results that are inherentlysubject to significant economic, competitive, and other uncertainties and contingencies and have

been included solely for illustrative purposes. No representations, expressed or implied, are made as

to the accuracy or completeness of such statements, estimates or projections, or with respect to any

other materials herein.

Assets managed by Broyhill and its affiliates have shorted common stock and purchased equity put

options on Lumber Liquidators Holdings, Inc. (LL). Broyhill manages a fund that is in the business of

trading buying and selling securities and financial instruments. It is possible that there will be

developments in the future that cause Broyhill to change its position regarding LL. Broyhill may buy,

sell, cover, or otherwise change the form of its investment in LL for any reason. Broyhill herebydisclaims any duty to provide any updates or changes to the analyses contained here including,

without limitation, the manner or type of Broyhill investment.


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Background

Lumber Liquidators (LL) is a low cost provider of flooring which operates discount stores across the

United States. They maintain this advantage by locating stores in low-rent areas (translation inferior

locations), developing direct relationships with mills, and most importantly, sourcing about 40% of their

total product from China. Typical stores are 6,400 to 6,600 square feet and leased for five years withrenewal options. Each store has a manager and a few associates paid a low base salary plus bonus. The

company was founded in 1994 and went public in 2007. Tom Sullivan, founder and chairman, owns

roughly 13% of the shares outstanding.

Hardwood floors represent 57% of their sales with the companys flagship Bellawood product making up

20% of net sales in 2009. LL also sells laminates (18%), moldings (13%), and bamboo/cork products

(11%).1 Their top ten suppliers accounted for 69% of 2009 flooring purchases with 44% sourced from

Asia, 37% from North America, 13% from South America and 6% from other locations. All foreign

purchases are negotiated and paid for in USD. In 2009, 88% of orders went through their Virginia

distribution center. They are expanding a new program where goods are shipped directly to stores fromChina. LLs hardwood flooring market share was roughly 10% in 2009 2 (8-9% in 2008 and 7% in 2007).3

Da Bulls

Bulls view LL as one of the few remaining retail growth stories as management aims to open a few dozen

stores annually for the next several years in a roughly equal mix of new and existing markets. About half

of the companys stores have opened in the past three years. It is easy to understand why when new

stores are typically profitable within three months and have returned the initial cash investment within

a year. But while a rapidly expanding store base has produced revenue expansion throughout the

housing bust, same stores sales fell off a cliff during this period. We wonder how quickly bullishoptimism over new store growth might turn into concerns for cannibalization as comps at mature stores

continue to deteriorate. As we discuss in detail below, we believe demand for LLs core products are set

to decline next year as the foreclosure moratorium and expiration of homebuyer tax credits will have a

meaningfully negative impact on existing home sales. With the street forecasting a much stronger

outlook for home prices (we struggle to find anyone calling for a decline more than 0% - 5%), investors

in LL shares are set up for a major disappointment.

Wall Street claims that LLs low cost advantage provides the company with a market niche that is

difficult to lose. Bulls point to its focused product assortment, direct sourcing and good customer

service as core competitive advantages over big box retailers. We think the street is missing several

key issues that are likely to present major challenges in the year ahead. First, gross margins are likely to

come down more than expected due to rising energy and transportation costs and increasing wage

pressures in China. Because labor is a greater percentage of the total cost for engineered wood flooring,

increasing Chinese labor inflation would quickly put a big dent in any cost advantage assumed by the

bulls. In addition to downward pressure on gross margins, we also anticipate upward pressure on SG&A

due to continued difficulties with the implementation of SAP into next year. Management guidance and
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the streets acceptance that this is a one or two quarter blip runs contrary to past experience. Last but

certainly not least, we are shocked by investors total and complete disregard for the pending US

International Trade Commission investigation into Multilayered Wood Flooring (MLWF) imports from

China. At best, this investigation introduces substantial uncertainty into the business and serves as a

distraction to managements limited time and resources. At worst, if the ITC were to set a tariff

anywhere near the maximum level requested, we believe LLs business model and cost advantage

would be severely challenged.

