Lumber Liquidators Holdings' (LL) CEO Robert Lynch on Q2 2014 Results - Earnings Call Transcript

Jul.30.14 | About: Lumber Liquidators (LL)

Lumber Liquidators Holdings (NYSE:LL)

Q2 2014 Earnings Call

July 30, 2014 10:00 am ET

Executives

Ashleigh McDermott -

Robert M. Lynch - Chief Executive Officer, President, Director, Chief Executive Officer of Lumber Liquidators, Inc and President of Lumber Liquidators, Inc

Daniel E. Terrell - Chief Financial Officer and Principal Accounting Officer

Analysts

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Daniel T. Binder - Jefferies LLC, Research Division

Matthew McGinley - ISI Group Inc., Research Division

John A. Baugh - Stifel, Nicolaus & Company, Incorporated, Research Division

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Simeon Ari Gutman - Morgan Stanley, Research Division

David S. Strasser - Janney Montgomery Scott LLC, Research Division

Aram Rubinson - Wolfe Research, LLC

N. Richard Nelson - Stephens Inc., Research Division

David S. MacGregor - Longbow Research LLC

Operator

Good morning, ladies and gentlemen. Welcome to the Lumber Liquidators Second Quarter Earnings Call. With us today from Lumber Liquidators is Mr. Rob Lynch, President and CEO; and Mr. Dan Terrell, CFO.

As a reminder, ladies and gentlemen, this conference is being recorded and may not be reproduced in whole or in part without permission from the company.

I would now like to introduce Ms. Ashleigh McDermott, Director of Financial Reporting for the company. Please go ahead.

Ashleigh McDermott

Thank you. Good morning, everyone, and thank you for joining us today. Before we begin, let me take a moment to reference the Safe Harbor provisions of the United States security laws for forward-looking statements, which are discussed in more detail on our Form 10-Q filed this morning.

This conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements regarding the future operating financial performance of the Lumber Liquidators. Such forward-looking statements are subject to significant risks and uncertainties. Although Lumber Liquidators believes that the expectations reflected in its forward-looking statements are reasonable based upon currently available information, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct.

Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in Lumber Liquidators' filings with the SEC. The information contained in the call is accurate only as of the date discussed. Investors should not assume that the statements will remain operative at a later time. Lastly, Lumber Liquidators undertakes no obligation to update any information discussed in this call.

Now I'm pleased to introduce Mr. Rob Lynch, President and CEO of Lumber Liquidators.

Robert M. Lynch

Thank you, Ashleigh. And good morning, everyone. I'm here with Dan Terrell, our CFO, we appreciate you joining us today for a discussion of our second quarter 2014 results, and outlook for the year, as well as an update on the progress we continue to make on our strategic initiatives. Our second quarter results were in line with the expectations we had discussed on our business update call earlier this month. For the quarter, net sales increased 2.3% to $263.1 million, though comparable store net sales decreased 7.1%.

Operating margin was 10.3%. And net income of $16.6 million resulted in diluted EPS of $0.60. To briefly recap what we had discussed earlier this month, our performance in the second quarter was negatively impacted by 2 primary factors: Reduced customer demand for wood flooring due to certain week macroeconomic trends and continued efforts -- effects from the unusually harsh winter weather. And lower conversion of the customer demand into invoice sales due to constrained inventory levels in certain key merchandise categories. We believe a portion of our reduced customer traffic reflects a weaker environment for large-ticket discretionary projects, such as flooring, in comparing 2014 to 2013, which is evident in a number of macroeconomic indicators that are traditionally associated with residential remodeling. Or perhaps equal or even greater importance to net sales in the second quarter was the constrained levels of inventory we experienced in certain key merchandise categories.

Before I add some color, it is important to note, that we expect to return to full in-stock levels in the current quarter and expect no material impact to our operations in the fourth quarter or into next year.

We are committed to leading our industry in quality and in regulatory compliance standards. And we expect the gap over our existing competitors will widen to a point that it provides a strategic advantage.

Since I arrived at the company in 2011, we have been successfully investing in people and processes governing our quality control and assurance with outsourcing interruption, and I wanted to raise the bar even higher in 2014.

As we continue to implement our enhanced standards, we did not fully anticipate the impact certain changes would have on our supplier base, especially on an aggregate basis. We implement change too quickly across too many mills.

Further, we weren't able to mitigate the impact to second quarter sales through our internal processes.

As Dan will outline in more detail, out of stock and low inventory leads to product substitution, often at a lower retail price points and greater point of sale discounting that impact both sales and gross margin.

Before I turn the call over to Dan, I have a few final thoughts on the second quarter. Although we are seeing periods of softness, I believe, we're in the early stages of a long-term housing recovery, we anticipate that customer demand for residential remodeling and more specifically for wood flooring will improve.

I believe our value proposition and its competitive advantages are as strong and as relevant as ever to our customers. We have been and we'll continue to be focused on implementing our multiyear strategic initiatives and on continuous improvement across our operations.

We're investing for the future where we expect to continue capturing significant share in the fragmented flooring market.

I'll return shortly to provide an update on our strategic initiatives and long-term outlook. For now, I'll turn the call over to Dan for a detailed review of our second quarter financial results. Dan?

Daniel E. Terrell

Thank you, Rob. Good morning, everyone. I'll provide additional details on our second quarter results and our outlook for the remainder of 2014. My references to percentage and basis point changes, are in comparison to the second quarter of 2013 unless otherwise noted.

Net sales increased $6 million or 2.3% to $263.1 million with an increase in non-comparable stores of $24.1 million and a decrease in comparable stores of $18.1 million.

