On Thursday, Lumber Liquidators Holdings Inc. (NYSE:LL) released its net sales results for the first quarter, to a market starved for information about the company's results following the 60 Minutes' allegations of potentially illegal and hazardous levels of formaldehyde in its products. Here are the numbers:
- Net sales for the full quarter were up 5.6% from 2014.
- Sales in March fell 12.8%, in line with management's expectations following the 60 Minutes story.
- Gross margin is expected to be between 35.5% and 36.5% for the quarter, below prior guidance.
Let's look at where things stand as the company works through the allegations featured on the news program, in addition to an investigation by the Consumer Product Safety Commission announced in late March.
Lumber Liquidators' sourcing challenges date to 2013, when the company was found to have potentially obtained illegally produced wood from Russia. While the financial ramifications of that incident are still unclear, the bigger issue is the recent claim that its Chinese-manufactured laminate flooring contains illegal (in California) and dangerously high levels of formaldehyde, Formaldehyde is a common ingredient in the glue used to make medium-density fiberboard, or MDF, which is found in everything from floors to furniture to countertops.
The basis of the 60 Minutes report was deconstructive testing, a method that essentially takes a product -- in this case laminate flooring -- completely apart to expose base components for, in this case, MDF for formaldehyde emissions testing. Lumber Liquidators' Chinese-made laminate -- according to the testing paid for by 60 Minutes -- produced dangerously high emissions levels, while its U.S.-made laminates did not. Furthermore, tested laminates from other retailers produced significantly lower emissions.
The issue -- as Lumber Liquidator sees it -- is that deconstructive testing does not produce real-world emissions to which a consumer would be exposed, but potentially much higher levels. Management has been steadfast in its position that deconstructive testing isn't a viable measure of its products' safety.
On March 25, the company received what seemed to be some vindication, when CPSC Chairman Elliot F. Kaye confirmed the commission was investigating the company's products, and that the investigation would (emphasis mine) "involve testing of samples as well as consideration of home-based exposure scenarios to consider risks."
What does that mean? Kaye made it 100% clear on a conference call. When asked if the CPSC would use deconstructive testing, he said,"We are not. So we're looking at testing in a method that most closely replicates the way that the products are used in the home."
While it will be months before the CPSC investigation produces any results, the fact that the commission is using the testing methods Lumber Liquidators has stood behind says a lot about the arguments made by those accusing the company of selling products that pose a health risk.
Looking at the business results
Sales came in within the company's projections back in mid-March, but we didn't get any color on the recent results. When the company launched its first major challenge to the allegations, 10 days had passed since the 60 Minutes broadcast. In the nine business days following the story, net sales had fallen 7.5%. Considering the company reported that sales fell 12.8% for the full month, there was a major falloff in business even after the company launched its defense.
The bigger concern, as I see it, is whether that trend is continuing into the second quarter.
In addition, the company's gross margin fell even further than management had projected. In 2014's first quarter, gross margin came in at 41.1%, and management was projecting it to fall to 37%-37.5% for the same period of this year. Now it is expected to land at between 35.5% and 36.5% for the quarter. What's not completely clear at this point is how much of the margin compression is the result of discounting to retain customers, and how much of it is related to a shift in product mix. Most importantly, is this a permanent reduction in gross margin, or can the company get past this and grow its margin back closer to 40%? At this point it's hard to say.
Lumber Liquidators remains surrounded by questions. The biggest concern is what the CPSC investigation will uncover. If the company is vindicated, that's great. However, it's probably not a good idea to invest on the hope that the investigation uncovers no hazardous products.
The biggest question could simply be whether customers will come back. I think they will, but even if the company is vindicated it is realistic to expect overhang for some time. It's really an issue of how much, as well as how long, this affects consumer perception.
I own shares of Lumber Liquidators, and I've added to my position recently, but it's still a rather small percentage of my portfolio. I think the company should emerge relatively unscathed from this controversy, but I'm not willing to bet the farm on it, or that customers will come back in droves even if it does. Today's price could be a great value, but I think there's just too much we don't know yet to make that call with total conviction. I suggest you measure how the company does after another quarter or two, especially once the CPSC's investigation is complete.