Six Minutes of Pleasure

Shares of LL rose 375% from a low of $7.02 in March 2009 to a high of $33.41 earlier this year. Its

worth noting that Tom Sullivan has sold roughly five million shares since the March lows with the great

majority of sales at prices north of $20.4

At last weeks closing price of $23.42, the stock changed hands

at 24x and 18x 2010 and 2011 consensus earnings expectations, respectively. Analysts are looking for

30% earnings growth next year driven by new store openings, operating leverage, and stabilization in

the domestic housing market. We have our doubts. Taking management at their word that MLWF only

represents 10% - 11% of total sales, we estimate that a 50% tariff on Chinese imports would reduce next

years earnings to $0.94, other things being equal. An earnings miss of this magnitude would likely

result in multiple compression, as valuations of high growth retailers are inherently unstable. For

perspective, note that LL has traded as low as 8.6x and as high as 27.6x forward earnings since the

company went public. Even giving the company the benefit of the doubt, and maintaining the stocks

current forward multiple, shares could easily trade down toward the $11 to $16 range based on the

midpoint of our estimates highlighted in this report. If our estimation that LLs exposure to MLWF

represents a much larger share of the hardwood segment is correct (our research points to anywhere

from one half to two thirds of segment sales), the impact would be much, much greater. And a higher

tariff (potentially north of 200 percent), when combined with greater exposure to engineered flooring

(as we believe), could present a disaster scenario for LL shares.

Recent Results

At quarter end, LL was operating

out of 213 stores in 46 states.

Management is expecting 9 to 11

additional openings in the current

quarter.5 New store growth

continues to drive top line results

as total sales increased 4.7%

during the quarter. Importantly,

comparable store sales were

down an ugly 5.7% alongside the

expiration of an important tax

credit for home buyers. While management blames the poor results on the implementation of SAP
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during the quarter (more

on this below), we think

there is sufficient evidence

to suggest bigger issues

lurking below the surface.

Despite earning over $20

million year to date, the

companys free cash flow

has fallen more than $11

million as LLs cash position

has swung from $50.7

miilion earlier this year, to $26.8M at the end of the most recent quarter.

Inventory increased over 50% year-over-year during the quarter versus the 4.7% increase in sales. While

management attributes the significantly increased inventory levels to the systems implementation, we

suspect there is more to the story and estimate that inventory would have increased materially even

excluding the impact from SAP. Our contacts in the industry have warned that sales have fallen off a

cliff post the expiration of the home buyers tax credit. Its certainly possible that LL is only now peering

over this cliff as the great majority of the companys floors are bought for existing homes rather than

new construction, so a lagged effect relative to industry peers could also drive a free fall in comps. Gross

margins declined during the quarter due to higher transportation costs, less efficient finishing costs and

SAP implementation. We think these headwinds are likely to continue into next year, as Quantitative

Easing predictably results in significant commodity inflation and increasing transportation costs,

aggravated by a weaker dollar. SG&A was also higher than expected due to increased labor costs - more

stores to staff and more overtime from SAP. Management warned investors to expect additional

reductions in productivity in the current quarter due to the use of greater resources than expected for

SAP implementation. Wed warn investors that these issues are likely to be a headwind through next

year and simply represent the tip of the iceberg. We think LL has over-earned as a public company as a

confluence of benefits propped up gross margins at unsustainably high levels. It now appears that many

of these tailwinds (i.e. cheap sourcing, cheap fuel, cheap transportation, excess capacity, etc.) are likely

to recede in coming quarters and should represent strong headwinds ahead.

Sapped by SAP

LL began implementation of SAP, a retail management system, during the third quarter. This is

ultimately a positive for the company as it will integrate systems, increase efficiency and potentially

reduce SG&A. But if the current quarter is any indication, investors should not expect any such benefits

until the latter part of 2011. We expect nothing but headaches between now and then.

Shortly after implementation, management claims to have experienced problems satisfying existing

customer orders, distributing product to stores, and allocating resources needed to operate.

