Lumber Liquidators - Normalized Gross Margin?

| About: Lumber Liquidators (LL)

Summary

Prior to the formaldehyde scare LL was facing allegations that their gross margins were unsustainable.

LL bears point to the loss of cheap Chinese laminate as proof gross margins were unsustainable.

In this article I will discuss historic and current drivers of LL gross margins.

In a previous article I discussed a rapid rise in Lumber Liquidators (NYSE:LL) gross margins under former CEO Robert Lynch's tenure starting in 2011; with gross margins going from ~35% to ~41% before the formaldehyde accusations came out in early 2015. Giving financial analysis is not my day job, I chose to ballpark that gross margins would eventually settle somewhere between pre-Lynch era 35% and the Lynch era high of 41% for that article.

I've seen the argument made many times, and again in the comments section of a recent LL focused article, that the remarkable rise in gross margins under Lynch was due to cheap Chinese laminate, and the loss of this sourcing will ensure gross margins can't return to pre-formaldehyde scare levels.

In an investor presentation in March 2015, addressing the formaldehyde allegations, LL detailed the proportion of Chinese laminate sales before the allegations and also provided guidance on the probable increase in cost to source the same products elsewhere. I copied and pasted the relevant information from that presentation below:

"As a manufactured product not requiring a native species, laminates are produced all over the world. In 2011, the year we acquired Sequoia, laminates were 23% of our net sales, and we sourced almost 70% of that volume from China, with the remainder coming from the US. By 2014, laminates represented 19% of our net sales, and we sourced 52% from China, 28% from the United States and 20% from Europe.

We currently believe that, using China as a base of all aggregate costs against a reasonable volume of products, producing those same products in Europe would currently represent a net increase of 2% to 4% and producing those same products in the United States would represent a net increase of 8% to 15%."

So at the high point of LL's business and gross margins, laminates in total netted to 19% of sales and 52% of laminates were sourced from China. This puts Chinese laminates at ~10% of total sales in 2014. LL also discloses that the increased cost to source elsewhere would be about 2%-4% for Europe and 8%-15% for U.S. If we ballpark a blended 10% increase in cost over Chinese laminates I get a 0.6% decrease in gross margins (if I did the math right). In other words paying 10% more for Chinese laminates would reduce a 40% gross margin to 39.4%. This is again assuming LL eats the entire increase and does not pass any of it on to their customers which is unlikely.

So from the above actual statistics the argument that the Lynch era marked improvement in gross margins was due to cheap Chinese laminates is largely unfounded. It appears Chinese laminates contributed to a modest improvement in gross margins over the Lynch era at best. So what were the drivers of gross margin improvement you ask? The same investor presentation linked above conveniently addresses them and I've copied and pasted the relevant information below:

"We have had many drivers of gross margin expansion since 2010, when our net sales were $620 million and our gross margin was 34.8%. In fact, gross margin has expanded 510 basis points through 2014, and has included numerous strategic initiatives including the acquisition of certain assets of Sequoia Floorings in September 2011. As many of you know, the operations we acquired from Sequoia, including quality control and assurance, product development and logistics, were services Sequoia only provided to Lumber Liquidators. With this acquisition, we began a multi-year investment in quality control and assurance that continues today.

Additionally, eliminating all middlemen in our sourcing has allowed us to capture the benefits that previously had been the middleman's profit margin and develop a direct relationship with the mill that can yield even greater benefits over multiple years. We have outlined the many benefits that have come with our "sourcing initiatives", and as many of you know, lower product costs due to competitive bidding is but one.

In fact, the primary driver of our gross margin expansion since 2010 has been successful expansion and marketing of our assortment, including sales mix shifts to both premium products and the attachment of moldings and accessories. In addition, our "Best People" initiative which began in 2011, has featured training, product expertise and retail sales concepts that we believe have led to a better experience for the customer, shifts in our sales mix and gross margin expansion."

O.K. so that was then and this is now, what's been going on since the formaldehyde scare in early 2015? For this I copy and paste relevant information from their most recent 10Q (Q1-16):

"Net sales in the first quarter of 2016 were $233.5 million, a decrease of 10.2%, from the first quarter of 2015. In comparable stores, net sales for the first quarter decreased 13.9% in comparison to the first quarter of 2015, due to a 0.1% decrease in the average sale and a 13.8% decrease in the number of customers invoiced. Comparable store net sales (NYSE:I) for the two month period ended February 29, 2016 was $141.2 million and (ii) for the one month period ended March 31, 2016 was $82.3 million. We believe the comparability of our sales performance during these periods is impacted by several events which occurred during either the current or prior year periods, including:

Changes in our promotional strategy in place during the two-month period ended February 28, 2015 which focused on aggressive advertised retail price points to improve customer interest and conversion rates. We believe those changes had a positive impact on our sales trends in 2015. While we believe our current promotional strategy remains competitive within the industry, we have chosen to be more strategic in our promotional activities, in response to current market trends and customer demand.

The impact of unfavorable allegations surrounding the product quality of our laminates sourced from China which were part of a 60 Minutes episode that aired on March 1, 2015 (the "broadcast").