Our non-comparable stores include 44 locations opened in the 12 months since June 30, 2013. In the current year, we have opened 26 new stores, including 13 in the second quarter, all of our new locations in 2013 and 2014 have featured our expanded showroom format.

Since the beginning of 2013, we have remodeled 31 existing stores either in place or through relocation within the primary trade area, including 9 in the current year.

At the quarter end, 87 of our 344 stores, were operating with the expanded showroom format. Net sales in comparable stores have been disappointing this year, as soft demand for wood flooring, reduced customer traffic and constrained inventory levels adversely impacted our ability to convert customer traffic to invoiced sales.

Our comparable stores decreased 7.1% in the second quarter with the number of customers invoiced down 5.3% and the average sale down 1.8%. As we have previously discussed, we believe soft customer demand for wood flooring has impacted our entire chain. In certain areas, those most severely impacted by the unusually harsh weather this past winter into spring, including sections of the Midwest and Northeast, we have seen surprising weakness in comparison to all other stores.

Constrained inventory in certain key products including laminates, vinyl plank and engineered hardwoods, reduced our ability to convert customer demand to invoice sales.

Across all product categories impacted, we estimate an aggregate net sales shortfall in the second quarter of up to $18 million. We believe customer demand will improve during the third quarter as the fall flooring season gets underway in mid-to late August. We have seen improvement in certain macroeconomic indicators, we regularly review, including unemployment, consumer sentiment and existing single-family homes, which have strengthened sequentially the last 2 months but remain negative on a year-over-year basis. We continue to believe we're in a multiyear recovery in demand for residential remodeling and more specifically, demand for wood flooring. The 2014 may well represent a small retraction from the significant improvement seen since 2011. We expect renewed strength in 2015 and possibly, as early as the fourth quarter of this year.

We have seen inventory levels. We considered constrained, improve throughout July, particularly with respect to premium laminates, the recovery of product availability will continue through August and into September, and we expect no material impact to our results in the fourth quarter.

Turning now to gross margin, which contracted 90 basis points to 40.4% in the second quarter of 2014. As most of you know, we segregate our gross margin drivers into those associated with our product, including our sales mix, those associated with transportation and those associated with all other costs. In product, our margin decreased 80 basis points after an increase of 320 basis points in the second quarter of 2013.

We believe the conditions of lower customer count and constrained inventory levels led to shifts in our net sales mix, that were adverse to gross margin.

Further, we saw an increase in ad hoc discounting at the point-of-sale, as a commission sales force sought to satisfy each customer interested in a flooring purchase.

Moldings and accessories continue to positively impact our gross margin, with a sales mix of 19% in the second quarter, up from 18% in the second quarter of 2013. As many of you know, moldings and accessories carry a higher-than-average gross margin and we have targeted increasing the sales mix of this important category as a long-term strategic goal. We expect product margin to remain under pressure in comparison to the prior year, until we achieve targeted levels of available inventory in the key categories we considered constrained in the second quarter.

In addition, we expect the promotional campaign launching our expanded Bellawood assortment in the third quarter, to potentially drive gross profit through higher retail price points, but pressure gross margin, as hardwood categories generally carry lower-than-average gross margins. Over the long term, we continue to see opportunities for further gross margin expansion across a number of our historical drivers, from lower product cost to favorable shifts in our sales mix to higher realized price points. We believe year-over-year gross margin expansion may be restarted as early as the fourth quarter of the current year.

In transportation, higher domestic transportation costs led to a net gross margin decrease of 30 basis points. Aggregate international container cost decreased as rates to a West Coast distribution center were significantly less than rates to the East Coast, and total gross margin benefited by 30 basis points.

Domestic transportation costs, however, were higher by 60 basis points, primarily due to a greater number of customers choosing delivery services and constrained inventory levels, which reduced the efficiency of warehouse to store deliveries and increase the unit flow between stores.

With full in-stock levels by the end of the third quarter, we expect net transportation costs led by savings from our West Coast facility, to benefit gross margin in the fourth quarter by as much as 50 basis points.

All other costs improved total gross by a net 20 basis points at certain operating efficiencies, including a reduction in shrink, were partially offset by lower net sales and our increased investment in quality control and assurance. Selling, general and administrative expenses for the quarter, increased approximately $6.1 million or 8.3% to $79.1 million due to -- due primarily to higher advertising, occupancy, legal and professional fees.

As a percentage of net sales, SG&A expenses were 30.1% in the second quarter, up from 28.4% in 2013.

Salaries, commissions and benefits decreased approximately $600,000, and as a percentage of net sales, decreased 50 basis points to 11.4%.

Incremental costs related to store base growth, launch of our installation services and the full implementation of the West Coast distribution center were more than offset by lower commissions earned by our store management and lower accruals related to our management bonus plan.

Advertising expenses increased approximately $2.3 million or 11%, as we continue to aggressively broaden our reach in frequency. As a percentage of net sales, advertising increased 70 basis points to 8.7%, as the lower impact of net sales was only partially offset by leverage of our national spend.

Occupancy expenses increased $2.3 million or 27% and as a percentage of net sales, increased 80 basis points to 4.1% due to store-base expansion, which added up to 50 basis points and our West Coast distribution center, which added up to 30 basis points.

Depreciation increased approximately 32% due primarily to store base expansion, our program to remodel existing stores and the opening of our West Coast distribution center.

All remaining SG&A expenses including stock-based compensation, increased approximately $1.3 million including all legal and professional fees, which increased $1.2 million.

Operating margin was 10.3% in the second quarter of the current year and 12.9% in the prior year quarter.