Management estimates that reduced productivity cost an estimated $12-14 million in lost sales during


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the quarter, and increased costs associated with inefficient product transportation and increased

inventory reduced gross margin by 30 basis points. Importantly, LL had still not reached pre-

implementation productivity even by the end of quarter. Capitalized costs for SAP were expected to be

$13 million. The implementation cost $13.9 million last quarter, with another $1.5-2.5 million expected

next quarter.6 We wouldnt be surprised by larger numbers ahead.

LL store managers we spoke with highlighted continuing difficulties with the integration and agreed that

it was continuing to impair their ability to address customer demand. This sentiment broadly confirms

our findings of others in relation to SAP systems. Conversations with people familiar with SAP

integration indicate that when a company is having this much trouble, there is likely more to come. We

expect SAP to be a net drag on performance for the next year or so, much longer than the street

anticipates. On the recent call, management explained that they have very ambitious plans to make

our whole allocation and planning process more complex and we . . . just did not have the tools to do it . .

. Having said this before, we had a lot of manual processes that are running a lot of things off of Excel

spreadsheets.7

Going Back to Cali

This is not exactly confidence inspiring for a company operating over 200 stores and

generating sales in excess of $500 million, but we imagine its typical for retail growth stories to

outgrow the spreadsheets put in place a decade ago when managing two or three dozen stores. Once

again, this is a long term positive for the company, but its almost impossible to imagine a smooth

transition.WhileSAP headaches are likely to drag on for several more quarters, we believe that many of

the difficulties experienced in the latter part of the quarter and attributed to systems integration are

also masking a fall-off in demand from the expiration of significant housing stimulus earlier this year.

Existing home sales and changes in home prices are the most significant determinants of demand for

LLs products. In the section below, well examine these demand drivers more closely.

Demand trends across the home improvement industry are largely dependent on several key variables.

Most critical for LL is the pace of existing home sales as roughly 90% of their products are sold to people

that have been in their home for several years and are remodeling. 8 Turnover in the housing market

encourages renovation, which is a leading indicator of traffic to home improvement retailers. Existing

home sales fell nearly 20% in September as the end of the homebuyer tax credit caused existing home

sales to fall off a cliff. The expiration of this tax credit should become an increasing headwind for LL in

2011.
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Negative equity is a major

problem with one in four

mortgages underwater and

the national loan-to-value

rates 75% higher than the

long term average.

Importantly, in two of LLs

largest markets, Florida

and California, over 40% of

all mortgages are

underwater. Given the

severity of the problem, a

homeowners ability to

extract equity from a home

to purchase a new home,

or to renovate their

existing household, is

largely impaired. Making matters worse, those mortgages currently close to being underwater are likely

to get wet with a further decline in home prices. Just a few months ago, Deutsche Bank projected that

the negative equity rate may rise to 48% in 2011. All of this is to say that the existing foreclosure issue is

likely to get worse before it gets better greatly inhibiting the natural level of housing churn, which home

improvement retailers have learned to depend on. If homeowners lack mobility due to negative equity

(an issue also aggravating todays elevated structural unemployment levels), LLs store traffic should

slow. This traffic is a powerful driver of wood flooring demand as the average new home owner spends

an incremental $2,000 - $3,000 on improvements in the first 12-18 months of residence. 9

After existing home sales, home

prices are the next most important

driver of home improvement

demand. As home prices increase,

consumers are more willing to

undertake major renovation

projects such as wood flooring.

But in a deflating home price

environment, few major

renovations are undertaken.

Continued foreclosures, high and

stagnant unemployment,

consumer deleveraging, and

growing fiscal headwinds should keep pressure on home prices and slow a recovery in big-ticket home

Dare We Say Double Dip?
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improvement purchases. As the backlog of housing inventory is likely to cause a double-dip in home

prices, we should see further declines in LLs average ticket.

