Back in November, I wrote about Liquidity Services (LQDT, Financial), conveying a generally positive outlook on the stock and throwing out a target price of about $28, with a buying target around $20.
Well, in the past month alone, the stock has hit almost both ends of that range, and just yesterday, plummeted down to under $18.50! It has fallen 32% in the last 2 weeks alone.
With it now trading well under the buying target set several months ago, is it time to think about buying LQDT?
A Major Negative Development
Few stocks drop so far in so short a time without a major change, and that's just what happened with Liquidity Services.
But first, a little background.
As outlined in the above article, 28% of Liquidity's revenue is from its surplus contract with the Department of Defense (DoD). In a nutshell, LQDT agrees to purchase the DoD's excess computers, office supplies, electronics, clothing - whatever - at a set percentage of original value, and then liquidates those items through its reseller networks.
This week, the company reported on the results of the bidding process for the new DoD surplus contract. Those results were unfavorable to LQDT and triggered the recent, dramatic sell-off.
The Contract Changes
There are two components to the surplus contract news.
First, LQDT announced that it would pull its bids for the "rolling" portion of the contract. Historically, this portion had accounted for about 30-35% of the gross merchandise value (GMV) of the entire surplus contract. Since the total surplus contract is about 15% of LQDT's total GMV, this works out to a loss of 5% of total GMV.
Second, while LQDT is likely to retain the "non-rolling" surplus contract, its purchase cost will increase from 1.8% of original value to 4.35%. That's an increase of 142%! This will squeeze Liqudity's gross margins on what remains of the surplus contract revenues.
Changing the Model
It is important to realize that these changes will not really affect LQDT until its 2015 fiscal year... this year's financial targets remain the same (i.e., about the same results as 2013).
However, the big changes for 2015 and beyond are to the revenue and gross margin percentage lines.
Assuming a similar contribution to revenue as GMV, the loss of the "rolling" contract will immediately reduce 2015 revenues by slightly over 9%.
As for gross margin, the percentage cost changes are similarly damaging. We can't be exactly sure what the margin differences are in LQDT's various contracts, so I'm assuming roughly equal contributions. Increasing cost by 140% on about 20% of total cost of goods, I see LQDT generating a 51% gross margin, well down from its recent 60% rates.
While that may not sound too bad, it is quite significant. The difference in gross profit is close to $70 million, which was nearly the company's entire pre-tax profit in 2013!
How Can the Company Recover?
The one positive thing about this development is timing. The effects will not take place for many months, giving management time to develop a mitigation plan.
There are two parts here: revenue loss and gross margin tightening. To offset the latter, Liquidity will have to go through some cost cutting. Its sales and marketing costs increased almost 29% in 2013, despite just 6% revenue growth. This looks like prime territory for cost cuts, as do G&A costs, which exhibit a similar pattern. I'd expect Liquidity to focus on about $25-30 million in operating expense reductions next year, mitigating some of the gross margin loss.
How the company aims to make up the revenue gap will be interesting. Liquidity has numerous contracts with large retailers including Walmart (WMT) and Costco (COST), so further expansion into this area seems likely. The question will be how fast can they replace the lost revenues from DoD?
Setting a New Price
The ultimate question is: what is the stock now worth?
The only definitive answer I can give here is: significantly less than $28!
Realistically, though, barring some huge new contract activity, Liquidity is going to lose at least $40 million from EBIT in 2015. From that baseline, the company should be able to continue its history of winning new contracts and readjusting its cost structure to drive 15-20% profit growth for several years thereafter. A $50 million share repurchase plan will also help in the meantime.
Altogether, the price target for Liquidity needs to be reset to about $18/share. Clearly, that puts the stock well out of "attractive buy" territory.