The effective tax rate was 38.7% in the second quarter of the current year and 38.6% in the prior year quarter. Net income decreased to $16.6 million or $0.60 per diluted share, based on approximately $27.6 million weighted average diluted shares outstanding.

Turning to our financial position, liquidity and capital resources. Cash and cash equivalents were approximately $48 million at the end of the second quarter, down $33 million over the 6 months of 2014, as operations produced $28 million, capital expenditures used $28 million, and net investing activities, primarily our share repurchase plan used $33 million.

Available inventory per store was $687,000 at the end of the second quarter, up from $680,000 at the beginning of the quarter and $636,000 at the end of June 2013. Invoices during the quarter were primarily due to weaker-than-expected net sales, and an increase in solid hardwoods and related moldings, including products to launch our expanded Bellawood assortment later this fall, all partially offset by certain constrained inventory levels.

Capital expenditures in 2014 are significantly higher than the first half of 2013, due to store base expansion, the remodeling of existing stores, property and equipment related to our new distribution centers, now totaling $9.6 million, and $5.5 million for the expansion of our finishing capacity in vertical integration projects.

During the quarter, we repurchased approximately 246,000 shares of our common stock using $20.7 million of cash. At quarter end, we were authorized to purchase an additional $29.4 million. We remain committed to repurchasing shares to reward our long-term shareholders.

Turning now to our outlook for full year 2014. As we reported earlier this month, we expect net sales for the full year in the range of $1.05 billion to $1.1 billion with net sales at comparable stores either up or down low single-digits. We plan to open 33 to 37 new store locations in 2014, all in the expanded showroom format, and remodel 15 to 20 existing stores either in place or through relocation within the primary trade area.

As I indicated earlier, we believe certain macroeconomic indicators of customer demand for residential remodeling, are likely to improve in the third quarter, but year-over-year strength may be delayed to the fourth quarter. In addition, while inventory levels of products, we considered constrained in the second quarter, have improved in July, we do not expect a full assortment of these products available until the end of the third quarter. Though we expect gross margin to expand in comparing the second half of 2014 to the second half of 2013. We expect the third quarter to remain under pressure as inventory levels improve and we launch our new Bellawood line. We expect SG&A expenses in the second half of 2014 to increase 8% to 12% over the second half of 2013. And second half operating margin to range from 12.9% to 14.5%.

We therefore, expect full year earnings per diluted share in the range of $2.65 to $3 based on a diluted share count of 27.6 million shares, which is exclusive of any future impact of the stock repurchase program.

I'll now turn the call back over to Rob, for additional remarks.

Robert M. Lynch

Thanks, Dan. We're taking steps today that are designed not only to drive overall long-term growth for the company but also to set up our organization structurally to support that growth. Critical to these steps is our continued implementation of our 3 strategic initiatives, namely expanding our customer base, expanding our gross margins resourcing initiatives; operational efficiencies and supply chain optimization; and developing the best people to serve our customers and deliver continuous improvement across our operations. We continue to expand our customer base by opening stores in both new and existing markets. We remain very pleased with the results we're seeing from our market-driven real estate strategy, and stores operating with our expanded showroom format. At the half way mark this year, 25% of our store base now features the expanded showroom format. And we expect to end year at 30%.

While our new stores are not immune from the challenges we experienced across the chain in the first half of the year, the productivity of these stores have been greater than historical averages and we continue to plan our future operations with annual unit growth in the range of 8% to 12%.

In addition to our store base expansion, we're also expanding the products and services we provide to our customers, particularly those that need more assistance than our traditional DIY customer, while still limited in scope, we are pleased with the customer service levels and financial metrics provided by our installation services initiatives. We continue to believe that offering these services, will help us build and further solidify long-term relationships with our customers. We expect to expand this initiative to additional stores in the second half of the year and accelerate rollout in 2015.

We are also continuing to test our 3 LL tile stores and are gaining new insights, as these stores are open for a longer period of time. Similar to our installation services, we view these stores as a potential opportunity to leverage our core value proposition into adjacent and complementary businesses.

Over the last few years, we have effectively broaden the customer base that appreciates the strength of our value proposition. We have aggressively pursued market share through the reach and frequency of our advertising and branding messages. And we believe there is future benefit in continuing this approach. We plan to leverage our national advertising programs over a grown store base, and seek efficiency in the media we use, but the first half weakness have not changed our view of the long-term customer potential available.

Turning to our supply chain initiatives, we're making good progress on the consolidation of our existing East Coast distribution facilities into a single larger location and we remain on plan to be fully operational, late in the fourth quarter this year. As you know, we successfully opened our West Coast distribution center in the first quarter and this facility is now serving as the primary distribution center for over 90 of our Western stores.

In connection with the new distribution centers, we have implemented a new forecasting and replenishment system, which we anticipate will enhance the effectiveness of our product allocation. We remain confident that these 2 distribution facilities will significantly benefit our operating income long-term by helping us to improve our labor productivity, lower transportation costs and add overall strength to our underlying value proposition.

We also continue to invest in our finishing operations to more than double our finishing capacity here in Toano. Further, we continue the evaluation of vertical integration opportunities that may increase the supply of our domestic wood to feed the finishing line, including our flagship Bellawood product. We believe increasing our control over the raw material, drying process and milling will provide greater stability and supply and diversity of assortment and quality in the finished product, all of which we believe, has the potential to drive future gross margin expansion. As we announced recently, we are launching an expansion of our Bellawood product line later this quarter. With the launch, we will introduce our Bellawood 2.0 finish to further enhance our already industry-leading finish and 100-year transferable warranty, with improved scratch and stain resistance across the entire line. We have also added a full line of Bellawood stains and low-gloss matte finishes. The reset has been completed across all of our stores, and we look forward to the sales opportunity from these enhancements to our core Bellawood assortment.