We have yet to see any meaningful improvement in the national housing inventory overhang. The chart

at right highlights months of supply

of homes on the market. Currently,

there are almost 11 months of

supply on the market, which is near

the highs of 2008. There are now

over 4 million housing units on the

market, a number which has

accelerated throughout the year. In

addition to the official inventory,

there are also an estimated 6 million

houses that are not on the market,

but are considered shadow

inventory. The good folks at

Hedgeye calculate that supply of

housing is in the top two deciles of inventory levels, and historically prices have typically fallen more

than 15% over the following 15 months when at these levels. 10

We believe home improvement demand is set to decline next year as the foreclosure moratorium and

expiration of homebuyer tax credits will have a meaningfully negative impact on existing home sales.

When considering the shadow inventory overhang alongside these factors, a further 10% - 20%

decline in home prices from existing levels is not difficult to envision. Any growth in the industry is likely

to be focused on smaller projects driven by more regular traffic, neither of which bode particularly well

for LL, whose focus on high dollar renovations should result in underperformance within an already

weak industry. With the street forecasting a much stronger outlook for home prices (we struggle to

find anyone calling for a decline more than 0% - 5%), investors in LL shares are set up for a major

disappointment.

More Talk About Consumer Deleveraging11

Beyond pure housing industry data which does not paint a pretty picture, it is important to consider the

state of the consumer. We view changes in consumer confidence and the level of private sector credit

for indications of consumers willingness and ability to take on debt. Declines in credit can have a

material impact on home improvement spending as can a fall in consumer confidence. Needless to say,

the U.S. consumer remains extremely over-indebted, with aggregate private debt to GDP now at 267%

versus the peak level of 298% achieved back in February 2009. With debt levels as high as they are, the

potential for further deleveraging still exceeds the worst experienced during the Great Depression.


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So the consumers ability to take on

additional debt is questionable at

best. Wed argue that their

willingness to take on additional

debt is equally as low based upon

the lackluster rebound

experienced by the Conference

Boards Consumer Confidence Index

and this years surprising decline.

Contrary to bullish beliefs, lower

mortgage rates do little to spur

incremental demand, as the

marginal buyer has already

refinanced, and those that havent

already refinanced may run into

difficulties swimming that far under

water. Against this consumer

backdrop, we expect comps to

remain under pressure next year

due to the companys high average

ticket and declining selling prices. A

few years ago, Todays Homeowner

indicated that flooring replacement

was low on consumers priority list,

far below minor kitchen and bath

remodels, deck additions, siding and

window replacement, and

additions. Wed imagine it is even

lower today given the credit

constraints and high price tag relative to cheaper alternatives. The U.S. consumers new fervor for

frugality means her preference for LLs bamboo earrings . . . at least two pair12

is clearly waning. On

LLs recent earnings call, management confirmed our suspicions warning that average ticket indicates

that it is a person doing one room at a time. Most store sales contacts we spoke to also indicated that

the average spend remains lower than they ever remembered due to: less expensive products, reduced

potential for incremental sales (peripherals, glues, sheeting, etc.) and increased push back from

customers in terms of price. Almost all of them noted the continued preference of customers towards

lower priced flooring products. And speaking of lower priced goods . . .

Punked by Protectionism

On October 21, the Coalition for American Hardwood Parity (CAHP) filed a complaint with the US

Department of Commerce and the US International Trade Commission regarding Chinese MLWF
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products. The complaint alleges that the Chinese are unfairly subsidizing the product, dumping below

cost on the US market, and stealing intellectual property from domestic producers. On top of this, the

petition cites the low cost of labor and low cost of raw material sourced from illegally logged lumber as

unfair advantages. For the first six months of 2009 and 2010 value per square foot were $1.50 and $1.49

from China, less than half the cost of domestic products which carried a value per square foot of $3.18

and $2.99 over the comparable periods.13

CAHP supports our view that improvements in the wood floor market in late 2009 and early 2010 were

the direct result of the homebuyer tax credit, which was applicable from Jan 1, 2009 to April 30, 2010. If

a contract was signed prior to April 30 and closed before Sep 30, it also qualified, which would help

explain the lagged decline in LL comps relative to already falling existing home sales. Obviously, CAHP is

upset that the massive stimulus intended to benefit American consumers and industry did not have a

meaningful impact on domestic producers. We dont blame them, although we recognize that being

rightfully angry probably doesnt warrant slapping a massive tariff on your competitors. More

importantly, we believe the evidence clearly points in that direction, regardless of domestic emotions.

