Lumber Liquidators: After CARB Settlement, Business Results Must Improve

| About: Lumber Liquidators (LL)
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Summary

Lumber Liquidators reached a settlement with CARB that removes a significant overhang from the company.

$2.5 million is not much to Lumber Liquidators, but it is substantial for CARB and represents one of the largest CARB settlements in recent years.

Lumber Liquidators does not admit to any wrongdoing as part of the settlement. Thus, the resolution with CARB probably helps the company when defending class action lawsuits.

There is the potential for the class action lawsuits to be settled for a reasonable amount (such as less than annual incremental legal expenses).

Weak business results may be a negative catalyst that occurs before any class action lawsuit resolution though.

Lumber Liquidators (NYSE:LL) reached a settlement with CARB where it agreed to pay $2.5 million to CARB and implement voluntary measures such a risk based supplier audit program and a testing research program. Lumber Liquidators does not admit to any wrongdoing as part of the settlement.

The CARB settlement removes a significant overhang on Lumber Liquidators' stock, as there were some fears of massive fines that could threaten the financial health of the company. I never thought that was likely given the relatively small size of prior CARB fines/settlements, but any non-crippling settlement was bound to be looked on favorably by the market.

That being said, I am likely to close my Lumber Liquidators position as the positive catalyst of the CARB settlement is now in the past.

Notes On CARB Settlement

The CARB settlement was never likely to be a massive amount. Between 2011 and 2014, the largest CARB settlement was for only $3.02 million, so the $2.5 million settlement is actually a relatively high number as those things go. The $2.5 million number was based on $10,000 per day for each day that Lumber Liquidators allegedly sold or offered for sale certain disputed products in California without taking reasonable prudent precautions to ensure that the products complied with the emissions standard. Lumber Liquidators disagrees with the allegation that it did not take reasonable prudent precautions and denies liability.

However, the $2.5 million number is a relatively small amount for Lumber Liquidators and it makes sense for it just to settle and move past the issue in California. The $2.5 million settlement is a large one for CARB, and the settlement amount plus the increased compliance measures satisfy it.

As Lumber Liquidators did not admit wrongdoing as part of the settlement, this doesn't provide additional ammunition that can be used against it in the various class action lawsuits that are going on.

Class Action Lawsuits

Lumber Liquidators is probably weighing the cost of settling the various class action lawsuits versus continuing to incur legal expenses fighting off the lawsuits. Sometimes companies decide that it is cheaper to settle than to continue incurring legal expenses. In 2015, Lumber Liquidators incurred $37 million in incremental legal and professional expenses related to legal matters.

The settlement with CARB reinforces my opinion that the class action lawsuits will not be crippling to Lumber Liquidators. Without the benefit of an admission/finding of wrongdoing from the CARB settlement, perhaps the class action litigators will settle for a lower amount than they were previously aiming for. I think that if all the class action lawsuits can be settled for under $35 million or so, it would make sense for Lumber Liquidators to contemplate settling.

Business Risks Remain

Lumber Liquidators still faces major business challenges though. It has been facing a tough combination of elevated SG&A (mainly due to legal expenses), lowered gross margins and declining sales.

Some have wondered why a 13.7% decline in net sales in Q4 2015 should translate into an 80+% decline in Lumber Liquidators' share price. My answer to that is that it isn't just sales that Lumber Liquidators is having challenges with, but also the other components that affect operating income.

In 2014, Lumber Liquidators did $1.047 billion in net sales with nearly 40% gross margin. SG&A was $314 million, resulting in $104 million in operating income. If we run the numbers with a 10% decrease in net sales, 35% gross margin and the same SG&A, then operating income would fall 85% to $16 million. While still positive, this is a major decrease and shows why even a 10% drop in sales results in a much greater decrease in Lumber Liquidators' value when combined with the other components.

In $ 000s

2014

Hypothetical

Net Sales

$1,047,419

$942,677

Gross Profit

$418,167

$329,937

SG&A

$314,094

$314,094

Operating Income

$104,073

$15,843

If sales remain depressed, then Lumber Liquidators could probably reduce SG&A. Some costs such as occupancy are fixed, but other areas could likely be trimmed so that it gets close to the previous level of SG&A as a percentage of sales. This would take time though, and would also be harder to do if the sales decline becomes too precipitous. Reducing SG&A to 30% of net sales (2014 levels) would still put operating income in the hypothetical scenario at $47 million, a 55% decline from 2014 levels.

The 35% gross margin is what Lumber Liquidators did pre-Robert Lynch, so it is probably a reasonable target for them to work towards. In the near-term though, Lumber Liquidators is dealing with steeper sales declines, worse gross margins and higher SG&A than my hypothetical scenario above, which is why I would characterize its business outlook as poor right now.

Conclusion

I have been treating Lumber Liquidators as a trading stock. With the positive CARB settlement catalyst in the past now, I am likely to close my long position. I may end up taking a short position at some point in the future depending on where the share price ends up as I think the next catalyst will be Lumber Liquidators Q1 2016 business results in April (likely late April for the earnings, although there is a possibility of a business update in early April). This catalyst is likely to be negative as sales results are likely to be poor. The next positive catalyst may be a resolution of the class action lawsuits, but I think the Q1 2016 business results will come well before the class action lawsuits are resolved.

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.

Additional disclosure: I may change my position within the next 72 hours.