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Can Lumber Liquidators Pass The IPO Litmus Test?

Posted: Nov 27, 2008 10:31 AM by Will Ashworth

Tickers in this Article: CATM, LOW, HD, LL

For an initial public offering (IPO) to be a success it takes three things: 1) the company making the offering must benefit substantively from the additional capital it raises, 2) the selling shareholders are able to exit their investments profitably and 3) most importantly, the new shareholders must also profit from their investment, just like the existing shareholders. If these three conditions aren't met, what's the point?

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An IPO must be a win-win situation in my opinion or there's no justification for it. It's that simple.

Putting Lumber Liquidators to the Test
To test out my criteria for a winning IPO, I'll look at Lumber Liquidators (NYSE:LL), the Virginia-based hardwood flooring retailer you may have seen on ABC's "Extreme Makeover: Home Edition". Its star, Ty Pennington, has his own line of Bellawood flooring, available exclusively through their stores. Lumber Liquidators started in 1994 by now Chairman Tom Sullivan, and it offered customers a better selection in hardwood flooring than traditional home improvement stores like Home Depot (NYSE:HD) and Lowe's (NYSE:LOW). Growing from one store in the Boston-area, it now has 140 nationwide, selling online as well. It went public on November 8, 2007, and sold 10 million shares at $11 each to investors. On its first day of trading, the stock closed down 11.3% at $9.76. One year later, it's down 27% from the IPO pricing to November 26 close. (For more on the issuing of new shares, check out IPO Basics: Introduction and The Murky Waters Of The IPO Market.)

Test No. 1: Did the Company Benefit?
Lumber Liquidators received net proceeds of $36.4 million from its 3.8 million shares sold in the offering. Lumber Liquidators paid off all of its $14.1 million in outstanding debt, and used the remaining $22.3 million for working capital and corporate growth. Given its average store is 6,400 square feet with about 800 square feet of showroom space, it requires approximately $240,000 per new opening. Of this about $190,000 is used for initial inventory and payables. But once built, each store has an average sale of more than $1,750 per customer per month, excluding orders under $250 and over $30,000 which are usually samples and contractor orders respectively. Due to this, its stores are profitable within three months, the importance of this capital for timely expansion can't be understated.

Furthermore, as a public company, it's in the spotlight more often, which isn't a bad thing if you're in the retail business. It certainly hasn't suffered under the extra stress of its public status. Third quarter results ended September 30, 2008, saw sales increase 20.6% to $123 million and net income 47.6% to $5.5 million. Management estimates full-year 2008 revenue to be around $482 million with earnings per share of 74 cents, despite a weak economy. Year-to-date it has opened 34 stores. While 2009 will present economic challenges, it believes it can still grow.

The verdict: On a scale of 1 to 10, with 1 representing very little benefit and 10 representing the maximum, I'd give it an 8. The IPO wasn't essential but its timing couldn't have been better. If it waited until 2008, the reception by investors would have been cool at best.

Test No. 2: Did the Selling Shareholders Benefit?
They sure did. Founder Tom Sullivan sold more than 4.13 million shares and TA Associates 2.07 million. In December 2004, Boston-based TA Associates, one of the world's largest private equity firms bought $35 million in convertible preferred stock from Lumber Liquidators. Immediately prior to the IPO, TA Associates preferred stock converted on a one-to-one basis into 7.95 million common shares. After the IPO, it held 5.89 million shares, or 22% of the stock. As of November 26, it still owns 3.40 million shares. From November 2007 until September 30, 2008, it received proceeds of $54.48 million with 3.4 million shares still to sell, which currently are valued at $27.2 million. That's an annual return on investment of 23.61%. That's assuming TA sells at $8, and it doesn't take into account the $1 up-swing on Wednesday. So assuming the up-swing sticks, returns will increase even further. Considering TA Associates' average price paid per share was $4.40, even at these depressed levels TA is making money.

The Verdict: On a scale of 1 to 10, TA Associates gets a 9 and the founder an 8. (Keeping tabs on company executives can provide clues about where a stock is headed, read more in Delving Into Insider Investments.)

Test No. 3: Did The IPO investors Benefit?
The answer to this is straightforward. Shares closed trading at $9.45 on November 27, so those who paid $11 per share and still hold today have definitely not benefited from the IPO. In fact, to obtain the same rate of return over the first four years of their investment as TA Associates did, the stock would have to appreciate 47.51% in each of the next three years. While earnings are growing substantially, it's unlikely they can meet this kind of increase. The one caveat is it's likely that many IPO investors sold for a profit in the first half of 2008, when prices were in the $15+ range.

The Verdict: On a scale of 1 to 10, I give it a 6. The reality is, like every IPO, the real moneymakers were the insiders.

Bottom Line
While this wasn't a perfect IPO, it is far from being a disaster. That honor goes to Cardtronics (Nasdaq:CATM), which went public at about the same time, and whose stock is down 90% to under a dollar.

By Will Ashworth

Will Ashworth lives and works in Toronto, Canada. He's worked in and around the financial services industry for much of his adult life. He loves investing and is passionate about helping others learn how to put their money to work.

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