Lumber Liquidators: Operating Margin Recovery Slows Down
Summary
- Lumber Liquidators appears to have solid comparable store sales growth, with +4.7% comps in Q2 2018 putting it on track to meet its mid-single digits guidance.
- Gross margins took a step back in Q2 due to obsolescence costs and higher installation sales.
- Adjusted operating margins are therefore expected to come in around the low end of guidance for 2018.
- Lumber Liquidators is progressing in its recovery, but the slower recovery pace makes a $20 share price reasonable.
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The Q2 2018 earnings for Lumber Liquidators (NYSE:LL) shows a company that appears on track for sales growth, but is having a slower than previously anticipated recovery in operating margins. The decline in its share price in response to the operating margin issues is largely warranted as the stock was priced for 3+% operating margins in 2018 and it now looks like that operating margin percentage will be reached in 2019 instead.
Comparable Store Sales Growth Remains Solid
I had mentioned before that I expected Lumber Liquidators to do around +4% comps in 2018, which would require it to achieve +4.4% comps during Q2 2018 to Q4 2018 after Q1 2018 came in a bit lower at +2.9%.
Lumber Liquidators' Q2 2018 results point to Lumber Liquidators being on track to reach +4% comps. It did +4.7% comps in Q2 2018 and reaffirmed its 2018 guidance for mid-single digits comparable store sales growth.
Gross Margins Go Off Track
While Lumber Liquidators is in a good position with respect to its comparable store sales growth, its gross margin performance went off track a bit during Q2 2018. Lumber Liquidators reported 35.0% adjusted gross margins during the quarter, which was a decrease from 35.5% in Q2 2017. This was also a marked decline from the 36.3% adjusted gross margin in Q1 2018, although Lumber Liquidators noted that Q1 tends to be seasonally less promotional.
I had assumed that Lumber Liquidators would continue to make progress with gross margins throughout the year and average 36.5% for 2018 despite issues with higher transportation costs. However, it appears that target was too optimistic.
Lumber Liquidators mentioned that around 85 to 90 basis points of the decline in gross margin from Q1 2018 was due to seasonally higher promotional activity. The remaining decline of 40 to 45 basis points was due to an increased mix of installation sales (which are lower margin) as well as higher obsolescence costs due to assortment turnover. Lumber Liquidators mentioned that transportation costs were unchanged as a percentage of sales compared to Q1 2018 (although this would mean that transportation costs were likely higher than Q2 2017).
Lumber Liquidators believes that it can still achieve 36+% gross margins for 2018, although it does appear that gross margin improvement will be fairly incremental over time.
Higher SG&A In Q2
Lumber Liquidators also saw its adjusted SG&A increase to $96.2 million during Q2 2018. This compares to $88.8 million in Q2 2017 and $93.1 million in Q1 2018, although this increase was partially driven by the addition of 21 new stores since Q2 2017, including 8 new stores that were opened in Q2 2018. Part of the increase related to promotional/advertising seasonality as well.
Lumber Liquidators expects adjusted SG&A to be around $93 million to $96 million during each of the remaining two quarters.
2018 Outlook
I have kept my estimate of Lumber Liquidators' 2018 sales at $1.101 billion, which involves +4% comparable store sales and +7% net sales. Lumber Liquidators is showing solid sales growth still.
Due to the gross margin challenges in Q2 2018, I have revised my estimate for Lumber Liquidators' 2018 gross margin percentage down from 36.5% to 36.1%. This still represents a 60 basis point improvement over 2017.
SG&A for the remaining two quarters is estimated at $94 million per quarter. This results in a forecast for $20 million in operating income for 2018 (excluding special items). At 1.8% operating margin, this is slightly below the 2% to 3% guidance range. If Lumber Liquidators reaches 2% operating margins instead, its operating income will be around $22 million in 2018.
| $ Million | 2018 |
| Net Sales | $1,101 |
| Adjusted Gross Margin | $397 |
| Adjusted SG&A | $377 |
| Adjusted Operating Income | $20 |
Future Outlook
I had once thought that Lumber Liquidators could reach $58 million adjusted EBITDA in 2018, but due to the slower pace of gross margin improvement and higher SG&A costs, it seems more likely that it can reach that number for 2019 instead. My current estimate of Lumber Liquidators' EBITDA for 2018 is around $38 million.
At close to a 10x EV/EBITDA multiple, Lumber Liquidators would be worth approximately $20 per share for 2019.
Conclusion
Lumber Liquidators is still on a path to recovery, but the pace of the recovery is slower than I previously thought (which already involved a recovery over several years). Comparable store sales growth remains solid, but the rate of gross margin improvement is fairly slow. I had mentioned sub-$20 as a potential entry point for Lumber Liquidators, but now that its stock is under $20 the slower pace of operating margin recovery is preventing me from pulling the trigger yet.
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