Lumber Liquidators: Tariffs Negatively Impact Growth And Margins

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About: Lumber Liquidators Holdings, Inc. (LL)
by: Elephant Analytics
Summary

Lumber Liquidators gets around 40% of its merchandise from China.

It (and other flooring companies) are taking steps to mitigate the impact of tariffs, but there will likely be at least some impact still.

Passing costs onto consumers may slow demand growth, while absorbing costs will affect Lumber Liquidators' gross margins.

A 2% impact to 2019 comparable store sales growth and a 1% impact to gross margins would drop its estimated value from $20 to $14.

Lumber Liquidators can still add value through operating margin expansion, but the tariffs may set back its efforts by close to a year.

Lumber Liquidators (LL) has seen its stock suffer due to the tariffs placed on Chinese imports. It currently imports around 40% of its merchandise from China, and while it should be able to mitigate much of the damage from tariffs, that issue will likely have at least some impact on near-term results.

If tariffs result in 2019 comparable store sales going from +4% to +2% (due to higher prices leading to some projects being put off) and in a 1% hit to gross margins (from Lumber Liquidators absorbing some of the cost increase), then its estimated value falls from around $20 to $14.

Longer term, Lumber Liquidators may have some upside as it seeks to expand its operating margins. However, the tariffs probably set back its operating margin expansion efforts by nearly a year.

Product From China

Lumber Liquidators didn't provide exact percentages for its sourcing mix in 2017, but did mention that around half of its merchandise was sourced from overseas. This was similar to what it mentioned for 2016, when it also provided additional detail that 39% of its merchandise came from Asia (mostly China).

In its Q2 2018 conference call, Lumber Liquidators mentioned that around 40% of its merchandise came from China, so 39% to 40% seems like the right number. Floor & Decor (NYSE:FND) mentioned that almost all of its China-sourced merchandise would be affected by the tariffs, so I'd expect the same for Lumber Liquidators.

Other flooring companies typically have significant levels of exposure to China as well. Floor & Decor mentioned that 47% of its merchandise comes from China, while Tile Shop (NASDAQ:TTS) mentioned that around 50% of its purchases come from Asia (primarily China).

The retailers will try to manage the tariff issue through various means, including increasing non-Chinese supply and passing on costs to the customer. There will likely be some impact on gross margins at least in the nearer term though, which I am estimating at 1% for 2019. China has previously had at least a slight cost advantage, as shown by Lumber Liquidators' laminate cost slide from a few years ago.

Source: Lumber Liquidators

As well, if some of the costs are being passed on to the consumer, that will not be helpful for demand growth, which is viewed as softening.

2019 Outlook

The new outlook for 2019 involves +2% comparable store sales growth (down from +4% before), with the reduced growth due to the impact of a weaker outlook for housing (both new homes and remodeling).

Due to the impact of the tariffs, Lumber Liquidators may also end up with marginally lower gross margins in 2019 compared to 2018. I am modeling Lumber Liquidators' gross margin at 35.8% in 2019.

This results in an estimate that Lumber Liquidators will generate $25 million in operating income and $44 million EBITDA in 2019. This is a reduction of $14 million from my earlier estimates due to the combination of slower growth and increased product costs.

$ Million 2019
Net Sales $1,170
Adjusted Gross Margin $419
Adjusted SG&A $394
Adjusted Operating Income $25

Trade War Duration

While some believe that a trade war with China could last decades, I think it will probably be at least de-escalated well before decades. Tariffs are not particularly popular among swing state voters at the moment, and generally both Republican and Democratic voters have been in favor of free trade in the past. There has been more of a partisan split on the issue since Trump won the Republican nomination, but after Trump's time as president finishes, I'd expect public views around trade and tariffs to largely return to the pre-Trump situation.

Conclusion

At a near 10x EV to forward EBITDA multiple, Lumber Liquidators would now be worth around $14 per share based on 2019 expectations. The investment thesis for Lumber Liquidators largely revolved around operating margin expansion, driven by a combination of sales recovery and gross margin improvements.

While Lumber Liquidators is likely able to mostly mitigate the tariff issue, the impact on sales and gross margins appears significant enough to erase most of the improvement between pre-tariff 2018 projections and 2019.

As time goes on, Lumber Liquidators will likely be able to mitigate the tariffs issue more (as well as there being a possibility that the trade war ends), so I think there should be some longer-term upside for Lumber Liquidators.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.