Ouch. 

Specialty flooring retailer Lumber Liquidators Holdings (NYSE:LL) reported second-quarter sales on August 5, and it wasn't pretty. The highlights:

  • Sales fell 5.8% in the quarter; same-store sales were down 10%. 
  • Gross margin was 25.1%, while SG&A as a percent of sales was over 36%. 
  • Working capital has declined sharply, largely due to inventory reduction. 
  • Management outlook is for low margins and higher expenses to remain for the foreseeable future. 

On the surface, Lumber Liquidators is reeling, with costs skyrocketing as the company deals with a bucketful of legal and product safety concerns, and profits falling sharply as it fights to close sales and move through major inventory changes. Management says it has a plan, and is executing on that plan, while the company's board of directors has taken the lead on the non-operations issues. 

What's really happening? Honestly, we can't answer everything, but we can dig into the earnings filing and management's comments on the earnings call, and at least get a better idea of where things stand. Let's take a closer look. 

Rising costs, falling prices creating unsustainable trend 
One of the key drivers of Lumber Liquidators' success over the past several years has been its very high gross margins, helping the company drive strong profits in a cutthroat business. 

LL Gross Profit Margin (Quarterly) Chart

LL Gross Profit Margin (Quarterly) data by YCharts.

Gross margin percent tumbled even further last quarter, to 25.1%, a level that quite frankly is not sustainable without severe cost-cutting. Last quarter, sales, general, and administrative -- or SG&A -- cost as a percent of sales was more than 36%. In other words, gross margin dollars fell short of covering SG&A expenses. 

However, context is key here. Lumber Liquidators is spending a lot of money to address a number of issues, including allegations that its Chinese-sourced laminate is harmful, pending Lacey Act charges for illegally sourced Chinese hardwoods, anti-dumping duties, and a number of just-announced charges relating to what management described as simplifying the business. Here's a summary of the abnormal costs that affected gross margins:

  • $4.9 million for antidumping duties
  • $4.9 million related to formaldehyde testing program for current customers
  • $3.7 million to phase out tile business
  • $1.5 million to discontinue vertical integration initiative

Here are short-term additions to SG&A expense:

  • $6.3 million increase in legal and professional fees
  • $3.2 million accrual toward Lacey Act violations

That's $24.5 million in added expenses versus the year-ago period. The company reported a net loss of just over $20 million, so it's pretty clear that these "one-time" items had an outsized role on the bottom line. While it's good to be able to draw a direct line between these costs and the impact on profits, it doesn't address what the company is doing to correct it. 

Management says it's executing on a plan, but working capital bears watching 
During the quarter, Lumber Liquidators pulled all Chinese-made laminate products off its shelves, and management says the company is going through a major product realignment. This is evident from two perspectives: discounting and sharply declining inventory values. 

On the earnings call, management reported that the average retail price fell 6.3% in the quarter, as the company discounts products both to close sales and clear out inventory. CEO Tom Sullivan and interim CFO Greg Whirley both discussed this, saying that the company carries a lot of products that are too similar to one another, and that it will simplify the process for customers and improve efficiency to focus on core SKUs and eliminate overlap, especially when it doesn't result in better sales. 

The decision to exit the tile business and vertical integration program are also expected to simplify the business and focus on its core strengths. 

At any rate, it's allowing the company to utilize its inventory in the meantime as a source of capital while it retains cash. At year-end, inventory was valued at $314 million and declined $13 million to $301 million at the end of Q1 in March. Since then, it fell a whopping $38 million to $262.7 million. Even factoring out the $3.7 million adjustment related to the tile business, that's a $34 million decline. Overall, working capital declined $16.2 million sequentially. 

It's probably an overstatement to call this a problem at this stage, because management says that it's going to take more time to work through existing inventory, as well as time to source more laminate product from non-Chinese mills before inventory levels start to normalize. Further, it's unclear what those new levels will look like, with the planned reduction in SKUs carried. Whirley also warned that, depending on the outcome of the investigations of its Chinese-made laminate, the company could be forced to take significant further writedowns on that inventory, valued at $19.8 million. 

Status of pending issues 
The company accrued $10 million toward potential losses related to pending charges related to prior Lacey Act violations in the second quarter, but apparently a company review of more recent sourcing compliance turned up more product that violated the act. However, the company self-reported, and the Department of Justice indicated that it wouldn't seek criminal charges in this matter, but would accept a $3.2 million fine. It's good that the company discovered this issue in-house,  but it's not a positive that it was discovered at all. 

So far in 2015, it has spent $7.2 million on the testing program for customers that bought this product, and has another $2.3 million in reserve. Of the amount spent so far, $2.5 million has been spent on customers not satisfied with the test results, primarily testing of flooring samples. The company said that over 90% of the tests that have been returned so far have recorded acceptable levels of formaldehyde emissions. It is working with the 10% remaining to determine if the flooring is the source of those emissions or not. 

The Consumer Product Safety Commission investigation -- announced in March -- remains ongoing with no further updates since then. The CPSC has said that it will conduct "real-world" testing in an effort to determine the level of risk that consumers face. As long as this investigation is ongoing, it's very difficult to determine the potential impact. A worst-case scenario would be the CPSC determining that emissions levels from a large quantity of product are at harmful levels, and the company would be forced to recall and replace tens of millions of dollars in products, as well as potentially pay the costs of installation. This would also open the company up to potential lawsuits as customers line up to claim further damages. 

Lumber Liquidators also reported that CARB -- the California Air Resources Board -- opened an investigation in May, having tested product it sourced on both 2014 and March of 2015, with some samples exceeding emissions levels based on deconstructive testing. It says it thinks that CARB is testing multiple vendors, not just its products, but offered no estimate for potential losses if CARB were to assert a claim. 

Unknowns remain a big risk, but balance sheet is strong
As of this writing, Lumber Liquidators stock is getting killed today, which shouldn't be a shock considering the impact on sales and profits so far, and most expectations that the company would break even or post a small profit. 

With that said, much of the losses were one-time or short term in nature, and management is adamant that it is taking necessary steps to simplify and realign the product mix and inventory, and that this will make for a better, stronger, profitable company once it's completed. One thing to watch for going forward is improved gross margin, based on adding more high-profit laminate back into the mix in future quarters. 

As things stand today, even after the big decline in working capital, Lumber Liquidators has more than $205 million in working capital, including $45 million in cash, plus almost $80 million in available debt on its credit line. While that doesn't address the unknowables, it's a safety net that the company can rely on while things progress. To answer the question posed in the headline: It's probably too early to tell. 

Jason Hall owns shares of and options for Lumber Liquidators. The Motley Fool recommends and owns shares of Lumber Liquidators. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.