Trade of the Day: Lumber Liquidators (LL)

LL shorts can’t see the forest for the trees

   

Trade of the Day: Lumber Liquidators (LL)

Lumber Liquidators (LL) was on an amazing run from 2007 through the end of 2013. The stock’s price rose from just over $8 per share to a high of nearly $120 in November 2013. However, there have been a few setbacks since and the stock is currently hovering near $75 per share.

The company’s troubles started last year when it suffered three major price shocks.

  • The first of these was triggered in September 2013 when the Federal government raided the company’s warehouses in search of illegal hardwood. The Lacey Act prevents U.S. companies from importing certain wildlife and plants. If the company knew (or reasonably should have known) it was breaking the law, the penalties could be quite severe. LL is likely guilty to some degree but the potential liability has been overpriced into the stock.
  • The raid stalled the stock’s multi-year run and compounded the selling during the second shock triggered by Whitney Tilson (Manager of Kase Capital) who made a strong short case for the stock at the Robin Hood Investors Conference on Nov. 22, 2013.
  • The bearish hat-trick was completed with the third shock on Dec. 10 when the company’s guidance failed to meet expectations.

A run of bad news like this happens from time to time. Most profitable firms recover from setbacks like this in the short term – think Netflix (NFLX) – but the short-selling/profit-taking feedback loop can lead to major declines before finding support. We think the upside for Lumber Liquidators has largely been overlooked and this week’s pending home sales numbers point to much higher prices in the short term.

Pending homes sales (and existing home sales) data are often overlooked by investors because they are not included in other aggregate economic reports like GDP. However, stocks like Lumber Liquidators, Home Depot (HD), Lowe’s (LOW), etc. are very sensitive to the data because the sale of an existing home triggers a series of other economic transactions when new buyers refurbish or remodel an existing home. In the chart below you can see the lagged-correlation that LL (blue) has with the pending home sales numbers (yellow), and existing home sales (red).

lumber liqudators1 Trade of the Day: Lumber Liquidators (LL)

Home improvement stocks tend to lag the improvement in home sales data by three to four months. If that pattern continues to hold, Lumber Liquidators is just about due to boomerang higher. The bad news from last year may have led to an overreaction that will resolve itself in favor of buyers through 2014.

As you can see in the next chart, LL has just recently paused near $75 per share. From a technical perspective, this is an important level where the stock found support following its June 24, 2013 earnings report when rumors of product quality began to circulate. This is also the top of the April 24, 2013 bullish-gap that opened after the company beat earnings expectations and raised 2013 guidance.

lumber liqudators2 Trade of the Day: Lumber Liquidators (LL)

Lumber Liquidators (LL): Chart Courtesy of eSignal

If the stock can find support here, we recommend it for new buyers. However, because the price has been falling so precipitously, we recommend setting conditional entries if the stock can break above its recent short-term high of $80 per share. That should increase the likelihood for a long-term move higher and reduce the odds of a whipsaw.

There are significant risks to this stock that should be accounted for as well. What if there are larger issues in Lumber Liquidators’ supply chain that will expose the company to more civil and criminal penalties than are already being accounted for by investors? In addition, competition from Home Depot is increasing and the scandal may have given HD a larger window of opportunity to snag market-share than traders have fully accounted.

The company’s last earnings report at the end of April was a disappointment. The company blamed the weather (of course) but did not reduce their outlook for 2014. Management would have to be expecting to blow the doors off its report on July 21 in order to meet its full-year projections. Based on the recent improvement in housing data (both new and existing) we agree that the outlook is strong and a big surprise is quite likely.

In our opinion, the biggest problem Lumber Liquidators is facing in the short term is bearish sentiment rather than poor performance. There have been setbacks, but rumors and speculation tend to be overpriced into stocks in the short term. No one knows for sure if this is the case for LL and analysts are divided on the stock. However, one way to evaluate the opportunity is to try to make an estimate of the upside versus the downside following the outcome of July’s earnings.

If the company reports below expectations (currently around $0.91 per share) and begins to fall, some of the most pessimistic analysts (Whitney Tilson excluded) have set a longer-term target in the $70-$80 per share range. That isn’t much lower than where the stock is now. However, the company has historically surprised to the upside over 75% of the time. If the stock meets expectations and begins to rise, the upside targets are over $100 per share in the near-term.

Because of the risk of large moves one direction or the other following the July 21 report, we recommend appropriate risk control for investors looking to add the stock to their portfolio. For example, going long the stock and also buying a protective put option would be expensive but could provide loss prevention even if the stock gaps lower on a negative surprise.

John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.

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Article printed from InvestorPlace Media, http://investorplace.com/2014/07/trade-day-lumber-liquidators-ll/.

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