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3 Questions for Lumber Liquidators

Saturday - 7/20/2013, 2:36pm  ET

It's about that time again, Lumber Liquidators  investors! With the hardwood flooring specialist all set to announce earnings on Wednesday, July 24, it's a good idea to begin thinking about what we should expect from this fast-growing niche business.

To get you started, here are three questions I would like Lumber Liquidators to answer with next week's report:

1. Can you grow into your valuation?
Sure, shares of Lumber Liquidators have been on an absolute tear having risen more than 160% over the past year, easily trouncing the S&P 500's perfectly respectable 27% gain over the same period.

But that gain definitely occured for a reason. Remember, the company has made a habit of beating earnings expectations of late, most recently posting an amazing 92.5% year-over-year net income gain last quarter on a 22.5% increase in revenue over the same period.

What's more, Lumber Liquidators also increased their revenue and earnings guidance for the remainder of the year, telling investors they now expect net sales in the range of $912 million to $942 million (up from the previous range of $885 million to $920 million), and earnings per share between $2.10 and $2.35 (up from the previous range of $1.90 to $2.15).

That's all well and good, but with the stock trading at 44 times last year's earnings and 72 times free cash flow, any slip-ups that negatively affect the profitability of the company could cost shareholders dearly. 

This leads me to my second question...

2. Are both sales and margins continuing to expand?
OK, this is technically two questions, but Lumber Liquidators CEO Robert Lynch did express optimism during the company's conference call last quarter that home improvement could be "somewhere between the end of a more than five-year contraction and the beginning of what could be a multi-year recovery."

As a result, Lumber Liquidators should be well positioned to benefit from the trend alongside its more diversified competitors like Home Depot  and Lowe's , especially as the smaller company continues adding new locations and works on strategic initiatives to improve efficiency to drive the "multiyear expansion" of its net sales operating margin touted by Lynch in April.

But remember, one of the big advantages Lumber Liquidators has over those industry giants is the fact it operates a relatively simple business model, which itself hinges on negotiating directly with the lumber mills who make the products it sells. By eliminating the middle man, then, this allows Lumber Liquidators to pass the majority of those savings on to their customers, which more than makes up for the larger infrastructures and buying power wielded by its much larger competition in Lowe's and Home Depot.

3. Any color on those product safety concerns?
That said, in contrast to those dividend-paying Steady Eddies, which each boast giant market capitalizations of roughly $48 billion and $117 billion, respectively, the $2.4 billion Lumber Liquidators is also much more susceptible to any negative publicity surrounding its comparatively narrow scope of products.

If you recall, just three weeks ago Lumber Liquidators fell 11% after one author (who also happened to hold a short position in the stock), leveled accusations against the company of selling wood flooring from China that contains dangerous (and illegal) levels of formaldehyde.

Of course, it remains to be seen whether those claims have any validity or if they'll truly have any long-standing negative effects on Lumber Liquidators' image or profitability, but it's a safe bet analysts will be asking the company to address the issue next week.

Foolish takeaway
I still believe Lumber Liquidators is a fantastic company and one whose potential I've already learned can be dangerous to underestimate. While the questions above by no means represent an exhaustive list of things to look for in analyzing Lumber Liquidators from an investment standpoint, they're certainly a great place to start.

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This article was originally published as 3 Questions for Lumber Liquidatorson Fool.com

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