Lovesac: Key Takeaways From The Q3 Results

Summary

• Net sales growth despite the challenging macroeconomic environment, fueled by more aggressive advertisement and the opening of additional pop-up shops and shop-in-shops.
• As the firm could not pass on the additional costs to the customers, margins have contracted. It may indicate that the demand for LOVE's products is relatively elastic.
• Inventory levels have substantially grown year-over-year. If inventory becomes obsolete, it may lead to further margin contractions.
• We maintain our "hold" rating.

Annie Otzen/DigitalVision via Getty Images

The Lovesac Company (NASDAQ:LOVE) designs, manufactures, and sells furniture. We have published an article on the firm in June 2022, titled: "Declining Consumer Confidence May Slow Lovesac's Growth". At that time, we have rated LOVE's stock as a hold, due to the following reasons:

• Strong financial performance in the first quarter with double-digit sales growth across all distribution channels.
• Gross margin contraction in Q1 due to the increased inbound transportation costs, despite the improving product margin.
• Declining consumer confidence has been expected to result in lower demand for Lovesac's products in the near term, potentially slowing the firm's growth.

Since our writing, the firm has lost more than 37% of its market value, substantially underperforming the broader market.

Data by YCharts

Today, we are revisiting our thesis on LOVE's business and highlight some of the key results from the third quarter.

Q3 results

Sales

LOVE's net sales have increased once again by double digits, 15.5%, year-over-year.

Results

While growth has slowed compared to the prior year, we believe that in the current market environment these results may be a proof that there is a demand for LOVE's products, even during periods of poor consumer sentiment.

The following table breaks the sales results further down.

Percent increase

Total comparable sales have increased by 8.9% (in contrast to the more than 47% increase in the year ago period), comparable showroom sales have grown by 18.5% (in contrast to the more than 53% growth in the year ago period), while internet sales have declined by 6.3%.

The main drivers of the comparable showroom sales growth, compared to the prior year period, were:

• Higher point of sale transactions
• Strong promotional campaigns
• Addition of 41 new showrooms and 13 new kiosks

The reintroduction of physical pop-up-shops in Costco and the addition of 17 new Best Buy shop-in-shops, for a total of 22 Best Buy shop-in-shop locations have also contributed to the revenue growth.

The reason for the internet sales decline can be largely explained by the changing consumer behavior. As the impacts of the Covid-19 pandemic are fading, people are spending more time shopping in physical stores, rather than online, causing the internet sales metrics to decrease, in the case of LOVE.

Costs

While the gross profit has increased along with the net sales, the gross margin has contracted by as much as 300 basis points compared to the same period in the prior year. The two primary factors leading to the contraction were:

• Increase in total distribution and related tariff expenses (~160 bps)
• Decline in product margin (~140 bps)

We would like to pay attention to the declining product margin here. In order to support the sales growth, the firm has had to spend substantially more on advertisement.

Advertising and marketing expense increased 20.3% due to continued investments in marketing spend to support our sales growth and expand brand awareness. As a percent of net sales, advertising and marketing increased by 50 basis points due to a slight increase in media spend to support our third quarter net sales growth.

They have not been able to offset these cost increases by pricing, meaning that the demand for their products is likely to be relatively elastic. For this reason, we believe that as long as the consumer sentiment is poor, we are not likely to see a reversal of the margin contraction.

Further, SG&A expense as a percent of net sales have also increased, by as much as 720 basis points. Deleveraging of employment costs, infrastructure investments, rent, selling related expenses, travel, and insurance have been the primary contributors, partially offset by the increase in the equity-based compensation.

As a result of the cost increases, the firm ended the quarter with an operating- and net loss of $11.6 million and $8.4 million, respectively.

Inventory

Inventory management plays a key role, when it comes to margins. Rapidly increasing inventory may be a sign that the demand for a certain product is not as strong as expected. It may be a temporary or a permanent phenomena. If it is a permanent one, then the firm likely needs to use significant discounting to get rid of their "obsolete" goods and reduce their inventory.

The firm has made the following comment one their inventory levels:

Total merchandise inventory was $154.5 million as of October 30, 2022 as compared to $94.5 million as of October 31, 2021 with the year over year change principally related to a stock inventory increase of $43.2 million coupled with an increase in freight capitalization of $16.9 million related to an increase in inbound freight expense.

In our opinion, an increase of $43.2 million in the stock inventory is substantial. When considering investing in LOVE's business, one has to keep in mind that margins may be hurt in the near term by inventory management issues.

Conclusion

In our opinion, the firm has done a great job by achieving sales growth despite the challenging macroeconomic environment. On the other hand, we need to highlight that growth has substantially slowed compared to the prior year and that they have spent a lot more on advertising, which has led to margin contraction.

The firm has not been able to pass over the excess costs to the customers, which may signal that the demand for LOVE's products is elastic. For this reason, we do not foresee a substantial improvement in the margin in the near term.