Chinas share of the US market increased from 10% to 27% between 2002 and 2007 as US imports of

Chinese MLWF increased by 76% over this period, and Chinas total wood flooring production increased

by 64%. Chinas total MLWF output increased by a further 49% from 2008 to 2009 to 1.27 billion square

feet. US MLWF market share held by Chinese imports hit a peak of 34.7% in June 2010. Due to

underselling by Chinese imports, domestic producers have curtailed product lines (or eliminated them

altogether) leading to plant closures and employment reductions. The petition requests a 242% tariff be

placed on multi-layer wood flooring from China for these reasons and notes that even if the housing

market recovers, the recovery will likely be dominated by cheap imports. An initial hearing in early

November determined that the United States International Trade Commission will investigate the issue

and potentially put a tariff in place on Chinese MLWF imports. 14

We expect the ITC to determine if

theres enough evidence to hold a preliminary hearing this Friday, December 3 rd. Given the extensive

evidence weve reviewed, we are confident this will pass. At the end of the preliminary phase, which we

understand will conclude during the second quarter, the ITC will implement a preliminary tariff if there is

enough evidence to support it. Investors should mark their calendars accordingly, as these are important

dates. We have yet to find a single sell side research piece that properly considers these hearings (the

first time it was even mentioned was a few sentences in a report this week) and management has yet to

say a word about them publically despite filing an earnings release and hosting a conference call since

the initial hearings, where an army of LL representatives were present. Hmmmmmm.

Chinese MILF MLWF

MLWF has a more advantageous raw material yield when compared with solid wood flooring (20-30% of

the log ends up in the final product for solid wood flooring compared to 70-80% for MLWF).15 Therefore,

labor is a greater percentage of the total cost for engineered wood flooring, providing China with an

advantage over domestic producers. The increase in the volume of imports has been a result of home

centers and direct distribution centers such as Home Depot, Lowes, and Lumber Liquidators. This growth


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has come at the expense of smaller distributors. LL is estimated to account for 10% of the total US wood

flooring market, up from 5.1% in 2006.16

At a September conference, LL noted that 40% of their product

is sourced from China. We estimate that a good portion of these imports are engineered flooring, and as

such, it is curious that management has yet to even mention the potential for such a large increase in

costs. Perhaps they dont believe it is significant or a realistic threat to their business model. But while

management downplays the potential impact of a tariff, industry insiders weve consulted put the odds

of a 50% (or higher) tariff at 70%, 75% (or higher) tariff at 50% and a tariff in excess of 100% at a 30%

probability. If assigned at the conclusion of the preliminary hearings (likely sometime in Q2-11), an

escrow tariff would be charged immediately and any difference between the final tariff and the

preliminary tariff would be collected retroactively after a final decision was concluded.

2011 EPS Estimates

Tariff

20.0% 50.0% 70.0% 100.0%

MLWFas%ofTota

l

Hardwood

20% 1.14 0.94 0.81 0.6230% 1.08 0.78 0.58 0.29

40% 1.01 0.62 0.35 (0.04)

50% 0.94 0.45 0.12 (0.37)

60% 0.88 0.29 (0.11) (0.70)

70% 0.81 0.12 (0.34) (1.03)

In 2009, Lumber Liquidators derived 57% of its revenue from solid and multi-layer wood flooring

combined. While management will not publically disclose what percentage of this is MLWF in company

filings, checks with stores and industry experts reveal that it is the majority of their wood sales.

