Lumber Liquidators' (NYSE:LL) Q2 earnings report is coming up on July 27. Although the company has made significant progress in resolving its various legal issues over the past few months, I am skeptical about its current value at $17 given that its recovery is likely going to be protracted and that may post several more challenging quarters before its business improves noticeably. Lumber Liquidators was showing some potential signs of initial recovery in January and February, but was then set back again by the coverage of the CDC report. Thus, it could take until 2017 before the negative effects of that coverage starts to significantly wear off. Studies have shown that negative news has a much stronger and persistent impact than the equivalent positive news.
The Negativity Bias
Lumber Liquidators' March 2016 sales were hit hard by the late February CDC report discussing cancer risk and Chinese laminate flooring. I believed that the issue wasn't that bad given that the study was looking at extreme exposure situations. The CDC appeared to concur, as it didn't recommend that installed Chinese laminate flooring be removed. As well, Lumber Liquidators won a court ruling that dismissed claims that it failed to adequately warn consumers about formaldehyde. However, the damage from the initial association of cancer risk, Chinese laminate flooring and Lumber Liquidators is likely to linger for a while and overwhelm the positive effect of the legal victories that Lumber Liquidators has achieved.
Humans have a demonstrated negativity bias as we react to negative things more strongly, quickly and persistently than to equivalent positive things. For example, the negative effect of a setback on frustration levels is over three times greater the positive effect of progress on reducing frustration.
Negative reactions do not necessarily need to be entirely logical either. The consumer response to the CDC report about cancer risk in Chinese laminate flooring was a 16.5% decrease in Lumber Liquidators' net sales between January/February and March (based on two-year stacked comps). Lumber Liquidators hasn't sold Chinese laminate flooring since May 2015, so sales shouldn't have been theoretically affected that much. However, the discussion of cancer risk and Chinese laminate flooring spilled over to affect Lumber Liquidators' current brand image.
The two-year stacked comparable store sales number for Lumber Liquidators was around -9% in January and February, but this fell to -24% in March as the negative publicity about the CDC report hit. Q2 2016's comps should be helped a bit by the positive legal results for Lumber Liquidators as well as some passage of time. However, the comps improvement for Q2 2015 versus March 2015 was helped by heavy promotional activity as Lumber Liquidators attempted to attract customers back into the stores after the initial 60 Minutes report. If Lumber Liquidators aims to get an adjusted gross margin around 35% (as opposed to the 32.1% adjusted gross margin recorded in Q2 2015), it may end up with two-year stacked comps of around -18% as the improvement from March to Q2 2016 may not be as strong without heavy promotional activity.
Two-year stacked comps of -18% for Q2 2016 would translate into comparable store sales of approximately -8.9% for the quarter. That may translate into a net sales decrease of around 6%, leading to around $233 million in revenue for the quarter.
Analysts current expect approximately $240.6 million in revenue for Q2 2016, so that would be a 3.2% miss on revenue. Earnings are quite a bit trickier to estimate though, so I won't hazard a guess about that. There are too many variables such as the various charges that Lumber Liquidators has taken over the past few quarters that could significantly affect the results.
Sales turnarounds often take a while after a crisis and sometimes even take several years. In Lumber Liquidators' case, it was showing some early signs that sales might be turning around at the beginning of 2016. However, the media coverage of the CDC report had a strongly negative reputational impact on Lumber Liquidators. This reputational impact was perhaps nearly as strong as the original 60 Minutes report and dealt a significant setback to Lumber Liquidators' turnaround efforts. Negative information tends to have a much stronger impact than positive information, so it is possible that Lumber Liquidators will not improve its sales levels significantly until 2017.
With Lumber Liquidators at $17 now and its Q2 2016 earnings coming up, I think that there is significant potential for disappointment. Future upside catalysts for Lumber Liquidators include a multidistrict litigation settlement and improving business results. Downside catalysts include continued weak business results. I believe that the Q2 2016 earnings will show weak business results, while the multidistrict litigation probably won't be settled by the earnings release date.
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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.