Continued negative consumer sentiment, which we believe was in part a result of heightened negative media coverage in the latter part of the first quarter of 2016 surrounding the product quality of laminates sourced from China, which have not been sold in our stores since May 2015. The heightened negative media coverage, including additional discussion of our products on 60 Minutes on February 21, 2016, focused on an error in, and subsequent correction of, a report issued by the Centers for Disease Control which discussed our laminate floors sourced from China. Subsequent to the additional negative media coverage, we assisted an increased number of individuals through our customer care department and processed an increased number of requests for indoor air quality testing in relation to recent history."

So let's summarize the information above. The 60 Minutes formaldehyde hit piece originally aired on March 1, 2015 which is conveniently 2/3 of the way into Q1-15. While this would suggest only 1/3 of the quarter was affected by these accusations, I remember seeing information suggesting management was aware of the upcoming hit piece in December of 2014 and managements discussion of heavy promotions in the first two month of Q1-15 suggests they were trying to get ahead of the game and move as much product as possible before the 60 Minutes hit piece aired. So even though the formaldehyde accusations came out 2/3 of the way into Q1-15 it appears they were discounting product the entire quarter and thus gross margins were affected over the entire quarter.

Since the original airing of the 60 Minutes hit piece they have re-aired it at least once that I know of and updated the status periodically as well. I've written a couple of articles in the past noting there never was any evidence LL was not CARB compliant let alone "poisoning people" and the clean sweep of regulatory decisions has validated this, however, like being accused of rape or pedophilia the burden of proof in the court of public opinion is on the accused, fair or not.

In addition to 60 Minutes sticking to their story despite it being pointed out their experts were using the wrong test and conflating numbers that don't correlate to CARB mandates, the CDC made a math error resulting in an absolute number of people who could potentially get cancer from the flooring that was still insignificant after the error was corrected, however, resulting in a 3X increase in potential cancer cases which in turn resulted in another round of hyperbolic headlines and put LL back in the dog house yet again in Q1-16. The impact on LL is yet another hit to sales and while they say they were more strategic in their promotions their pricing is surely still significantly discounted compared to pre-formaldehyde scare levels.

So even before the formaldehyde scare there was skepticism that the remarkable improvement in gross margins during the Lynch era was sustainable and the loss of cheap Chinese laminates has been widely attributed to the fall in gross margins and proof the improvements pre-scare were unsustainable and the skeptics were right. i.e. 40% gross margins were only achievable due to cheap Chinese laminate and LL would be lucky to get back to a pre-Lynch 35% gross margin level.

I've only followed the company since the accusations so maybe someone else can point out something I am missing, however, from what I can tell losing Chinese laminates likely resulted in a modest hit to gross margins at best, and the bulk of the hit is good old fashioned discounting to offset negative publicity which can be reversed in time. The gross margin notes below are from the Q1-16 10Q linked above:

"Gross profit decreased 16.9% in the first quarter of 2016 to $76.1 million from $91.6 million in the comparable period in 2015. Gross margin declined to 32.6% in the first quarter of 2016 from 35.2% in the first quarter of 2015. Notable items impacting gross margin include:

We incurred $2.9 million and $2.4 million for purchases of testing kits and professional fees in the first quarters of 2016 and 2015, respectively, related to our indoor air quality testing program.

We incurred costs of $1.6 million in connection with the consolidation of certain laminate products sourced from China to a central warehouse during the first quarter of 2016 and $1.6 million of incremental transportation expenses incurred in conjunction with the consolidation and transition of the East Coast distribution center during the first quarter of 2015"

Gross profit in Q1-16 was $76.1M resulting in a gross margin of 32.6%. However, when you add back in one-time expenses for the test kits, professional fees, and consolidation of Chinese laminates gross profit was $83M resulting in an adjusted gross margin of 35.5%. In other words in a quarter still mired in the aftermath of "poison flooring" accusations gross margins adjusted for one time expenses are already on par with pre-Lynch levels.

In my previous article I just assumed there had to be some validity to the argument that the Lynch era gross margins were unsustainable and ball parked sustainable margins somewhere between the high and pre-Lynch. However a deeper look into the drivers of margins during the Lynch era and post crisis has me optimistic that most of the improvement pre-scare were sustainable and gross margins approaching 40% can be achieved again in time.

While I'm optimistic that LL can ease up on promotions to increase their gross margin over time, my one concern is the loss of customers who see LL as a bad actor and don't have the time to research the formaldehyde issue in depth to see LL was wrongly accused. While management brought this very issue up on their last cc I find their solution perplexing. They propose a combination of ignoring the problem and waiting for it to go away and training employees to educate the customers who do walk in the door.

If a potential customer walks in the door by definition they're willing to give LL a chance. Having employees explain the issue to them is nice, however, it doesn't address the significant percentage of potential customers who won't walk in the door because they see LL as a bad actor. Maybe in a decade they'll let it go, however, in my opinion management needs to start going on the offensive and touting the fact the regulators have all vindicated their assertion that they were not poisoning people and they are not a bad actor and it's O.K. for people of conscience to shop there.

To wrap this up it would be nice to address how this affects valuation however this article is long enough and it just so happens my last article entitled "Lumber Liquidators: What's it Worth?" addresses valuation except I only ball parked a gross margin range. So between this article and my previous article readers can make judgments about valuation and see why I'm bullish on LL long term.

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.