Curiously, most of the research we have conducted produced very different answers than those verbally

suggested by management, who claim that engineered flooring only represents 10% - 11% of total

sales17

(although even using these lower figures, the potential margin impact from a tariff on Chinese

imports would be substantial as shown in the above matrix). A company contact in customer care

suggested it was a roughly even split between hardwood and MLWF. The 2011 Edition of The U.S. Floor

Reportindicates that MLWF is closer to two thirds of LLs wood flooring segment. We also thought it was

interesting that not a single sales person we spoke to tried to sell us solid hardwood products, even

when we specifically asked about them. Most store contacts we spoke with indicated that they have

received direct instructions from their managers to continue to push engineered products.

LLs Ears Should beJingling Baby

Importantly, we believe that the vast majority of Lumber Liquidators MLWF is sourced from China. A

salesman at the LL call center, after checking with the relevant department, informed us that 80% of

their MLWF was sourced from China. They followed up on this by checking with one of LLs buyers, who

reported that only the Bellawood line (20% of 2009 net sales) is sourced domestically. Another manager,

when asked if they carried any products not sourced from China, replied that they carried many
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products by Schn. But after confirming with a more knowledgeable store contact, he replied that

despite the Swedish name, these products were also sourced from China. He concluded by saying,

Nope, never mind, everythings from China. By far our favorite response came when we inquired

about domestically sourced engineered flooring. A store manager told us to go to the nearest hardware

store and buy an ax. Solid hickory handle - 100% US. Then go to the nearest forest and cut down a tree.

Next, go buy a band saw and mill it yourself. Perhaps a bit of an exaggeration, but it makes our point

nicely.

The magnitude of any tariff is unknown (well learn more by March 2011) but the effect that it will have

on Lumber Liquidators is clear. If this petition is passed in any form, we believe it would kick off a

scramble for cheap supply causing costs to surge before substantial product can be re-sourced or

mitigated in any way. In the event of a more extreme tariff, producers would predictably attempt to re-

source away from China. One flooring executive even commented in the ITC hearing that he expected to

be on a plane the day

after Thanksgiving to

Indonesia.18 But due to

the insignificant capacity

in other inexpensive

locations, this is not a

viable option on any

significant scale in the

short term. While

Indonesia is the cheapest

alternative, it represents

roughly a tenth of

Chinese capacity and our

sources tell us much of it

is illegally sourced. Those

unfamiliar with the Lacey

Act may want to quickly acquaint themselves with illegal logging practices as an important addition to

the act calls on vendors to be accountable for documenting the path of a product from harvest to sale.

According to an industry report by Catalina Research, only 18.8 million square feet of MLWF is imported

to the US from countries with an average cost within 100% of China. This compares to 71.2 million

square feet imported from China and 98.6 million square feet of total US imports. 19

Critically, we believe

that re-sourcing any significant portion of the Chinese production will result in greater demand for lower

capacity locations, ultimately increasing the price of imports anyway. The net result in any scenario is a

major impact on costs and margins, neither of which is being discussed by the street or by LL

management. We wonder why Armstrong felt it was material enough to include the language below in

their latest filing despite having a much smaller impact to their business than LL in our estimation

(emphasis added):


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On October 21, 2010, a coalition of U.S. producers of multilayered wood flooring (not including

Armstrong) filed antidumping (AD) and countervailing duty (CVD) petitions regarding multilayered

hardwood flooring from China. The AD petition requests that the Department of Commerce impose

duties of up to 242% on imports of multilayered hardwood flooring, which it claims is needed to offset

unfair pricing from Chinese imports that injure the U.S. industry. The CVD petition requests an

unspecified level of duties be imposed on importers to offset alleged unfair subsidies provided by the

Chinese government (such as the undervaluation of the Chinese currency, various tax benefits for

foreign-invested enterprises, VAT and tariff exemptions on imported equipment, and electricity being

provided at artificially low rates).