As we have stated previously, we have not and will not back away from deploying capital for long-term benefits. However, we are committed to doing so in a carefully calculated approach, to ensure these investments will add incremental value to what is currently in place.

Our people also continue to be an important focus area. We recently made additional enhancements to the structure of our store leadership team, adding an additional regional Vice President, bringing the total to 4. These 4 individuals report directly to me. We have determined that our organization functions better and more efficiently with a flatter management structure and more direct sightlines for the store.

Overall, we continue to believe that our people, particularly our store management, have the greatest influence on our success. And we'll continue to invest in store talent and training.

We believe that our sourcing capabilities and our ability to go directly to the mills for our products provides us with a competitive advantage. In previous calls, we have discussed efforts to further develop this advantage with regard to product quality, particularly international quality control and assurance. We have always been committed to sustainability and the responsible sourcing of our products from around the world. And we've backed that commitment with real action. We are continually investing in testing, evaluating and enhancing our practices with the goal of assuring the highest quality for our products. Just last month, we announced the appointment of Ray Cotton as Chief Compliance and Sustainability Officer. In his new role, Ray has been tasked with managing our quality assurance, sustainable sourcing, loss prevention, risk management and compliance with legal and regulatory requirements of global trade.

This speaks to our focus on continual improvement of our processes and procedures. And Ray, along with his team, will help maintain and improve our ongoing responsible sourcing efforts to deliver high-quality flooring to our customers.

We believe the actions we are taking will position us to lead the industry in quality control and assurance. And that we will continue to expand gross margin at the same time. As we look forward, we continue to have a very positive view of Lumber Liquidators' long-term potential for growth. Overall, our team is focused and motivated, and we are positioned well to capture share in our highly fragmented market. We remain intent on strengthening our unique value proposition, focusing on continuous improvement of our operations.

We expect to drive growth in the second half of the year, and set the stage for operating margin expansion in 2015 and beyond.

With that, operator, we're now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Matthew Fassler with Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Now that we have a little more time, perhaps you talked about this enhancement to quality standards, that you're making presumably back at the point of sourcing. Can you talk a little more precision about what those relate to, and what they do or whether they're aimed at addressing the environmental concerns that have been raised by some outsiders or the sourcing import of origin concerns, that have been raised or any other factors that you feel that those changes will address?

Robert M. Lynch

Okay. Thanks Matt. This is Rob. What I'll tell you is, we kind of discussed this on a couple of weeks ago. Quality is critical to our value proposition. So we take that very seriously. And as I mentioned in my prepared comments, since I've been here, it's been a focus of mine to raise the bar on our quality standards, our quality assurance, we've invested in our teams, in our international buying offices, in our quality control teams here and consider ourselves to be above the industry on all those requirements. What we've -- we've just continued on that process is basically what I would tell you, not in response to anything specific, more of a focus on our philosophy of driving continuous improvement into our operations. So we continue to put ourselves under a microscope and raise that bar over ourselves and the industry. And in hindsight, I think the lessons learned is that we did a little bit too much, a little bit too fast with too many mills, but we think is the right thing to do, as we look forward long-term. And again, as really walking the talk in terms of investing in our value proposition and creating long-term competitive advantage for the company around quality.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

My second question, by way of follow-up. Clearly if you look at your results and at this point, some of your competitors both retail and production, something is amiss at least for the moment in flooring. That being said, you pointed to some macroeconomic factors and some weakness, some of the housing data has been weak, much of the rest of the macro data has not been, as you think about your space and you talk to your vendors, what specific macro factors, do you think may have impacted macro or other factors, may be impacting flooring as an industry. And to the extent, Dan said that there are macro factors you see turning, I'm curious, which of those are that you think may have hurt, that you see getting better?

Robert M. Lynch

Yes. Matt, this is Rob again. I think we kind of spoke around this again a couple of weeks ago. In general, what I would tell you is that what we do feel long term is that we absolutely feel that we're in a long-term housing recovery coming off of the downturn. However, there is no straight line up there. So as we look back and as some of the macro step that we look at, obviously, are the remodeling statistics, the assisting home sales numbers, home price appreciation, interest rates and things like that. So we've had some very good positive trends in the last couple of years and as we mentioned a few weeks ago, we saw some of those numbers start turning around, 8 or 9 months ago, particularly if you guys look at the existing home sales. So we think this is a short-term issue relative to what's been going on. You add that in combination of with some of the other effects from the harsh winter weather earlier, in the last year and earlier this year. But we -- again I think, long term, we feel good about where that's going to go. There's been some slight improvement in the existing home sales the last couple of months. In terms of, they have been less negative, they have been up month-over-month, and we're -- our view is that we're going to continue to see that improve.

Operator

Our next question comes from Dan Binder with Jefferies and Co.

Daniel T. Binder - Jefferies LLC, Research Division

I had 2 questions. First, on the inventory recovery, I think on the last call, you were thinking that there wouldn't be much of an impact to Q3, it sounds like there might be a little bit more of an issue there from inventory shortages than we originally were thinking is. Can you just elaborate a little bit on that, what you think the impact could be relative to what we saw last quarter? And then, any color around recent trends and orders or customer deposits?

