It was a rough quarter for flooring retailers. For Floor & Decor (FND), growth slowed, and for Lumber Liquidators (NYSE:LL ), traffic failed to increase... again. LL management has done an admirable job returning the company to profitability on an adjusted basis; however, sustained comp growth from the heady days before the damning 60 Minutes exposé seems elusive, if not impossible. Surely, by now, after several years of declining traffic, investors are expecting the eventual rebound. Instead, traffic has persistently flat-lined for the last couple of years. My sense is that management is at a loss as to how to energize traffic growth, especially after LL's long-tenured Chief Marketing Officer departed without a replacement.

On the bright side, LL has made real progress offering installations and expanding the Pro business, but this only masks the deeper decline in what was traditionally LL's core business: DIY customers. Current management cannot be blamed for LL's past sins, but for some members of the board, that's a different story. Given the want of real progress at LL, I believe it's time for LL to consider radical change: either a board shakeup or an acquisition to extract the value in its underlying business model.

Let's look at average revenue per unit in thousands of dollars for the major publicly traded flooring retailers over the past 5 years. We can see Tile Shop's (TTS) per store numbers have been worsening at a time of rapid market share capture for FND, while LL's figures have started to rebound (albeit substantially improved by the addition of installation and pro sales):

Next, let's look at how all the major publicly traded home improvement or flooring companies have performed in total flooring sales during the same time period, in thousands of dollars:

As we can see from the overall sales numbers, everyone in the category is growing, and LL is finally bouncing back (Lowe's (LOW) numbers are a little erratic due to Home Fashions removal as a category and some reclassification to flooring according to the 2017 10-K.) LL's trajectory was interrupted due to negative publicity, but we must give LL's current management some credit as they recognized an opportunity to staunch the decline in sales by adding installation services and seeking out a closer relationship with its Pro customers. The downside is to this is it makes it difficult, under the current strategy, for LL to grow its gross margins back to the high-30s or let alone 40%+ of its heyday because both installations and Pro sales yield lower margins.

The good news, according to Catalina Marketing cited in sell side research and filings from FND and LL, is that the hard surface floor category is continuing to grow, taking share from legacy products such as carpet and vinyl sheet flooring. The bad news (for the competition) is that FND is growing rapidly and the sleeping giant, Home Depot (HD), is remodeling ~500 showrooms to a new look and feel that is remarkably similar to LL's showroom format. Moreover, HD also has the benefit of indoor warehouse space to display pallet stacks, which LL simply cannot do in its current footprint (but it can stack them in the parking lot), as well as one-stop shopping and convenience that only LOW can emulate. See an example of HD's new flooring showroom in the picture below:

Another big risk is international trade. If a trade war escalates, both HD and LOW are significantly better positioned to withstand short-term margin erosion. However, this does not mean FND and LL can't also gain ground. While the former is in a much stronger position to withstand sustained margin pressure, LL has a slight advantage by virtue of having already shifted laminate and some minor categories out of China due to LL's previous compliance problems. Ultimately, this is significant advantage over the smaller independents in the highly fragmented retail flooring market as it is much more difficult to source domestically or from Europe without scale. Indeed, if LL were privately held and not subject to quarterly market swings impacted by short-termism or acquired by a larger company, it could further press this advantage versus both the big box stores and the smaller players, lower its gross margin, and recapture lost market share.

So, what about TTS or LOW? Well, TTS has its own problems, the primary issue being its entire product offering and ship-to-store model are under assault from FND, and its designer-driven revenues are likely to continue declining over time unless it makes significant changes. That's another article for another day. LOW, however, has a Pro problem. It is slowly losing the battle for the professional wallet to HD. Enter new CEO Marvin Ellison, who is tasked with fixing precisely this Pro problem. LOW could make a major step in improving its presence in the hard surface flooring Pro market, as well as expanding its own DIY offering, by buying LL.

LOW may sell more flooring than FND and LL combined, but it is still far behind market leader HD. One problem, out of many, is that LOW does not stand out in the category, and has not developed its own private label flooring brand such as HD has recently done by introducing its Lifeproof brand. Sure, LOW sells Pergo, but so does HD. Instead of trying to catch up by devoting time and energy to coming up with its own brand, it may be less risky and more cost efficient to buy a proven winner. And it just so happens, despite the media drubbing that LL took, its flagship brand remains untarnished and is one of the most recognizable in the industry: Bellawood.

Unfortunately, LL has not done enough to capitalize on the Bellawood brand, and the corporate brand, "Lumber Liquidators," no longer reflects what they do: no significant unfinished wood sales ("lumber") and no liquidation sales (primarily in-stock SKUs), and this name has been under assault for years from negative press related to a series of questionable business practices and decisions (this is possibly why traffic is not growing.) Efforts to expand LL's waterproof offering have been admirable. For instance, I really like the new X2O moniker for water-resistant laminate flooring. However, LL blundered by using the "Dream Home" brand as the genus under which X2O is marketed. Dream Home is the brand associated with its unfortunate Chinese-made, formaldehyde-laden laminates; information glaringly evident to anyone who googles the name in consideration of a purchase. It would have been preferable to call the product Bellawood X2O and present this product as a much stronger competitor to FND's Aquaguard and Pergo's Timbercraft or Outlast brands. But, perhaps, the fact that LL has not cashed in on the Bellawood brand leaves the door open for an acquirer to reap the benefits.