Armstrong World Industries, Inc. is a domestic producer of multilayered wood flooring. We also import

multilayered wood flooring from suppliers in China and we have a plant in China that manufactures

multilayered wood flooring for export to the U.S. Armstrong is specifically mentioned in the AD and CVD

petitions as an importer. Under the U.S. AD and CVD laws, a U.S. importer may be responsible for the

payment of any antidumping and countervailing duties. The Department of Commerce and the

International Trade Commission have only just commenced their investigations and the outcome of the

cases are uncertain. As a result, at this time we cannot say whether an adverse ruling is probable or

estimable. However, if such an adverse ruling were to be issued,Armstrong could be subject to duties on

multilayered hardwood flooring imported from China, and it is possible such duties could be

material20

.

Score One for Consensus

While the street remains willfully blind to the potential business-busting tariff on Chinese imports, we

have noticed more than a few analysts correctly mentioned sourcing as a risk to LL shares going

forward. Compliments of our beloved Fed, most domestic retailers can now look forward to spiraling

commodity costs in the year ahead. This factor, which should be familiar since they faced a similar

dynamic in early 2008, is compounded by a weaker dollar and labor inflation in China. All of which

should keep steady downward pressure on gross margins. And while most goods sold in home

improvement stores have a relatively small labor cost, engineered flooring is much more labor intensive,

which of course, explains why most of it is imported from China in the first place. Once again, this

negative gross margin cocktail does not bode well for the LL profit outlook. Labor costs have already

begun to increase as a percentage of net sales, perhaps signaling inefficiencies and diseconomies of

scale.

Dont Wake the Beast

The home improvement industry remains largely fragmented despite the dominance of two big box

retailers, Home Depot and Lowes. Bulls claim that there is plenty of room for LL to grab share. Wed

prefer not to agitate the sleeping giant in the market as these boys bring product selection and

efficiency that is impossible for the niche players to match. Home Depot and Lowes have built

tremendous brand franchises with powerful logistical capabilities and strong vendor relationships. Wed


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rather not get in the ring with the big boys, but it seems that LL has gotten their attention. In the first

quarter, Lowes took on additional flooring inventory with the aim of taking share in this category.21

We

would not want to be seen as an emerging threat to these industry powerhouses. Come to think of it,

given Home Depots lower ticket products, rigorous cost controls, substantial free cash flow generation

and 3% dividend yield, HD/LL appears to offer compelling risk/reward for a pair trade.

Fanfare for the Low Cost Provider

Customer reviews on the companys website are wonderful. What we found more interesting was that

when searching for the companys website, the second auto-fill option in the Google search bar is

Lumber Liquidators Complaints. Weve highlighted just a few of these mostly for entertainment

purposes. The general idea is that you get what you pay for both in product quality and customer

service.

Shame on Bob Vila for representing this company.

Lumber Liquidators should change their name to "Customer Liquidators." The service is the worst I have

ever encountered! Stay away from these people; they should not be in business.

They are by far the worst company I have ever dealt with in my 23 years in the trade. Deceitful, poor

quality and the WORST CUSTOMER SERVICE.

Bought Supreme Bamboo with 15 yr finish warranty. The finish has worn off in 8 months. Sought the

help of customer care to settle a claim. It literally took 3 months for them to resolve the issue and finally

send a letter denying the claim. Lumber Liquidators was the worst customer experience I have ever had -

and the ONLY online vendor that has prompted me to submit this type of e-review. Bottom line, buy a

nicer wood from another vendor if you want long lasting beauty and quality. Their price was great, but

now I have a worn scratched, dented floor that will have to be removed and replaced much earlier than

I'd ever imagined.

When I tried to pick up an order from one of the stores, the store manager persuaded me to submit a

new order because "they were upgrading their software and couldn't retrieve my order information,

saying I could easily cancel the internet order. However, one month passed, 4-5 phone calls have been

made, and still they haven't refunded the credit back. Horrible customer service.

We ordered 23 boxes of product, which came from 2 different mills with production years stamped on

the end of the boxes between 2006 and 2010. The tongue and groove did not interlock and the color

variation between the product (natural birch) in the various product runs were not even close. We

purchased a premium Bellawood product - not a cheap or close-out product.


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What If Were Wrong?