Daniel E. Terrell

Dan, this is Dan. The earlier call this month, we were looking to get back in stock in some of the categories like laminates by the end of July. And engineered products, vinyl by the end of the quarter. While that's still basically the case, we were comfortable with what we've seen through July so far, but we recognize that it's still going to take 1 week or 2 into August before we really feel the effect of the laminates out there on third quarter operations. And still have the same approach to engineered that it's going to take through the end of the quarter. We are comfortable that we're going to begin the fourth quarter at strong inventory levels, and that it will not have a material impact on our operations in the fourth quarter.

Daniel T. Binder - Jefferies LLC, Research Division

So it sounds like there is some improvement. So I think you were estimating it was about 6-point impact to comps last -- this last quarter. Just rough numbers, what do you think that could look like in the current third quarter?

Daniel E. Terrell

Yes, I think the third quarter is still going to remain under some pressure. You're right, and we think it's about 600 basis points in the second quarter on comp sales. The third quarter is going to be uneven, its weighted more to August, September, anyway as the fall flooring season gets underway in the second half of the quarter. But guidance is still looking for pressure and potentially negative comps that may be flat in the third quarter, and then we see a stronger recovery coming in the fourth.

Operator

Our next question comes from Matt McGinley with ISI Group.

Matthew McGinley - ISI Group Inc., Research Division

My first question is a follow-up on that inventory question. You changed the expectations overall from 580 to 620 per store at year-end, to less quantifiable, just higher than historical. What do you -- I guess, one, can you give me some context about what the higher than historical will be at, at year-end and; and two, is that higher level reflective of just more safety stock from China, is that more inventory in the DCs or is that more in store to help increase your close rates?

Robert M. Lynch

This is Rob. I'll start and then I'll kick it to Dan. What I would tell you is that there's a number of factors that are driving the inventory up that are actually all planned and strategic as part of what we're doing. As you know, we're investing in the business. So the new DCs are creating a temporary increase in some inventory. To mitigate some of the constrained inventory issues, we bought in some domestic products for substitution issues. We also made some -- we've made some bulk purchases strategically to mitigate some domestic pricing pressure. And obviously as Dan mentioned, we made investments in new inventory, as we relaunched the whole new Bellawood line, which is such a very exciting initiative that we're kicking off. But as you can imagine, every single skew in that assortment is being replaced with a new item. It might be the same wood underneath, but the finish is completely changing and being improved. So we have to back out of all the inventory on the existing assortment and then bring in and invest in new inventory at the same time, while we're transitioning. That's pretty much it, I think, and then obviously some of the sales shortfall is driving inventory up as well, but as we're planning and forecasting, we're looking forward to come back in line over time, as we implement these initiatives and work through some of this product. I would tell you that, operationally, this product doesn't spoil. And overall relative to the quality of the inventory, I would tell you, although, the inventory levels are higher, the amount and percentage of obsolete and unproductive inventory is lower than it's probably ever been because of the processes and the improvements we have made underneath, and how we manage our inventory.

Daniel E. Terrell

Rob, just took all of my answers, so I agree with what he said. I was just going to add that, it was a little harder to target the year end, where we're trying to evaluate how the progress is going on the East Coast distribution center, which has been far improved with the weather improving here in the summer. So we're definitely going to hold some safety stock through that conversion. It's a large process for us. We're comfortable that we will be able to execute it well. But we're going to end the year with inventory levels higher than we anticipated, certainly much higher than the 580,000 to 620,000. We may be as high as 700,000 per store or even a little higher than that at the end of the year. As Rob just said, that we expect in 2015, that we'll be able to return to more efficient inventory levels with the new center open, with the Bellawood product launched and back fully in stock again.

Matthew McGinley - ISI Group Inc., Research Division

That's very helpful. And the second question is you didn't comment on 3Q sales to date, but you expressed a lot of optimism about the fall selling season in general. How important is August and September versus July, historically to your business. And moreover, as you look at the lopsidedness that you're going to have in the third quarter versus the fourth quarter, you gave us some indication of gross margin being down and then, I suppose, up in the fourth quarter. What does that look like on the sales basis in the third quarter versus the fourth quarter?

Daniel E. Terrell

Yes, the third quarter starts off slow, the summer months are -- June and July are not the strongest months of the year. A lot of family vacations taking place, not a lot of projects being planned. As the kids go back to school in mid-August, you generally see the fall flooring cycle get underway, so the last 6 weeks of the quarter are a lot more important than the first 7. That said, we still see some pressure in the third quarter. I mean, we've seen improvement in single-family homes, but there is still not any year-over-year strength. We've seen improvement in unemployment, we've seen improvement in customer sentiment. But then again, you have things like the slowing of the Case-Shiller index, the price increase. So there is factors, we think are still going to put pressure on the third quarter sales, including our restocking getting back fully in stock. We're far more optimistic about the fourth quarter. We said longer-term, we still see so many drivers within gross margin, we see so many opportunities to drive our core business forward, that we are excited looking forward into 2015 and we think some of that maybe as early as 2014.

Operator

Our next question comes from John Baugh with Stifel.

John A. Baugh - Stifel, Nicolaus & Company, Incorporated, Research Division

Two questions. One, I'm curious there was a mention in the Q about an update from the DOC on duties. I was wondering if you could comment on that. And then, as we look out at the '15, I guess, when we flip to switch on the DC here in Richmond, how do we think about that cost, as we start expensing. I know you had the West Coast hurts you this year. I'm kind of interested in the puts and takes on how that expense impacts '15?