With respect to the newer categories of rigid vinyl flooring, LL had an opportunity not only to recast its Bellawood image in a burgeoning, new product category, but also to be the defining product in the class. LL calls its product in this category, Corelux, which sounds very familiar to FND's Duralux. I don't know which came first, but to the average customer, I doubt they can tell the difference. Frankly, LL should have slapped its Bellawood brand on these floors and taken advantage of its brand recognition. If LL won't do that, then at least use some derivative name such as Bellalux, so there's some association to its flagship brand.

Based on channel checks, both HD and LOW will be launching new waterproof products this fall. Without getting into specifics, it appears they'll be using a third party, which is already selling a different flooring product in LOW's stores. Since there is still considerable uncertainty as to which "Betamax or VHS" waterproof standard will ultimately dominate the category, I think LL has a real opportunity. So far, HD has taken the approach of marketing practically all of its new tile, vinyl and other waterproof products under the Lifeproof brand, which I think sounds pretty damn good compared to the rest of the bunch. So, why doesn't LL take this approach and use Bellawood for its entire line up of tile, waterproof and water-resistant flooring options? Especially since LL's other existing brands have questionable value, whereas Bellawood is still considered the best of breed.

After my recent visit to several factories in China, there appears to be an imminent breakthrough in rigid vinyl production that will eliminate the current bottlenecks in the extrusion production process. Again, without getting into the weeds, as the LVT, non-rigid, category is weakening and production declines, the machines can be recalibrated to produce the stone polymer composite floor (rigid vinyl, or rigid LVP.) This expansion of capacity will bring unit costs down and could allow the larger companies to capitalize on their superior sourcing to erode further the independent's sizable market share. Moreover, using the premium Bellawood brand could present an opportunity to expand margins while other names compete on price. LL and/or LOW should have buyers in place to see these trends and capitalize on them by pricing these products based on future expected costs rather than today's costs. If they don't, then it is yet another reason for a shakeup.

Speaking of gross margins, a significant opportunity for expansion exists in Tools & Accessories. When LL first tried to sell these to Pros and DIY consumers it turned to William Schlegel the former VP of Merchandising at Harbor Freight Tools to get into the business. If you are not familiar with Harbor Freight, it is not exactly known for selling high quality tools. This is precisely the wrong approach if you want to build a loyal pro customer base. Yet, there is still an opportunity here. Most of the tools that LL sells are marketed under the creative Norge brand (this just happens to be a small unincorporated township outside Toano settled by Norwegian-Americans; hence the name.) Pros typically buy better quality tools with longer life expectancies. Unfortunately, Norge isn't one of them. Selling cheap, unreliable items to DIYers might have worked in the past, but no longer. And after HD's most recent quarterly report showing tools comping in the HSD, this is a category that is assuredly under-performing for LL. With this transition from DIY low-end tools to contractor tools, LL should consider dropping its Norge brand completely and bring in quality brands such as Milwaukee, Bosch or Makita.

Selling quality tools is competitive, so where is the margin opportunity? It's in the caulk, tape, floor pins, brad nails, adhesives, floor patch and level, and basically any other item required for a floor installation on almost EVERY job. These items can amount to 10% of the total ticket. LL could capitalize on selling its own Bellawood branded accessories to both installation and Pro customers instead of relying on third party products. On these items alone LL could gain 1000 bps of extra margin, which if they account for 10% of sales could add 100 bps to overall gross margin.

Besides capturing the Bellawood brand, how else could LOW benefit from an LL acquisition? I think the 400+ retail LL locations could essentially function as a Pro Checkout on steroids. Whereas HD has a dedicated lane(s) for pros, LOW could direct pro customers to LL locations for faster pick up for in-stock tools, certain millwork items, fasteners and flooring as well as any special order items coming from the nearest distribution center (DC). Speaking of which, LOW has 15 DCs in the continental USA that could accelerate the delivery time of special-order flooring and allow LL to go deeper on the best-selling SKUs in stock at each location. See the locations of LOW's DCs shown as a blue dot vs the LL DCs (including its small Houston warehouse that was initially set up to capitalize on Hurricane Harvey) shown as a yellow dot along with all of LL's retail showrooms below:

Source: Lumber Liquidators website and SEC Filings

If you look at these DCs and draw a 100-mile and 250-mile (or shorter if applicable) radius around each one, you get the following number of LL store locations near each:

I left off two LOWs DCs as they were either not meaningful for LL fulfillment or redundant: Cheyenne, WY and Statesville, NC. The takeaway is that ~40% of LL stores are within 100 miles of a LOW DC; and over 75% are within 250 miles.

