Lovesac: Time To Divest

Summary

• Shares of Lovesac have soared 30% this year after sharp declines in 2022.
• The outlook for the company doesn't look much brighter, with sales growth decelerating and inventory piling.
• In addition, gross margins are being pressured by higher freight costs and more aggressive discounting.
• Though cheap at ~12x forward P/E, I find it difficult to believe Lovesac can hit consensus estimates with both top and bottom line pressures weighing.

Roy Rochlin/Getty Images Entertainment

Yes, the market is rebounding in 2023, but now is not the time to be complacent. I've been aggressively reviewing my portfolio of small and mid-cap growth stocks to determine which companies are poised for a further rally while also cutting out those that I think have reached the end of their rope.

Lovesac (NASDAQ:LOVE) is a position that I have decided to trim. This furniture vendor, popular for its "Sactionals" products that offer a modular mix-and-match design, has already seen its share price climb by ~30% this year. And though the stock continues to be cheap on paper, I think Lovesac has run out of fuel for a further rebound, especially as fundamental results are tipping toward worsening in 2023.

Data by YCharts

With revenue deceleration, margin compression, and inventory buildup, Lovesac has become a value trap

Though previously bullish on Lovesac last summer, I am sharply cutting my outlook on this company to sell. I see too many red flags here to ignore.

No doubt that Lovesac was a powerful investment during the heyday of the pandemic. Back then, the company enjoyed a bevy of fundamental tailwinds. The stock market was riding high, and well-to-do upper-middle class consumers were spending more and more on home comfort. At the same time, the rising popularity of remote work and out-migration from cities and into suburbs drove a big one-time boost for furniture and home-goods companies.

But as we know now, big hard-goods purchases like furniture have a very long replacement cycle. The pandemic pulled-forward a lot of this demand, and Lovesac's growth has slowed to the mid-teens. Amid this backdrop, however, potentially forecasting that outsized growth would continue at a much faster pace, Lovesac has aggressively expanded its showroom fleet across the U.S. while piling on more sales and marketing expenses. It's taking on the typical tech playbook of "grow now, hit profitability later" - but the biggest draw to Lovesac, in my opinion, was its relatively rich profitability profile and reasonable valuation against those earnings.

Yes, Lovesac is still technically a value stock. At current share prices near $29, the company trades at just a 12x forward P/E against Wall Street's consensus FY23 pro forma EPS of $2.45 (data from Yahoo Finance). This is an assumption of 24% y/y earnings growth (versus consensus estimates of $2.05 in FY22 EPS) on 11% y/y revenue growth.

Both assumptions, in my view, are at risk. Revenue growth has already decelerated to 15% y/y as of Lovesac's October quarter, and in my view macro pressures have only sharpened since then. We also can't ignore the state of the housing/real estate market in relation to Lovesac's sales. With interest rates high and real estate activity low, the number of people moving is also declining - which is a big driver behind furniture sales.

The assumption of EPS growth faster than revenue growth (implying margin gains) is also one to challenge. Gross margins have been in sharp decline, driven by rising freight costs. With Lovesac's most recent quarter showing a rise in inventory, the company may also see an increase in holding costs as well as more promotional activity to move product.

The bottom line here: I think most signs point to downward estimate revisions for Lovesac, and the current stock price reflects the company's new macroeconomic reality. I would cut any losses at this point and wait for Lovesac to either show an upward growth trajectory or see a sharp compression in share prices before diving back into this stock.

Q3 indicators point to further pain ahead

There are several red flags in Lovesac's fiscal Q3 (October quarter), released in early December, to watch out for - as I think these conditions will only worsen heading into 2023.

Lovesac Q3 results (Lovesac Q3 earnings release)

First, we've started to see a sharp deceleration in revenue. As shown in the chart above, revenue growth decelerated to 15% y/y in Q3, down sharply from 45% y/y growth in Q2.

And this result is in spite of Lovesac's broad expansion in showrooms. At the end of the October quarter, Lovesac had 189 showrooms in its fleet, up 40% from 135 in the prior-year Q3.

Lovesac showroom metrics (Lovesac Q3 earnings release)

What I think is a better indicator of underlying sales growth, which normalizes for the expansion of Lovesac's geographic coverage and store footprint, is internet sales - down -6% y/y. While it's true that there has been "channel mix shift" into physical retail outlets since last year due to the re-opening of malls and brick-and-mortar stores, I think Lovesac's underlying business growth performance is better reflected in its total comparable sales growth of 9% y/y, which excludes the impact of new stores added since the prior year. Against this backdrop, I find it difficult to believe that Lovesac can truly hit consensus expectations of 11% y/y revenue growth in 2023 without significantly expanding its store fleet again (which would come at a cost to profitability).

Gross margins, too, are down 300bps to 47.2% (though we note that for a consumer products company, Lovesac still carries quite a high margin profile, reflecting a decent buildup of brand equity). Per CFO Donna Dellomo's remarks on the Q3 earnings call, gross margin declines were primarily driven by freight increases:

The decrease in gross margin rate of 300 basis points over the prior year period was driven by an increase of approximately 160 basis points in total freight costs, which includes in-bound and outbound freight, tariff expenses, and warehousing costs, and 140 basis point decrease in product margin driven by higher planned promotional activity.

Our gross margin rate exceeded our guidance, driven primarily by lower in-bound freight costs and realization of the lower freight benefits through the P&L earlier than we have projected, partially offset by a slightly lower product margin rate. We do anticipate in-bound freight rates to stabilize at this level for the remainder of fiscal 2023, but because of the amount of inventory we maintain on-hand to support customer satisfaction of the brand, we will not see the full benefit to the P&L of the drop in these rates as compared to prior year until the associated inventory is sold during late Q4 and continuing through the first half of fiscal 2024."