Daniel E. Terrell

Let me take them in reverse. The East Coast DC is going to be a transition process. Obviously, we're taking 4 centers at about 750,000 square feet and moving that to 1 center and 1 million square feet, so there's a lot of transition that's going to take place, once we move into the new East Coast facility. Read that as we'll have some incremental cost SG&A related to that transition. In the first quarter of '15, with the East Coast center fully open, the facilities around Hampton closed down, you're going to see a net benefit to SG&A as depreciation begins on the facility we own and occupancy costs go away from the Hampton facility. We haven't really quantified that yet, we will as we start to talk about 2015, but that's kind of the nutshell there that you'll see incremental SG&A and then you'll see some benefit looking into 2015. On the ITC matters, I think there was a countervailing duty and antidumping, 2 different issues, and I think countervailing duty had an update just 2 days ago, that they lowered the rate by about 60 basis points. I think they were adding about 1.5% duty on all others, and they taking that down to like 80 or 90 bps now. I think there's still an appeal process that's pending and there hasn't really been a change to the dumping side of it. I think we're looking at maybe on a net-net basis, if you take the maximum that were -- we're looking at somewhere between 150 to 200 basis points of increase, but again, all pending appeal.

John A. Baugh - Stifel, Nicolaus & Company, Incorporated, Research Division

And that would impact about 10% of your product mix?

Daniel E. Terrell

Yes. Our engineered wood is subject to and I think our total mix in that area is about 11%. And the product that comes from Asia, is maybe somewhere in the 7% to 9%, 8% to 10% range.

Operator

Our next question comes from Brad Thomas with KeyBanc.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

I wanted to follow-up about the recent trends and if you just look at the weather affected regions versus the non-weather affected regions from earlier in the year. What you have been seeing over the last couple of months? And not just with sales, perhaps as well with what you're seeing in terms of traffic and the samples that you're giving out?

Daniel E. Terrell

Brad I'll put it this way and then maybe Rob will follow my comment. We're excited about the fourth quarter in 2015, because we don't see anything that's structurally changed in those markets. We've certainly been surprised by the weakness, the discrepancy in performance between those markets that were most severely impacted and all other stores. But we don't see anything that is -- has structurally changed, we don't see another correlation to that sales discrepancy. And just like we expect a change to benefit from recovering in our inventory levels, we do, as Rob said and I commented on, we do believe we're in a multiyear recovery, and we don't think those areas are going to perform differently once we are back in stock and once we're through this fall flooring season.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

And then If I could follow-up about the competitive landscape, anything different that you're seeing out there, I know that, that Home Depot has been doing some flooring resets. Is there anything that you've noticed in terms of how that may be impacting your business?

Robert M. Lynch

This is Rob. We watch our competition regularly. We are in -- I'm in the stores all the time, walking them, communicating with our stores all the time as well. So, we know they're focusing on flooring somewhat, they're doing in the significant expansion in some stores, particularly heavy in the tile side in terms of what I've seen hands-on.

But nothing significantly different relative to what they're doing competing with us. They're -- they have introduced some additional laminates at their low OPP level. But we contend -- what we look forward to going forward is especially with the launch of our new Bellawood assortment is we -- the trends we've seen overtime are that we are really excited about in flooring, in general, are the trends away from carpet to hard surface. And then the trends within some other competitors, away from the solid woods and down into the easier to stock and sell OPP laminates and vinyls and things like that. So what we see relative to our core business is our advantage in the core solid and engineered are going to continue to increase, particularly with the relaunch of our new Bellawood line. And that part of our value proposition is good to continue to resonate as the housing market improves and turns around and people get more confident.

Operator

Our next question comes from Simeon Gutman with Morgan Stanley.

Simeon Ari Gutman - Morgan Stanley, Research Division

A couple of questions. First, margin and then on sales. On margin, Rob, business has been pretty successful in internalizing the supply chain. But I think in the couple -- in the last few years, also bidding out business to the lowest cost mills and suppliers. And so now that you've raised the bar on the QA side and quality control side. And it seems like your suppliers have made some changes as well, presumably at their own expense, does it make it more difficult now to really to have a bidding out process, meaning you're more beholden to a certain group? And therefore, the margin gain from just buying better may be more limited going forward?

Robert M. Lynch

What I would tell you is, as we said in our prepared remarks, we've had significant margin improvement in the last few years. We still see multiyear opportunity and improvement in margin around our overall comprehensive gross margin enhancement initiatives. And we'll see how successful we are with the vertical integration projects and some of the other thing we're doing, with the pricing disciplines in the stores and the training there. So long term, we see us returning to, as we said, most likely in the fourth quarter and then into next year, where we are growing and enhancing gross margin. So we don't see anything that systemically has changed that view for us here. Any of the issues that we saw in Q2 and following into Q3 around margin are short term, they are temporary they're mix related. In terms of shifts away from because of these constrained products and discounting in the store.

Simeon Ari Gutman - Morgan Stanley, Research Division

Got it. And -- but the suppliers you use, who did instill some of these changes. Did you instill them to everyone you deal with or just the people that you were buying from in the very near term?

Robert M. Lynch

No. I mean, we did them with whoever we were buying from right now, obviously. So -- but in -- we didn't see -- there's no material impact on the cost of goods.

Daniel E. Terrell

Simeon, this is Dan. I'll add one other thing, too. I think our line review process, while there were certainly some cost increases that were achieved, it was never simply about cost. It was about finding the best partners, who could help us round out the assortment, who could produce a quality product, who could achieve the scale we needed and certainly had sustainable sourcing. So it may ultimately limit some of the players, who wouldn't have gotten the business anyway. But certainly, I think, we're an attractive company with our volume and we have -- now it's just part of the process that a vendor that comes to one of our line reviews knows what they have to do, and there are now some elevated requirements related to that. So it may ultimately cut down number, but I'm not sure it would cut down a number of people we would have selected, had we not made these changes.

