Like many companies, Lumber Liquidators (LL) is feeling the sting of US tariffs and downplaying it for investors. The company’s Q1 earnings call reflects this tempered optimism, describing the offset of rising inventory costs by "cost mitigation efforts." The company will face a challenging year, and its share price will likely continue to struggle as operating profit remains elusive in a 25% tariff environment.
Despite a bleak prognosis for 2019, the company has several factors in its favor in the long term. It maintains a lean business model and continues to strive to shrink expenses. Its installation business is growing at a rapid clip, representing an ever-growing share of revenue protected from the tariff threat. The company’s business model also demonstrates a resilience to tough economic times, a fact demonstrated by the last recession.
The combination of these factors, in my opinion, translates to a weak near-term and strong long-term outlook for the company. Actions necessary to lean into its advantages include a shift of supply out of China, an increased focused on its tariff-immune installation business, and a sustained effort to continue reducing operating costs where possible.
Lumber Liquidators is certainly not alone in the pain it feels as a result of tariffs. Companies across sectors are preparing investors for a grimmer 2019 than previously forecast. In its Q1 earnings call, CEO Dennis Knowles attributed a 2% hit to gross margins to the tariff increase. Different companies naturally suffer more than others in a protectionist environment, and Lumber Liquidators’ supply chain leaves little cause for optimism.
Per the company’s financial statements, Lumber Liquidators sourced approximately 47% of its products from China in 2018, and “virtually all of these goods” were subject to the 10% tariff. As the aesthetically pleasing table below shows, we can use the 200 basis-point damage to gross margins to infer that, as a percentage of inventory value, Chinese materials comprise about 31%. At 10% tariffs, this amounted to a roughly $5 million hit to gross profit. Holding all else equal in Q3 of this year, the first full quarter of 25% tariffs, the hit to gross profit will swell to more than $13 million. Gross margins, one of the company’s top financial priorities in recent years, would fall by a hefty 5%.
Earnings will obviously be impacted as well, but Lumber Liquidators' unpredictable bottom line figures (unusual expenses related to litigation, volatile SG&A spending, etc), make it difficult to venture a prediction on what exactly net profit will look like. Suffice to say that the company is extremely unlikely to be in the black in 2019. This goes against my previous prediction for the year, and I’ll eat crow in admitting that I did not properly assess the risk or impact of these tariffs.
How to Adjust
This being said, my long-term thesis has not yet changed. The company is a fighter, and has suffered much more substantial and unique costs in the last five years without going out of business. We won’t resurrect the specter of the company’s legal nightmares, which seem to never fully disappear from its income statement despite a slow march toward resolution, but my position remains that the worst is over in that regard.
The challenge for the company in 2019 is to make core changes to improve its resilience amidst a changing economic environment. The company should do three things to properly adjust to these changes.
1) Get Back to What Works
It's not the time to hyper focus on protecting gross margins. There are factors outside of the company’s control which will make it difficult to maintain high margins, including not only tariffs but the likelihood of a sectoral slowdown in both new home builds and remodels in the near term. Lumber Liquidators may need to rediscover its roots as a recession-friendly, low-price provider. This means a skinny SG&A and a focus on sales growth, a strategy which worked well for the company during the last recession, as I mentioned in my previous article. As an encouraging sign, CEO Dennis Knowles described lowered advertising spending as part of a larger focus on cost reduction and shift toward what works for the company.
2) Installation: Tariff-Proof and Fast-Growing
This leads to the need to diversify revenue and put greater focus on a high-growth segment: Installation. While sales growth in Q1 was only 1.6%, installation service revenue grew 12%. While comparable store sales fell 0.8% in Q1 year-over-year, the figure was nearly 9% growth for installation services. The attach rate (percentage of purchases which include installation) has continued to grow and is approaching 15%.
Customers clearly prefer to have the same company that sold their flooring install it as well. This makes perfect sense, as it offers additional protection and fewer headaches to the consumer. It also represents a source of revenue protected from tariffs and a way to boost margins by increasing the company’s topline, an area which it has more room to aggressively pursue than inventory costs.
Installation, one of the only areas of sales showing some life, also is immune to supply chain shocks. The company should put greater focus on expanding this segment, which has now surpassed 10% of total revenue, as both a revenue source in itself and a way to attract more purchases.
3) Stop Touching the Stove: Get out of China!
Lumber Liquidators has plenty of reason to be wary of sourcing from China, one primary reason being that their toxic, stock price-destroying laminate came from the country. Add to this list the fact that they source half of their products from one of the most economically risky countries for an American company in 2019. If the tariffs remain indefinitely, or even if the perception persists that they will, global supply chains will adjust with dizzying speed, as they already are.
If the trade war continues, company success will depend on how quickly they extricate their production from this tariff time bomb. The new tariff environment should serve as an impetus to begin a departure from the area, even if it means a new normal of slightly higher margins and some short-term adjustment pain. Note that this recommendation is not an attack on China itself, but a recognition that it's prudent for the company to anticipate and get ahead of a changing geopolitical reality, as competitors will surely do.
Lumber Liquidators will likely experience more pain in 2019 as tariffs continue to eat into profits. Share price will probably fall in reaction to tough earnings in the immediate quarters. However, the company has proven to be resilient if nothing else, and its growing installation business and cost reduction efforts warrant encouragement.
In my opinion, the company can do little to avoid a performance pinch in 2019. In order to compete effectively in the medium term, Lumber Liquidators should own its budget segment by focusing on sales growth and operating cost reduction over gross margins, continuing to invest in its high-growth installation service, and making efforts to shift its substantial product sourcing out of China.
I'm neutral, leaning bearish, on Lumber Liquidators' performance in 2019. In the long run, I expect the price to dramatically rise once the company finally reaches consistent profitability. The current share price, and more so if it falls below $10, warrants the risk inherent in this thesis.
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.