Comments On Lumber Liquidators’ First Quarter Business Update by Whitney Tilson, Seeking Alpha.

Summary

  • Lumber Liquidators reported that same store sales were down 17.8% in March.
  • Even worse, gross margin plunged from an estimated 38.5% to 31%.
  • The company’s margins soared in 2012 and 2013 in large part, I believe, because it was cheating by sourcing tainted products.
  • Now that it can no longer do so, margins will likely return, at best, to historical ranges, which will significantly reduce earnings going forward.
  • Using even generous assumptions, the stock is significantly overvalued.

Lumber Liquidators released its First Quarter 2015 Business Update yesterday morning, in which it disclosed that same store sales in March were down 17.8% – a terrible number, to be sure, but better than some had feared, so the stock was actually up slightly on the news.

I’m not surprised that sales weren’t as bad as expected given how much the company is slashing prices – just go to the company’s website and you’ll see what I mean. This obviously had a big impact on margins, however – the company didn’t disclose how much, but a Morgan Stanley analyst report out yesterday estimated that gross margin plunged from 38.5% in January and February to 31% in March. Here’s an excerpt from the report:

A knock on Q1 and future results is that gross margin is weaker than expected. The company is clearly being promotional in stores with a ~$1.00 off per foot of Bellawood and nearly every other SKU on sale. In addition a mix shift away from laminate towards hardwood (10%-15% margin difference) is putting pressure on gross margin. We think that while sales are the more important story line today, at some point the focus will shift to whether LL can bring these margins back up. Based on the gross margin range provided, and assuming higher SG&A than initially thought, we think Q1 earnings could be as low as $0.10 or as high as $0.17. Our Q1 EPS estimate goes to $0.14.

Q2 margins are also likely to be under pressure. At the beginning of Q1, LL anticipated gross margins of 38.5%. On its 03/10 call, LL lowered this target to 37% and further lowered it this morning to ~36%. Assuming LL was running margins at 38.5% for January & February (2/3 of the quarter), it implies March gross margins came in at 31%. It is a valid concern if this rate holds through Q2 and we look forward to more clarity on this on the April 29th conference call. But, for now, we believe better sales will carry the day.

Here is a chart of Lumber Liquidators’ gross margin by quarter from Q1 ’06 to the present (using Morgan Stanley’s estimates for January-February and March):

Lumber Liquidators

The key thing to notice here is the very consistent gross margin between 34% and 36% for four years – and then the extremely rapid increase starting in Q1 ’12, which is exactly when: a) Rob Lynch became CEO (1/1/12) and b) Lumber Liquidators acquired Sequoia Floorings, whose primary operations are in Shanghai (the deal, announced on 9/29/11, was “expected to close by the end of the year”).

The company would have you believe that the rapid increase in its gross margin was due to various legitimate and sustainable factors. On the Q3 ’13 earnings call, CFO Daniel Terrell said:

Our gross margin over the past two years has benefited from a portfolio of initiatives working individually and in combination to deliver cumulative multiyear benefit…We aggregate gross margin drivers in three primary categories, all of which contributed to third quarter expansion. The product margin drove 300 basis points due to shifts in our sales mix, including an increase in moldings and accessories, lower cost of product due to sourcing initiatives and higher like kind ASP, not due to retail price increases, but a result of greater retail price discipline at the point-of-sale. [emphasis added]

I believe that most of Lumber Liquidators’ margin expansion is due to only one of these three explanations – “lower cost of product due to sourcing initiatives” – but that this wasn’t done legitimately, but rather by cheating: buying, mostly in China, illegally harvested hardwoods, toxic laminate, etc. and thereby saving 10-20% on sourcing costs.

(Interestingly, one source told me that Sequoia, rather than being the cause of Lumber Liquidators sourcing tainted products in China (which is what I’d assumed), was, in fact, a good operator – but once Lumber Liquidators took control, Sequoia turned to the dark side.)

Why would Lumber Liquidators do something so immoral and potentially destructive? The oldest reason in the universe: greed. The company saved a lot of money on sourcing costs (not a “few pennies,” as founder and Chairman Tom Sullivan claims), which I think was a major contributor to a quick doubling of operating margins, which in turn helped send the stock price up eight times from $15 to $119 in less than two years. Both Sullivan and Lynch recognized a golden opportunity when they saw it, dumping $37 million worth of stock at prices more than double today’s level in early- to mid-2013.

Another key thing to notice in the gross margin chart is that the outlier isn’t the 31% gross margin in March – it’s only 300 basis points (bps) below the bottom end of the 34-36% historical range – but rather the 42% peak gross margin, which is 600 bps above the top end of the historical range.

I confidently predict that, even if one excludes any potential fines, remediation costs, legal bills and settlements, damage awards, etc., Lumber Liquidators’ gross margin will at best only return to the 34-36% range. This means that operating margin will, at best, return to the historical range of 5-9%, as one can see in this chart of Lumber Liquidators’ operating margin over the same period:

Lumber Liquidators

Earnings Estimates and Resulting Stock Price

If we take the midpoint of the historical operating margin, 7%, and assume $1 billion in sales, that means Lumber Liquidators would have $70 million of operating income. Applying a 39% tax rate and dividing by 27.2 million shares results in earnings per share (EPS) of $1.57 – which is almost exactly current consensus analysts’ estimates for 2015 of $1.60.

The difference between us, however, is that I think $1.57 is normalized earnings power in a best-case scenario, excluding many costs that I believe are likely to be substantial and long-lasting, whereas analysts think 2015 will be an unusual trough year and that the company’s EPS will soar 41% to $2.26 in 2016. I would bet my last dollar that Lumber Liquidators doesn’t earn $2.26 in 2016.

Rather, I think it would be extremely generous and optimistic to estimate that the company’s earnings grow 10% in 2016, which would result in EPS of $1.76. If I’m right, what multiple might the stock trade at? It could trade as low as 6x if regulators take strong action and various lawsuits gain traction (which I think is highly likely), and as high as 15x if not, which results in a stock price range of $10.56-$28.16. Either way, it’s a substantial discount to the current price of $33.20, which is why

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