Driven both by gross margin declines and opex increases related to the company's store fleet expansion, adjusted EBITDA swung to negative -$8.4 million, while pro forma EPS of -$0.55 also showed a sharp contraction versus a profit of $0.18 in the year-ago Q3.

We should also note Lovesac's dramatically weakened balance sheet position. As of Q3, the company has only $3.8 million of balance sheet cash remaining. The good news is that Lovesac does have an unused line of credit from Wells Fargo (WFC) (which provides for up to $40 million of borrowings, per the company's latest 10-Q filing) - but as this line of credit is priced on a variable basis amid rising interest rates, Lovesac's profitability will continue to get crushed by the additional burden of interest costs if it turns to debt to finance its buildup in inventory.

Lovesac balance sheet (Lovesac Q3 earnings release)

Key takeaways

Lovesac is in a tough position. It is chasing sales growth by expanding its store fleet, but this is requiring the company to hold more inventory, draining its cash reserves and potentially requiring it to dip into interest-bearing debt. And amid a potential recessionary crunch, the company may need to turn to more aggressive discounting to keep its inventory moving, damaging gross margins and impacting profitability further.

Steer clear here.

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.

Comments

[cruiser88]

You recommended buying this stock in 4 previous articles, all at higher prices than current. Q4 revenue up 21% y/y, FY24 guidance raised to $700-740M, $1.83-2.24 EPS. I wonder if you still maintain your sell rating?

[antoncretu]

- If comparable sales growth was 9% AND they are expanding, why is it difficult to reach 11% YoY growth target? Only because of the interest rates / mortgage / house market situation? Yes, this is a risk indeed, but not sure how much known...anyway, if, let's say only 9% growth instead of 11%, not so bad
- Gross margin under pressure again not sure why: freight / fuel cost is kind of "stabilizing" (like management is saying). Then, they have some inventory, but that's kind of a very short-term problem
-Opex increases will give low / negative EPS...hmm...I would like to see that for a whole year, one quarter is nothing (even 3 quarters I doubt, maybe the 4th quarter is pretty important :))

[ErwinIgel]

I like this company too (both as a consumer and as an investor). And I bought a fairly large position just after Q3 earnings. However, I tend to agree with the author's conclusions, if we focus on the short-term outlook.

Consider that the stock stood at $22.49 the day before Q3 earnings. On Q3 earnings day it sold off sharply, down to $17.71. Now it has soared way past the pre-Q3 earnings level, and is currently sitting at $28.17 - importantly: without ANY notable company-related news, but instead simply reflecting broader market sentiment (which one could also question).

I fear the author might be correct in stating that the negative drivers having impacted on their Q3 top and bottom line will likely exacerbate into 2023. It's an assumption, but one that makes sense to me. The operational cost savings (e.g. freight) will likely be more than offset by subdued revenue over the next couple of quarters.

I do have high conviction long term, and will definitely buy back in at some point, certainly if it revisits the $20 mark (and also above that level if/when the outlook brightens). For now though, I have significantly trimmed my position.

[Naples Investor]

@ErwinIgel agree on all of that.

[Naples Investor]

I got assigned shares for sub $20 by selling puts repeatedly and then sold some $25 covered calls and had the shares taken away. About a 30% profit in less than five months.

I LOVE $LOVE!

I am hoping we are in a bear market rally and the stock comes back down to $20. I will buy back in and sell a bunch more puts!

[DogeLoin]

Yes, if you have a less than 1 year time horizon. Of course it is affected by macro, 5 year time this will be a multi bagger . Q4 is highly cash generative quarter and will boost the balance sheet

[Zoisdem]

I think a lot of the decelaration is already priced in, but will see at the earnings report. Anyway, if it drops, it is an opportunity to pick some, as I see it as a potential multibagger

[Ghost of Graham]

@Zoisdem I agree. We need to stay levelheaded about it. KO sells at 24x earnings and there's a very hard upper limit on their 7-8% expected growth going forward long term. I get that people like to pay a premium for safety, but that's a little nuts to me.

Even though current price of $28 is way above recent prices at sub-$20/share, the "grand" picture, the very big picture is that earnings growth is expected at 27%, 78%, and 21% for the next three years according to fast graph. Half each of those, and you're STILL looking at a deal at $28.

[K. Oakes]

Maybe short term? Maybe? But this is a buy for long term investors

[Ghost of Graham]

I would suggest that all the reasons stated in your article are explanations as to why we can buy this company at 12.5x forward earnings. Even if the supposedly horrendous deceleration of growth down to 15% annually stayed that way long term, would 12x earnings not be a reasonable price for that? Further, the cash position of 3 million makes sense if you realize their dynamics. Q4 is their megahaul of the year. It makes sense to spent the last bit of cash they have on advertising and new store-in-stores.

Thanks for the article. I don't see this company in a precarious position - just transitioning through tough seas decently. The fact of the matter is we have a winning product in a huge TAM from a company that cares about offering customers something amazing. At 12x forward earnings, and with a megaquarter coming in shortly, I'm happy to hold. There's no reason to think revenue can't rebound to at least 20% for the next few years, given it's history and strategy and popularity. With a few years of stability the multiple won't be 12x, it'll be 25-30x.

[bluesblues]

Nothing has changed 24 to 36 month PT $75 plus

[Augie91]

Was fortunate to buy small position at 52 week lows. Will buy more if it falls again. Long term focus. Goal is to buy one of their couches in 5ish years. Love their products! Thanks for writing your article, I look forward to reading more!