The growth of inventory levels may be concerning. If inventory becomes obsolete, larger discounting may be needed to get rid of the excess inventory, which may hurt the margins.

We maintain our "hold" rating.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Past performance is not an indicator of future performance. This post is illustrative and educational and is not a specific offer of products or services or financial advice. Information in this article is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. This article has been co-authored by Mark Lakos.

Comments

[Britton Bush]

@Ghost of Graham is right. This is a Peter Lynch stock.

— Look at gross margin compared to other furniture companies, LOVE is significantly higher.
— Inventory has been growing steadily over time consistent with revenue. This shouldn’t necessarily be a surprise; as the amount of net sales and size of a company increases, then inventory generally increases as well. Additionally, as others have pointed out, LOVE’s inventory is more robust due to the modularity of sactionals. Also, one should consider that inventory is higher this quarter (Q3FY2023) to support the higher demand expected for the holiday season (Q4FY2023). The CEO makes a comment to this effect in the press release “We believe we are well positioned for the all-important fourth quarter holiday-season where early signs point to strong cash flow generation for the quarter.”
— Valuation is at all time lows. LOVE has zero long term debt.
— SG&A and Advertising as a percentage of sales are going up, which is unfavorable, but understandable given the reduction in consumer discretionary demand in conjunction with the current economic environment. However, I would reiterate what others have said, brand awareness and market share capture are hugely important, and if LOVE can expand its brand and market share in this environment by exercising relatively higher marketing and advertising, then that is a good thing for the long term shareholder.
— I see relatively low downside risk and significant upside potential over the next 5 years. Assuming we emerge from this recessionary cycle (like history has shown that we always eventually do…), say in 5 years or so, then it is unlikely that this level of growth will be trading at the current low valuation levels.
— Others have pointed out, analysts project earnings growth of ~20% over the next two years. Non-GAAP (FWD) PEG is 0.25! LOVE is a BUY.

[Maximilian Alexander]

Inventory has increased dramatically QoQ while cash has decreased quite substantially. Luckily for them their products aren’t seasonal and have a very low risk of obsolescence. Many retailers are facing inventory gluts due to the bullwhip effect from Covid. The next couple of quarters are going to be key for Lovesac to turn that inventory into sales so they don’t experience a cash crunch. The company is trying very hard to disrupt the furniture industry and time will tell if they can get over the hump. A common misconception is that low P/E companies such as Lovesac are “lower risk” because of their multiples, but it’s the contrary. These are some of the riskier companies to bet on since the upside in theory is so high if they can execute their business plan; the risk is proportionate since they may have to dilute their stock to raise cash or may just lose relevancy in general. Wall St does not believe this company is going to make it as reflected by the share price but if it does, you will most certainly hit a multibagger over the next decade.

[Belu21]

@Maximilian Alexander I would be very disappointed if we see any accelerated shareholder dilution here. They would first need to pick up some debt, also, they clearly signalled a cash generating Q4. Hence if they disappoint on this front, that would be deviously misleading management commentary in Q3 call

[K. Oakes]

@Maximilian Alexander these are fair points. I would just add that the depressed multiple does not necessarily mean that the market doesn’t think the company will “make it.” The market May very well (likely correctly) believe that this is dead money for some time until the fed pivots and recession is in the rear view mirror

[Bela Lakos]

@Maximilian Alexander I completely agree with you on the cash crunch part. I believe many people underestimate, how important financial flexibility is during times of downturns.

[Belu21]

Author riding on inventory risk signals to me he didn't yet familiarize with Lovesac's evergreen and lean product platform - sactionals. Hope I am wrong on the amount of research conducted by the author prior to writing about the stock.

[jaynemesis]

@Belu21 Seems to be a recurring theme for people "analysing" $LOVE - their products are specifically designed to avoid redundancy. If anything, they incentivize ongoing future sales.

[Belu21]

@jaynemesis The recurring nature and stickiness seems to be quite unique in its category. Though it will need to show its advantages in above sector profitability not just sales growth. I am banking on this to see a re-rating of the stock

[Bela Lakos]

@Belu21 Thanks for your opinion! To a certain extent I agree with you. But my main concern with inventory is related to the consumer sentiment. During times of low consumer confidence, people are likely to spend less on durable products, like the product of Lovesac. In Q3 it has been already pointed out that the marketing expenses had to be substantially increased to keep the demand high.
Before investing in the firm's stock I would like to see an improving consumer sentiment and also the company's ability to reduce inventory. The main question is, when the sentiment starts to improve, will people still want Lovesac's products, which are currently in inventory, or would they like newer models?

[Psmith6545]

Thanks for the update. Have recently traded, like the story. Like the vaule as growing revenue with almost no debt. But have been challenged by how many will pay for a $7000 couch.