Lumber Liquidators: Murky Business Outlook And Brightening Legal Outlook

| About: Lumber Liquidators (LL)
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Summary

Lumber Liquidators has rallied after the CPSC decided not to require a mass flooring replacement.

The CPSC agreement means there is only a limited chance that it will need to replace any flooring, as none of the tests have resulted in above remediation guideline results.

The company is still dealing with significant ongoing legal costs, though, and the class action lawsuit remains a threat, albeit one that I don't think will be crippling.

Business visibility remains murky, and with a $16 share price, Lumber Liquidators is priced for relatively favorable remaining legal results and a fairly high level of business improvement.

It may take at least 1-2 years for Lumber Liquidators to rebuild sales and gross margin to the level required for $16/share value. Gross margin upside is also questionable.

Lumber Liquidators (NYSE:LL) has gone up over 20% since there was news that the Consumer Product Safety Commission (CPSC) completed its evaluation of the safety of the company's Chinese-made laminate flooring and did not require mass flooring replacement. The flooring replacement was part of Tilson's argument for shorting Lumber Liquidators, as he believed flooring replacement costs could be at least $42 million, although I have always believed the risk that a mass flooring replacement would be ordered would be quite low.

This news is a positive for the company, as it removes another legal/regulatory uncertainty (in this case, a low-probability, high-potential cost outcome) that threatened it. Lumber Liquidators has agreed to continue its air testing program, offer remediation help to any consumers with testing results that warrant it and also not to ever sell without CPSC approval the Chinese-made laminate inventory that it withdrew from the market in May 2015.

However, like the CARB settlement, this agreement doesn't change the fact that the company has a lot of work to do to rebuild its business. The share price has risen in conjunction with the resolution of its legal issues. The only remaining legal catalyst (albeit a big one) that could boost Lumber Liquidators' share price further is the resolution of the Multidistrict Litigation (MDL) class action lawsuit. Other than that, the stock is priced already priced for a business recovery that the stock has shown limited signs of achieving so far.

Remediation Notes

Lumber Liquidators has agreed to offer remediation help (that may possibly include replacing the flooring in question) to consumers with flooring samples that have a calculated emission rate at or above 120 μg/m2-h of formaldehyde. This probably won't amount to much, though, since the company mentioned that none of the floors tested so far have been above the remediation guideline level. Given that formaldehyde emissions naturally decrease over time, the chances appear small for the company needing to take those additional remediation steps for any customer.

From reading Lumber Liquidators' press release, I'd interpret it as saying that it has tested air quality for over 17,000 households, and around 7-8% (1,300 total) have high enough initial reading to warrant the next step of formaldehyde emissions testing of the flooring. Those tests have indicated that Lumber Liquidators' flooring is below the remediation guideline level, meaning that the high readings on the air quality tests are at least partially caused by other factors.

Continuing Costs

Lumber Liquidators mentioned that its customers had returned 35,900 testing kits as of Q1 2016, but also mentioned that it had tested air quality for over 17,000 households in its recent press release. I'm not sure why there is a discrepancy - although if households are allowed to order multiple test kits for various rooms, that could cause the difference.

The company has incurred $12.34 million in direct costs for its air quality testing program. It has sent out around 69,600 kits so far. Since 614,000 customers purchased Lumber Liquidators' Chinese-made laminate flooring from 2011 to 2015, the total testing costs could be significantly higher. It appears likely that only a fraction of the customers with Chinese-made laminate flooring will end up asking for testing kits, though.

Lumber Liquidators also has continuing legal expenses related to its MDL class action lawsuit to deal with. These expenses will likely remain significant for a substantial amount of time, although I remain of the opinion that the final result of that litigation will be manageable for the company.

Valuation Questions

It is true that Lumber Liquidators still does nearly $1 billion per year in sales and has retained most of its customers (sales in Q1 2016 were nearly 90% of Q1 2015 numbers). However, the problem is that a 10% reduction in sales, along with the decrease in gross margin from previous level results in the difference between a highly profitable company and one that isn't profitable. The old Lumber Liquidators with $1.05 billion in annual sales and 40% gross margins would be worth much more than $16. The current company with $0.93 billion in annualized sales and 34.5% adjusted gross margins would be worth significantly less than $16 per share if it can't improve much. The question is what level of sales and gross margin improvement should be baked into the stock.

If we assume the company can increase sales by 5% from current levels, increase its gross margin to 36% and reduce its SG&A to $315 million once all its incremental legal and professional expenses are over, then it could achieve EPS of $0.82. At a P/E ratio of 22.5x (similar to Home Depot), Lumber Liquidators would be worth $18.45 per share. This would be the value with both its legal issues and related expenses behind it.

I'd probably deduct $2-3 from Lumber Liquidators share price for its remaining legal issues, making the company fairly valued if it can hit those performance numbers.

However, I think that those sales, gross margin and SG&A targets would be on the upper end of my expectations for the next one to two years, so there is little safety margin built into the share price right now.

Conclusion

Due to the limited visibility into the current pace of Lumber Liquidators' business improvement (management is currently not providing guidance about sales growth or future gross margin expectations), the shares appear somewhat risky at $16. The potential for sales and profitability results to fall short of expectations in the near-to-medium term is probably greater than the chance that the MDL class action lawsuit gets settled soon.

I have purchased a small amount of put options based on Lumber Liquidators potentially pulling back as more focus gets put on its business again. I may go long the stock again in the future, but probably will need either a lower entry price or better visibility into where its gross margins will likely end up to do so.

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.

Additional disclosure: Short LL via put options.