Simeon Ari Gutman - Morgan Stanley, Research Division

Okay. And then my follow-up is on the sales side and cannibalization, I don't know if it's for Dan. Can you talk about cannibalization in more detail? I don't know if it's come up in a while. Can you remind us how it's calculated? And I bring it up given some of the sales challenges in the last quarter, we talked about high ticket and frequent nature of the sale, and I think, Dan, you mentioned or it came out last quarter that 3.5 transactions per store per week was about a 10% comp difference. And so I just look back, last year, comps were very strong, you were building out 30 new stores, pretty high footage growth. It seems like there could be some materiality on that as well, just curious if there is any update there?

Daniel E. Terrell

Yes, the cannibalization, we calculate by taking a simple approach for the disclosure so that we put in the K, which is just simply with our comp as we currently calculate it, and then we pull out those stores that have cannibalization where there's at least 1 comp, 1 non-comp and then look at the difference. As we implemented our real estate strategy, where we were focusing on market, as we looked at our expanded showroom format, we saw cannibalization go down to about 200 basis points. Some years back, it had gotten up in the 300-, 400-basis-point range. In 2014, we have had a concentration of stores open, unfortunately, in the areas that were hardest impacted by the weather. We have some Northeast Corridor, Upper Mid-Atlantic and an emphasis in some of the Midwestern areas of our new store base that have increased the cannibalization impact really because of the poor performance in those markets. In the all other category, the cannibalization has remained about 200 basis points. So when you aggregate them it makes it look like cannibalization is increased, but we sort of understand that the main driver for it is where we've concentrated the stores and in the performance of those markets where they have been concentrated. I don't believe there is anything that's going to structurally change. I think somewhere 200, 250 basis points is what to expect with cannibalization going forward.

Operator

Our next question comes from the David Strasser with Janney Capital Markets.

David S. Strasser - Janney Montgomery Scott LLC, Research Division

I just wanted to talk a little bit about your buyback strategy. I was surprised that you guys bought a lot of stock back here, a decent amount of stock back in $80, $84 range in the quarter. Even I would have imagined that even as you saw the business, sort of the difficulties in the business, I'm just trying to understand how you -- how we should think about that going forward. I think you have about $30 million left on the current authorization. Now you have a stock at far more attractive price, what do you think as you go forward through the rest of the year?

Robert M. Lynch

Sure, Dave. I'd start with just the strategy is we believe the best way to use excess cash and reward the shareholders is the share repurchase plan. We are committed to that, you've seen we have done that for a period of time now. And we'll continue to go down that path in the future. As far as the way we implement it, we use a grid based approach, we adjust the grid based on periodic valuations and we can actually change grid during open windows, we set that obviously based on our long-term estimates of what the value of the company is. And we hope to take advantage of short-term movements in the stock. And in hindsight, what we purchased in the second quarter is obviously at an average price higher than it currently trades, but we still believe long-term we're going to get back to where we were, and then that's going to look like a value, and our plan adjusts for the changes in the share price.

David S. Strasser - Janney Montgomery Scott LLC, Research Division

Would you attempt to even accelerate it at current prices based on the optimism that you're talking about here, sort of as an opportunity here?

Robert M. Lynch

Dave, certainly, we're going to look at our excess capital. This is a heavy year for capital improvements. We're excited about the business, there is no question. Our specialty is in driving this business and not handicapping the market. But we obviously think the stock looks attractive at these prices, we obviously believe the business is going to improve and we're really excited about the long-term value of the company.

Operator

Our next question comes from Aram Rubinson with Wolfe Research.

Aram Rubinson - Wolfe Research, LLC

A couple of things. One, again, just to beat the dead horse on inventory and then I wanted to get personnel. I know that the wood that you carry generally doesn't rot, but it does consume a lot of cash, and your DSIs are running 165, I think by the end of this year versus where they used to be at 100. Can you just give us a little bit more insight into the composition of that. I was surprised that the in-transit inventory was flat year-on-year when there is kind of -- I thought more stuff would be coming in, and also Bellawood replacing some of the old wood. Could you just give us a little more composition whether it's by year or age or average age or something to help us understand what the inventory bulge is, if it's not helping with sales, it must be doing something?

Robert M. Lynch

Well, Aram, we certainly, this has been the largest transition year for the company as far as the distribution. We opened in the West coast facility in the first quarter and planning for this investment in the East Coast in the fourth quarter. This is quite a year, because we have a low obsolescence risk, it's always easier to carry a heavy inventory levels. Certainly the West Coast DC impacts transit times, so the in-transit inventory you would have expected in the normal basis to go down just because of the timing, the shorter transit of about a third of our chain going to the West Coast now.

Inventory levels, obviously we planned coming into this year, for more robust top line based on what we had seen in '12 and '13, we expected -- while we expected the weather to knock things sideways a little bit, we didn't expect it to last as long as it did. So planning for higher sales, we had higher inventory levels. You're always going to adjust that, but the fortunate thing is we're not a fashion product. We don't go out of style and as long as we don't strand inventory, we don't have those kind of issues.

So you've got the 2 new facilities where you want safety stock, you've got lower sales than expected and then you do have the Bellawood transition. It's an important product for us. It's our flagship brand. You want to make sure that you're looking at every angle there, that you're getting this new product out and you're minimizing the adverse impact of taking certain products out of the assortment. I mean, it's easier to stay heavy than it is to run lean there. And as we said earlier, I think as you look into 2015, the 2 facilities will be up, we believe, sales will be improved. The Bellawood transition will have taken place, and we'll return to more efficient inventory levels.

