After the close yesterday, Lumber Liquidators (LL) updated its guidance (see press release here) and released a new investor presentation (here). I believe this new information provides evidence to support the key pillar of my investment thesis (outlined in my original presentation, posted here): that margins will come under pressure, leading Lumber Liquidators to miss the exuberant expectations built into the stock price.
While LL increased its prior guidance for Q4 and 2014, it missed current consensus analyst estimates. Specifically:
- Net sales of $252-$258 million; the midpoint, $255 million, is exactly the current consensus
- EPS of $0.69-$0.72, below the current consensus of $0.73
- Incremental SG&A of $1.8-$2.3 million, up $0.4-$0.5 million from prior guidance due to "the start-up of the West Coast distribution center and certain incremental legal and professional fees" (interestingly, on page 5 of the investor presentation, the language is different: "the start-up of the West Coast distribution center and certain incremental legal and professional fees associated primarily with regulatory matters, including the Lacey Act investigation, and the continued enhancement of our compliance programs" - exactly the areas I highlighted that would cause expenses to rise and margins to fall)
- Most importantly, LL guided to materially lower gross and operating margins relative to Q3 and the trend over the past 2+ years, as this chart shows:
(Note that while LL gave Q4 gross margin guidance of 40.4-40.7%, it didn't give operating margin guidance. I estimated a range of 12.5-12.8% based on the average of 12.4% for all of 2013 - see page 31 of the investor presentation.)
- Net sales of $1.15-$1.2 billion, in line with the current consensus of $1.16 billion
- EPS of $3.25-$3.60; the midpoint of $3.43 is below the current consensus of $3.50
- Operating margin of 13.0-13.8%, up from 12.4% for all of 2013
This guidance would be fine if the stock were trading at 15-20x earnings (which is where it would be trading if the market were rational), but at yesterday's closing price of $103.80, the stock is trading at 38x the midpoint of 2013 estimates and 30x the midpoint of the new 2014 guidance.
Such nosebleed multiples can only be sustained by companies consistently beating estimates and raising guidance - which is what LL had been doing for the past two years, leading to a nearly 7x rise in its stock. But LL just missed and lowered - and for precisely the reasons I outlined.
As investors wake up to LL's new reality, I think the stock drifts lower until the next earnings report in the third week of February, at which point the company will update 2014 guidance. I expect even weaker guidance for the year at that time, as I think it's highly unlikely that LL can increase its operating margin from 12.4% in 2013 to the 13.0-13.8% it's now promising for 2014. Rather, I think operating margin will be flat to down, which spells big trouble for the stock.
For those of you who really want to dive into the weeds, LL's latest investor presentation includes a number of new and updated slides that aim to address the many issues I've raised - see the appendix below for the highlights. LL is very clever in presenting information which makes the case that even if the Environmental Investigation Agency report is correct, it focuses on only one supplier, which the company can simply stop sourcing from with minimal disruption.
I'm skeptical that this is an isolated problem limited to one rogue supplier. Rather, I believe that Lumber Liquidators has a big problem on its hands due to the combination of a) the evidence in the EIA report, b) the unusually rapid increase in Lumber Liquidators' margins to unprecedented levels immediately after acquiring a Chinese supply chain company, and c) the hugely corrupt business environment in both Russia and China. Though I can't prove it, the evidence I see, combined with common sense, makes me think it's highly likely that what EIA has uncovered is a pervasive problem across Lumber Liquidators' Chinese supply chain.
Since the raid, the company is surely scrambling to show the authorities that whatever problems are in their supply chain are isolated cases, they didn't know about it, etc. But keep in mind that the authorities raided Lumber Liquidators based on the EIA report, so they're not going to be easily fooled by some spin and token actions. Rather, I think Lumber Liquidators right now has no choice but to very quickly clean up its act to avoid major sanctions by the authorities.
Specifically, I think Lumber Liquidators will have to: 1) immediately stop sourcing from suppliers they even suspect are trafficking in illegal wood; 2) find replacement suppliers; and 3) ensure their entire worldwide supply chain is pristine. Doing all of these things is likely to be very costly and disruptive to the business - not to mention management being distracted by having to deal with the authorities for the foreseeable future.
Yesterday's updated guidance reinforces my belief, so I maintain my $53 price target (and I think I'm being generous), which is based on the following back-of-the-envelope math:
- Sales grow 16% annually in the next two years, as analysts expect (resulting in revenue of $1.35 billion)
- Operating margins give back half of the 830 basis point increase in the last nine quarters and fall to 9% (still far above the long-term average)
- The market responds to this by assigning the stock a 20x P/E multiple
- Result: $1.35B x 9% - 39% tax rate / 28M shares = $2.65 EPS x 20 = $53
Here are my comments on the latest investor presentation:
1) This was the slide in the prior investor presentation (dated 8/14/13; posted here) showing the sources of gross margin improvement:
This is the new version of it:
Notice how they’ve carefully removed any mention of buying product for less – instead it’s “eliminate markup” and “eliminate middlemen”.
2) In slide 21, Our Sourcing, LL repeats that “No single supplier provides more than 4% of our hardwood purchases” and “No single hardwood product represents more than 1% of our sales mix”. In addition, there’s new language here:
- Mills go through an on-boarding process and regular reviews of performance
- Since the fourth quarter of 2011, we have replaced 50% of the Asian mills existing at that time, yet doubled the net total number of mills to reduce risk by diversifying our supply base
- In any given year, we expect mill turnover to range from 15% to 30%, yet continue to broaden the number of mills supplying flooring products
3) On slide 22, LL highlights again that hardwoods are declining as a percentage of sales (now down to 43%, from 47% in 2012 and 64% in 2008).
4) Slide 23 is a new slide on sourcing mix, showing an “Increase in Asian sourcing where bamboo and Acacia hardwood grow, and where laminate, engineered and handscraped hardwood products are cost-effective to produce.”
5) Slide 24 aims to show how insignificant Asian hardwood is in LL’s supply chain:
6) Slide 25 addresses the formaldehyde issue: “Our emissions compliance policies and procedures are designed to go above and beyond regulatory requirements and make our products, whether sold in California or any other state/country, compliant with CARB’s wood product formaldehyde emission standards.”
7) Slide 31 shows the expansion in operating margin, but adds three more years and adds this box that reads: “SAP Implementation in August 2010: Full Productivity Restored in 2H 2011”. In other words, operating margin fell as the new SAP system was installed, and then expanded as the benefits of the system kicked in. Here’s the slide from August:
And here’s the new one: