It's been a tough couple of years for Lumber Liquidators Holdings, Inc (NYSE:LL). And one would think that finally returning to sales growth after six ugly quarters would be fantastic news. Unfortunately, the high rate of cash consumption at the company, which continues to repair its image following a scathing 60 Minutes report and months of bad press, has weighed heavily on Lumber Liquidators' results.
The market clearly didn't like the company's third-quarter earnings, sending shares down 16% on October 31 following the release, but long-term investors are better served digging into the details, and not buying and selling based on the headlines. Let's take a closer look at Lumber Liquidators' third-quarter results.
|Metric||Q3 2016||Q3 2015||Change (YoY)|
|Earnings per share||$(0.68)||$(0.31)||-219.4%|
|Gross margin percent||31.4%||29.7%||+70 BPS|
|Comparable store sales growth||1%||-14.6%||N/A|
A closer look at what happened in the quarter
This was the first quarter since Q4 of 2014 that Lumber Liquidators reported an increase in same-store or comparable-store sales, which were up slightly versus last year. However, it's worth noting that last year's third quarter, as you can see above, saw a massive decline in sales as numerous lawsuit filings and investigations into the company's Chinese-sourced laminate flooring kept "Lumber Liquidators" and "cancer" in headlines on a regular basis.
Management also pointed out on the earnings call that the company's product mix looks substantially different now than it did one-year ago. Last year, Lumber Liquidators was still working to replace its Chinese-manufactured laminate flooring with products made in North America and Europe, and it's only been in recent quarters that the company has optimized its sourcing and been offering the mix of products that it wants to sell.
While these improvements in store-level sales and gross-margin percent are positive, the big issue for Lumber Liquidators remains its very high expenses:
- Selling, general, and administrative expenses (SG&A) were $100.7 million, up 14% year over year. As a percent of sales, this was 41% versus 37% in the year-ago quarter. For context, SG&A was 29.9% of sales in 2014, the last full year before the current ongoing issues.
- Of this amount, $6.3 million was incremental legal and professional fees related to ongoing litigation, while $4.3 million was related to a proposed -- but not yet court-approved -- settlement of a securities class-action suit. The $6.3 million legal portion is a cash expense, while the $4.3 million amount is non-cash, and stock based.
- Even adjusting for these temporary expense items, SG&A would have been 37% of revenue, well above historical levels.
Cash and capital flows bear watching closely
For a business like Lumber Liquidators, particularly with its relatively high expenses right now, it's important to understand which are cash-based expenses and which are non-cash expenses, such as stock-based items or depreciation/amortization, which are tied to prior capital spending. It's also a good idea to discern how working capital changes play a role in supporting the company as it works through its ongoing issues.
Here's a look at some key asset items for the company at the end of the third quarter as compared to at the end of the second quarter:
|Metric||Q3 2016||Q2 2016|
|Cash and equivalents||$8.79||$12.70|
|Total current assets||$342.56||$360.00|
And here are key liabilities:
|Metric||Q3 2016||Q2 2016|
|Customer deposits and credits||$32.61||$30.99|
|Sales and income-tax liabilities||$4.50||$3.64|
|Other current liabilities||$28.16||$28.99|
|Total current liabilities||$194.73||$186.79|
Note the bottom row in both sections -- total current assets and current liabilities. The net difference here is the company's working capital. At the end of the second quarter, Lumber Liquidators had $173.2 million in working capital. At the end of the third quarter, it had $147.83 million. That's a $25.4 million reduction in working capital -- a bigger "negative" result than the $18 million GAAP net loss.
What does this tell us? In short, the company used up a significant portion of its available resources over the course of the third quarter -- primarily, cash and "other current assets," which are primarily made up of refundable income tax and a deferred tax asset.
Frankly, investors should pay very close attention to this, because it's not sustainable. At some point, Lumber Liquidators must either lower operating costs, grow sales, or -- most likely -- some combination of the two, enough to at least get to cash-flow breakeven.
But it's not all bad news. In addition to the assets on its balance sheet, Lumber Liquidators ended the quarter with $95.7 million in available borrowing capacity on its revolving credit facility, which was negotiated this past August. This gives management some breathing room.
At the same time, the reduction in inventory on a sequential basis, according to management, is an intentional step. The company continues to fine tune its store inventory levels, and "reflects a shift forward in the timing of planned inventory increases ahead of the spring selling season." In other words, the company plans to build inventories later in the year in preparation for the first quarter, which is historically the company's biggest.
Looking ahead: Still work to do
As the numbers above indicate, it's likely that the company will have to both find ways to reduce operating expenses and continue improving sales before profitability recovers. In the interim, investors will have to accept the reality that the company is likely to continue consuming cash and working capital, and will almost certainly have to tap its credit facility to make ends meet in coming quarters.
There's also the ongoing overhang of litigation that could result in further costs above and beyond ongoing legal expenses. The good news is that essentially all of the evidence supports Lumber Liquidators' assertions that its products didn't create any significant risk for consumers, but until the litigation is over, SG&A will remain elevated, and the uncertainty of a negative ruling will likely weigh on the company.
For investors today, there's probably huge upside. But there's still measurable risk when a company is forced to spend more than it brings in. That's the case for Lumber Liquidators today, and it's just not clear how long before that changes.