Aram Rubinson - Wolfe Research, LLC

Okay. And then just the follow-up is, I know there were some turnover in the U.S. organization with -- it was Jim Davis that had resigned or left. Anything going on in this Sequoia business that we can learn about or anything happening over there in the management of Asia? And then if you can comment just a bit on the Prop 65 lawsuit would be great.

Daniel E. Terrell

We are constantly, as I mentioned, looking at our team and investing in our people. With the transition that just happened we added a fourth regional Vice President in the field. We've gone back to them reporting directly to me, which creates less bureaucracy, cuts out a layer and gets me closer and kind of gives us better sightlines to the stores. So I think going forward, that's a positive. Relative to China and other offices, not sure I understand your question, but we've been investing, as I mentioned earlier, in quality assurance in our international QC team that we significantly -- post-Sequoia acquisition, we have been investing in those teams, we have continued to invest in them realtime on the last 3 years or so. And that's because it all ties back to our quality, our value proposition. Your other question was related to, which one did I miss?

Robert M. Lynch

The lawsuit that was filed California Prop 65, I think it's notification. As we responded, we believe the lawsuit is filled with errors. We test our product. We've always tested our products. We use third-party labs. They're certified by the State of California. We do have notice in our stores, we have notice on our invoices. So we don't believe the losses that was filed has any merit.

Aram Rubinson - Wolfe Research, LLC

Figured we'd give you the opportunity to say that out loud.

Operator

Our next question comes from Rick Nelson with Stephens, Inc.

N. Richard Nelson - Stephens Inc., Research Division

Can you talk about July comps, how they're tracking relative to what you posted in Q2 and in particular, I'm interested in the weather-affected markets, if you're seeing any improvement there?

Robert M. Lynch

Yes, Rick. We are really not -- not really talking about July. Other than to say, we're getting back in stock, we're feeling pretty good about what we're seeing in Laminates is going to take another couple of weeks to get out there. And then, that while the third quarter may remain under some pressure, as we get back in stock and it's going to take another couple of weeks from now before we really get into the flooring season. We're confident that we'll see improving demand. The demand that we lost related to being out of stock in certain products and then some improvement in the macroeconomic factors that we follow. We believe the fourth quarter is going to be better than the third, and we're going to enter '15 in a much better position than we are currently. So I just don't want to go into the specifics of July, because I just don't know what kind of bearing that's going to have on the real third and fourth quarters.

N. Richard Nelson - Stephens Inc., Research Division

I got you. And with some of the supply challenges lingering into Q3, do you change the promotional cadence and push more of it into the fourth quarter when you expect more normalized kind of supplies?

Robert M. Lynch

This is Rob. Good question. We are not going to necessarily change any events or cancel any events. But we're going to be prudent about what we're promoting and what we're putting in the ads, in terms of the content and the items and categories in them. Obviously, we're not going to want to be promoting something that's out of stock and disappointing customers, that's pretty much. I wouldn't -- I don't think you will see a major shift year-over-year in terms of activity, overall amount of events and adds.

Operator

Our last question comes from David MacGregor with Longbow Research.

David S. MacGregor - Longbow Research LLC

I wanted to ask you a question about price discipline and the price discounting that's been going on in the stores. And a major part of the margin progression store over the last couple of years has been pretty impressive price discipline that you've been able to implement at the store level. And then, this quarter we get into an environment where there was some distress and suddenly there was a lot of discounting. So I wonder if you could just talk about the distinction between what you have been doing over the last couple of years and then what happened this quarter, and also what gives you confidence that you can bring the stores back into a disciplined manner on pricing, once you get back to the fourth quarter and your model normalizes?

Robert M. Lynch

Okay, this is Rob. Yes, I would tell you that the pricing discipline focus really wasn't a focus until as we got in the last year, I would say it did benefit somewhat last year, but was not the main driver. So we feel that long-term we have a good amount of upside there, as we get back on track. And what happened in the first half this year, was really some natural discounting in terms of meeting customer demand, customer service related issues related to the constrained inventory, where stores were taking care of customers if customers were being constrained or pushed down on an order that they were expecting, and as we were moving them from one item to another and they were getting their purchase later than expected. We would -- we'll do things to take care of that customer and satisfy them.

So it's something that -- discounting in the store is something that we will always have, we will always have the stores, give the stores the autonomy and the ability to beat the best price to match competitors ads and have that flexibility. But to your last part of your question, relative to how do we feel about going forward, even during this year, the continuous improvement efforts around the specific training, the discussions, the reporting and focus on it, we've been increasing significantly. And so I am very confident that, that's getting back in control and will continue to be under control and will be a driver of margin as we get into the Q4 and into the future.

David S. MacGregor - Longbow Research LLC

Okay. And just as a follow-up, I wonder if you can talk about the development of your installation business, as a growth enabler in 2015.

Daniel E. Terrell

Yes, Dave. We are excited about installation. It's been a test out there for a long time. The team has done a great job putting it in, a lot of hard work here from the office and a lot of hard work out in the field. We believe it's going to serve our customers well. We've seen the financial metrics improve. We've made sure that it does no harm to the business as it goes out there, that we can stay focused on our core and that this is truly an additional add-on service that benefits the customer, so we have been at 60 stores for a couple of quarters now. We're going to expand that at a reasonable pace both in the fourth quarter of '14 and into 2015. So we have been pleased with what we have seen so far.

Thank you for joining us on today's call, everyone. As we look forward, our team is more energized and dedicated than ever to drive the growth that we believe is achievable long-term for Lumber Liquidators. We look forward to speaking with you again on our next earnings call, to report on our continued progress in executing our strategic initiatives to achieve our long-term objectives.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. And have a great day.

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