Lumber Liquidators: Upside Constrained By Margins

| About: Lumber Liquidators (LL)

Summary

Lumber Liquidators has done well with its legal issues, winning its Prop 65 case and settling with CARB. A significant probability of good legal results is likely priced in now.

Business remains challenging, with no sales recovery apparent by the end of 2015. Q1 2016 may be challenging too with the CDC report making headlines.

Lumber Liquidators may be worth $20 if it can get back to a 5% operating margin and increase sales modestly.

That would require 35% gross margins and reducing SG&A by around $20 million to $25 million.

Flat sales from Q4 2015 levels, 35% gross margins and a $15 million reduction in SG&A results in an estimated price of $9 to $10.

Lumber Liquidators (NYSE:LL) is a stock that I've traded from both sides over the past year and a bit. In general, its progress with legal issues has met or exceeded my expectations, while its business performance has underperformed my expectations. I am now short Lumber Liquidators since I believe that good legal results are now being priced into the stock, while its challenges in terms of regaining sales and improving gross margins while simultaneously reducing expenses have not been priced in as much.

Legal Situation

The news has been quite good for Lumber Liquidators from a legal perspective. It settled with CARB and won a victory in the Prop 65 case. I would imagine that the class action plaintiffs' lawyers probably would now willing to negotiate for a moderate settlement given the California results. The question for Lumber Liquidators is whether it would be better to fight on and incur legal expenses in an attempt to win a complete victory, or to settle for a moderate amount in order stop paying extra legal fees and put the legal issues behind it.

However, with the legal victories a higher likelihood of future good legal results is being priced into the stock, reducing its upside from legal results alone. I will now look at Lumber Liquidators' historical valuation before its legal issues.

Historical Valuation

If we look back at Lumber Liquidators during early 2011 and early 2012, we find that it had an enterprise value of approximately 10x to 11x its guidance for operating income for the year.

For example, 2011 guidance called for roughly $55 million in operating income, and Lumber Liquidators had an enterprise value of approximately $625 million at the time when guidance was released (February 2011). In 2012, guidance called for approximately $53 million in operating income and, Lumber Liquidators had an enterprise value of approximately $525 million at that time. This was a period marked by relatively flat comparable store sales growth and some modest overall growth based on expansion. Operating margins were expected to be around 7% to 8%.

2011 Guidance

2012 Guidance

Sales ($ Million)

$715

$725

Operating Income ($ Million)

$55

$53

Net Income ($ Million)

$33

$32

Enterprise Value ($ Million)

$625

$525

Click to enlarge

At its near peak in early 2014, Lumber Liquidators did have an enterprise value of approximately 17x operating income guidance, but that was a time of exceptional growth (expectation for 15% to 20% net sales growth, 10% comparable store sales growth, combined with operating margin expansion to over 13%).

Current Situation

Lumber Liquidators had $979 million in sales during 2015, but sales trends became worse towards the end of the year and the first two months of 2015 were before the 60 Minutes report. The current sales trajectory for 2016 is probably closer to the $925 million to $950 million range. If Lumber Liquidators can stabilize sales during 2016 and then deliver some modest growth in 2017, its 2017 sales could be around $975 million.

As for gross margins, Lumber Liquidators believes that it can do better than the 32% gross margin (adjusted to exclude inventory writedown) that it reached in Q4 2015. However, a return to 40% gross margin sounds quite unlikely from its commentary. I've previously estimated that 35% might be a reasonable target for Lumber Liquidators' gross margins as that would be consistent with its gross margins from 2011 and earlier.

Lumber Liquidators also is estimated to have approximately $315 million in annual SG&A currently (excluding elevated legal and professional expenses). If Lumber Liquidators can reduce this by $20 million to $25 million, it can end up with a 5% operating margin. This is lower than the approximate 6% to 8% that it did pre-2012, partly due to a decline in the average sales per store.

At a 5% operating margin and $975 million in sales, Lumber Liquidators would have around $49 million in operating income. This results in an estimated enterprise value of $536 million or a value of $20 per share.

SG&A Components

Here's a look at the estimated breakdown of the $315 million in annual SG&A costs. The $315 million excludes the extra charges and legal and professional expenses that Lumber Liquidators is currently incurring, and represents a baseline level. The other category includes items such as legal and professional expenses and information technology expenses.

$ Million

Salaries

$135

Advertising

$81

Occupancy

$46

Depreciation and Amortization

$17

Stock Based Compensation

$3

Other

$33

Total

$315

Click to enlarge

Of these items, salaries could potentially be reduced a bit through more efficient staffing, although the new compliance initiatives probably will boost the salaries basket beyond traditional levels as a percentage of sales. As well, cutting salaries may be difficult as Lumber Liquidators seeks to retain employees. Advertising could also be potentially made more efficient, with a target of 7.5% of sales, slightly below historical levels. This would put advertising at around $73 million, although cutting advertising too much would likely affect sales. The other items such as occupancy probably can't be reduced much without closing stores.

Therefore, unless we see store closures, Lumber Liquidators will probably have a difficult time bringing SG&A below $290 million to $295 million. This would result in a 5% operating margin for Lumber Liquidators with $975 million in sales and 35% gross margin. If Lumber Liquidators has $940 million in sales instead and can only reduce SG&A by $15 million, its operating margin would be 3%. This would still be an improvement over its current -1.5% operating margin (which excludes one-time charges and the elevated legal and professional expenses).

Conclusion

Assuming that a lot of things go right for Lumber Liquidators, it could be worth $20 in one to two years. This would involve halting the sales decline and growing sales modestly again (low-to-mid single digits from current levels), bringing gross margins back up to 35% and cutting SG&A by $20 million to $25 million (in addition to ending the elevated legal and professional expenses). For Lumber Liquidators to get to back to 7% operating margins probably would require sales to increase around 15% from current levels along with decreasing SG&A to $300 million. This seems quite difficult to do, but if it can do that, Lumber Liquidators could be worth a bit above $30.

However, if Lumber Liquidators ends up around $940 million in sales with 3% operating margins and $50 million in net debt, then it could be worth around $9 to $10 per share. This would require sales to be roughly flat versus Q4 2015 levels, while gross margins rebound to 35% and SG&A is reduced by around $15 million in addition to ending the elevated legal and professional expenses). I think that Lumber Liquidators has a fairly good chance achieving that, although its 2016 results are expected to be well short of that.

The reason that I am short Lumber Liquidators now is that at $14 to $15, it appears to be priced for both a favorable resolution of legal issues and some markedly improved (from current levels) business results. I believe that the former is likely to occur, but the latter could be considerably more challenging. I think that Q1 2016 results will indicate that Lumber Liquidators is still facing a tough business situation.

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Disclosure: I am/we are short 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.