While we have long believed that interest rates will remain lower for longer than current consensus

expectations, weve been wrong often enough to know that well likely be wrong quite often in the

future as well. In this particular case, if we are wrong on rates, we should be very right on LL as the real

negative demand shock would come in the form of a spike in rates. With nearly $1 trillion of option

ARMs and Alt-A mortgages resetting by 2012, if Bernanke is successful in engineering inflation, and

these rates reset higher alongside a rising CPI, it is game over for homeowners, who would default en

masse. Not exactly a happy ending for home improvement demand.

We recognize that the current investigation may not materialize into an import tariff and that the

potential impact of any tariff may be negated by LLs ability to pass costs through to the consumer. But

we wonder how a low cost provider maintains its competitive advantage when costs increase. Aside

from a dramatic recovery in the domestic housing market, it is difficult to envision material upside for

shares at todays valuation. Such a magical rebound would clearly fly in the face of historical evidence.

As Carmen Reinhardt detailed in a recent NBER Working Paper, about 90% of historical observations

examined surrounding a financial shock showed real house prices below their pre-crisis levels with

cumulative declines as large as 55% and median real estate prices 15% - 20% lower, a full decade later.

We wouldnt bet the ranch on a major resurgence of the home as an ATM machine in America.

Perhaps expansion into international markets will provide the upside bulls are hoping for? Management

recently pushed back its planned expansion into Canada from the fourth quarter into 2011 as it struggles

with the implementation of SAP. We think this is a good idea and might suggest shelving any northern

expansion at least until some of the air is let out of that bubble. The Canadian housing market looks

eerily similar to another commodity-related housing market we are quite familiar with. While

residential real estate prices at home are well off their highs, Canadian home owners have enjoyed a

continued surge after a brief blip lower in 2008. Historical data clearly indicates that the ratio of home

prices to income has always fluctuated around a stagnant long term average. The reason is that income

acts as an anchor limiting the price homeowners are able to pay, and has always pulled prices back to

earth in every instance. It is only a

matter of time. The average family can

afford a home about 3.5 times their

income. In 2005-2006, new homes in

the U.S. were selling for well over 5

times median income while other real

estate bubbles have grown to 6 or 7.5

times. Canadian real estate is at 6.5

times family income today nearly

double the price it should be. Not

exactly a market wed consider ripe for

expansion.
http://www.kansascityfed.org/publicat/sympos/2010/2010-08-17-reinhart.pdfhttp://www.kansascityfed.org/publicat/sympos/2010/2010-08-17-reinhart.pdfhttp://www.kansascityfed.org/publicat/sympos/2010/2010-08-17-reinhart.pdfhttp://www.viewfromtheblueridge.com/2010/07/27/who-can-it-be-now/http://www.viewfromtheblueridge.com/2010/07/27/who-can-it-be-now/http://www.viewfromtheblueridge.com/2010/07/27/who-can-it-be-now/http://www.kansascityfed.org/publicat/sympos/2010/2010-08-17-reinhart.pdf


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17/17

Endnotes

1Lumber Liquidators 2009 10-K

2Catalina Research, Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood

Flooring from the Peoples Republic of China, Coalition for American Hardwood Parity3

Lumber Liquidators 2009 10-K4 FinViz.com, LL Insider Trading5

Lumber Liquidators Q3-10 10Q6

Lumber Liquidators Q3-10 10Q7

Thomson Reuters, LL Q3-10 Earnings Call Transcript8

Lumber Liquidators 2009 10-K9

ISI 2011 Home Improvement Outlook10

Hedgeye Risk Management11

Broyhill Asset Management, The Great flation Debate12

James LL Cool J Smith, Around the Way Girl, Mama Said Knock You Out199013

Catalina Research, Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood


Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood Flooring from the

Peoples Republic of China, Coalition for American Hardwood Parity15Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood Flooring from the

Peoples Republic of China, Coalition for American Hardwood Parity16



November 23, 2010 Call with LL Management18

ITC Hearing Transcript19



Armstrong World Industries Q3-10 10Q21

Thomson Reuters, LOW Q2-10 Earnings Call Transcript

Documents

LL - Mama Said Knock You Out