Other obvious synergies include compliance, sourcing, legal, installation, and a unified pro desk. Indeed, the LowesForPros.com website could incorporate most of the LL SKUs and provide significant purchase experience improvements for LL's Pro customers from credit, to inventory access, to crossover promotions, to gifts and added points.

On a productivity basis, LL actually outclasses its peers as it offers the highest sales per square foot of any of the publicly traded flooring retailers and has the cheapest valuation on a price-to-book metric:

While FND has continued to show both absolute, per unit and sales/sq ft improvements over the last five years, its higher valuation already reflects that. Given that LL seems to have turned some of its metrics around, and is making progress with its top line, I think LL looks relatively cheap compared to TTS, whose products are moving slowly and are vastly overpriced vs FND's tile and stone. However, LL is not trading higher due to gross margin underperformance and elevated SG&A, but I have outlined ways margin will expand, and there's plenty of fixed cost leverage built in. But for now, let's uncover some additional value hidden in the balance sheet. Looking at LL's most recent 10-Q, if we fine-tune the balance sheet for expected customer sales from the $45.347 million in deposits, which according to the LL 10-K, are: equal to approximately half of the retail sales value and if we assume that all of those deposits converted into sales on 7/1/2018, then the journal entries would be:

Sales Tax Payable $ 7,256,000 (assuming an average tax rate of ~8%)

For the inventory side of this, assuming a 35% gross margin, we'd see:

The net of all this is that LL's cash would increase to $56.5 million, its inventory would decrease to $242.6 million, and its Tax Liabilities would increase to $11.7 million. For 2017, even though there could be a surprise ruling next summer, it appears LL stands to pocket an AD refund for the seven months during which it paid 17.37% in AD duties. This is likely in the neighborhood of $3-4 million. Then, there's the MDL settlement, $14 million of which is in soft dollar vouchers. At a 35% gross margin that's ~$5 million not counting whatever expires after 3 years or goes unused. Add it all up and LL's adjusted book value is a little over $8/share vs the current $6.87/share book value (I am also not counting the $20 million in Chinese laminate collecting dust in a warehouse in TN that could be sold in Latin America.) At today's current market cap of ~$489 million, that means LOW or any buyer would end up paying ~$260 million or ~$640,000 per store above book. That seems like a bargain. Indeed, the intrinsic value (market less leaseholds, inventory, etc.) of LL's stores could be worth far more. One other thing to ponder is what would the stores be worth if LL decided to franchise its concept. My hunch is it would be materially more than what's being priced in today, possibly even double today's valuation.

So, let's look at the synergies with LOW that make it an ideal suitor able to outbid rivals. LOW could begin remodeling its existing flooring display area, similar to what HD is rolling out, creating a store within a store, essentially an LL inside of LOW, bringing the best of the LL store experience to LOW, featuring the Bellawood brand. Store within a store is a concept that Mr Ellison has had some experience with during his time at JCPenney (JCP.) Actively promoting Bellawood would have significant synergies for LOW especially as it lacks a strong private label repertoire in flooring.

Lastly, I would be remiss if I did not mention the remaining potential liabilities that LL faces. There's the lingering Gold matter, the Steele suit in Canada, some employee litigation and an SEC/DOJ investigation. On this last issue, which is likely being discounted heavily by the market, I'd like to remind the reader that, according to the LL 10-K, the company received its first SEC subpoena on May 19, 2015, and LL believes that, "the focus of both investigations primarily relates to compliance with disclosure, financial reporting, and trading requirements..." Coincidentally, two days later, on May 21, 2015, the former CEO, Robert Lynch, unexpectedly resigned. Any cause-effect here? It is possible that the subpoena focus may be related to actions or trading of Mr Lynch and his team, and that the investigation is not entirely related to possible illicit company behavior. This is just speculation, but I assume the entirety of the new executive team was fully aware of the extent of potential legal outcomes, and risked coming on board regardless of what was disclosed.

In summary, LL has attractive assets: its premium brand, Bellawood, its 400+ locations that offer mostly Amazon-proof (AMZN) products to consumers and Pros, and ironically its advantageous sourcing position due to the self-imposed laminate sourcing exile from China with a trade war potentially in the offing. Moreover, the macroeconomic environment is favorable with rising wages and low unemployment, high consumer confidence and a favorable housing market with significant home price appreciation. All these factors lead me to conclude that LL's shares are undervalued, and could easily see 40% upside; substantially more if acquired. And LOW isn't the only company that could benefit by acquiring LL. I can see strategic combinations that make sense with Wayfair (W) or Amazon (both could use additional brick and mortar locations, and neither has successfully penetrated the difficult and expensive to ship flooring market), Shaw (vertical synergies), private equity, or even a suitor from left field such as Tom Sullivan buying up enough stock to regain control of his former company. However, I am not buying for any of these reasons but for the simple long thesis: LL has stabilized the business, is cheap relative to its peers, its legal troubles are mostly behind it, the macroeconomic environment is extremely favorable and due to further disruption of the independent retailer LL has opportunities to recapture share and margin.

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Disclosure: I am/we are long LL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.