Lumber Liquidators (LL, Financial) spiked 15% this past Friday after rising 13% the day before to a closing price of $18.84 per share. The stock’s recent ascent comes after the company announced a settlement with the U.S. Department of Justice related to its compliance with the Lacey Act. The Lacey Act relates to the protection of plants, fish and wildlife. Per the settlement, Lumber Liquidators will pay a total of $10 million in fines. The company had already reserved funds to pay for the fines in Q1 2015. Many investors believed the fines could have been much worse, and ostensibly that was the reason for the stock’s recent runup. Another reason may be investors who were short the stock took profits.
What’s important to note is that the Lacey Act settlement is unrelated to the charges that the company knowingly sold wood flooring sourced from China with dangerous levels of formaldehyde. These flooring issues were brought to light by CBS News' 60 Minutes on March 1. The investigators found that LL’s suppliers purposely mislabeled the laminate flooring to comply with California's Air Resources Board. Since then, the stock had plummeted 73% even after this past week’s price gain.
For investors counting on a turnaround, they would need to believe that LL will get past the CARB issues, and then also be able to regain consumer trust. In August, LL reported awful Q2 2015 results that were impacted by the bad publicity. Revenue was down 5.8% year over year to $248 million, but more telling was that their gross margins deteriorated from 40% to 25%. In-store transactions were down between 7% to 8%, implying lower foot traffic. As a result, the company lost $20.3 million during the quarter. It’s difficult to assess the potential fallout from an unfavorable ruling on the formaldehyde laminate issues as it will depend on the size of the punishment which could be huge.
The best case is if LL gets a slap on the wrist similar to the Lacey settlement. If that were to happen, investors still have to question today’s current valuations. The company was able to earn $2.31 per share in FY2014 on 40% gross margin prior to the 60 minutes story. Now that it’s become clear that margins will be much less going forward, what are reasonable expectations for normalized earnings? If Q2 2015 was any indication, and 25% gross margins become the new normal, then it makes sense to look at their past SG&A percent. Going back to 2003, the company’s lowest SG&A level was 26.8% and averaged 28.3% over that time span.
| In millions | Â | Â | Â |
| FY | Revenue | SG&A | SG&A % |
| 2003 | $101 | $30 | 29.7% |
| 2004 | $172 | $48 | 27.9% |
| 2005 | $245 | $68 | 27.8% |
| 2006 | $332 | $89 | 26.8% |
| 2007 | $405 | $116 | 28.6% |
| 2008 | $482 | $131 | 27.2% |
| 2009 | $545 | $151 | 27.7% |
| 2010 | $620 | $174 | 28.1% |
| 2011 | $682 | $198 | 29.0% |
| 2012 | $813 | $230 | 28.3% |
| 2013 | $1,000 | $285 | 28.5% |
| 2014 | $1,047 | $314 | 30.0% |
One needs to assume that LL will be able to cut SG&A substantially or raise gross margin to break even on an operating income basis. Either way, it’s reasonable to assume that the company will struggle with profitability in the near term with so much bad publicity fresh in consumers’ minds. Heavy discounting will likely be needed to get people in the stores. Some people may point to the company’s low TTM price to book ratio at 1.65 as an indicator of a cheap stock. A closer look shows that most of the book value is tied to inventory. This is the same inventory that many people are calling junk. Bottomline, it’s hard to see why LL deserves its current stock price.
