If you had purchased Lumber Liquidators Holdings Inc. (NYSE:LL) stock early last year, you would have likely paid over $90 and possibly as much as $100 per share. LL was coming off of a record setting top-line year with sales reaching over $1.05 Billion. Fast-forward to last week where LL was trading at yet another new 52-week low of just over $12 per share which had many investors wondering if the latest swoon was the harbinger of the end for the once heralded flooring company.
What caused this online flooring retailer’s fall from grace that led to over an 88% decline in stock value in only a year-and-a-half? As most investors already know, the trouble began with a 60-minutes expose in March of 2015 alleging that LL had bought and sold Chinese-sourced laminate flooring that exceeded the accepted level of formaldehyde – a known cancer causing agent often used in the manufacturing of laminate floorings. This was proceeded by the resignation of CFO Daniel Terrell, announced in April followed by the resignation of CEO Robert Lynch in May, which was then proceeded by a criminal investigation by the Department of Justice (DOJ) under the Lacy Act concerning engineered hardwood flooring also acquired from China. Sprinkle in a couple of missed earnings announcements and a general reluctance by Lumber Liquidator’s management to address the formaldehyde issue head-on and you have the perfect recipe for eliminating about $2.5 Billion in market value.
There’s no question Lumber Liquidators has inherent risk as an investment vehicle and there are no lack of headlines on a daily basis adding fuel to the short-sellers’ fire. But the question I find most intriguing and least written about is the same question investors should be asking themselves – “What is LL stock worth?”. Let’s explore a few facets of that very difficult question.
Predicting a company’s primary measure of success, earnings, can be a crap shoot in the best of times. Given the number of unknowns that Lumber Liquidators is currently facing it can be downright impossible. So much so that Lumber Liquidator’s management declined to provide a 2015 estimate during its Q2 financial review earlier this month. Current analyst estimates for full-year 2015 fluctuate wildly with each new headline but currently sit between a loss of $.80 per share and $1.56 per share. Fairly steep losses for a company that was making over $2 per share the previous two fiscal years, however keep in mind that included in that loss are a number of one-time items related to the ongoing litigation including $6MM for legal fees, $3.2MM for inventory forfeiture associated with the Lacy Act, and roughly $12MM for formaldehyde testing kits sent to customers who had purchased the suspect flooring.
The 2016 earnings estimates between a loss of $.27 per share and a profit of $.90 per share are much improved, but still a far cry from the earnings of 2013 and 2014. Even 2017 which arguably should mark a full return to normalcy for the embroiled flooring company is currently trending between a profit of $.35 and $1.40 per share. At 2016 estimates LL is currently trading anywhere from a 15 to a 51 P/E ratio. At 2017 estimates, we’re looking at a P/E of between 10 and 40. Clearly, much rides on the accuracy of these estimates – depending on which end of the estimate LL will ultimately fall, determines whether the current stock price is trading at roughly half of its competitors’ P/E or perhaps twice as much as its competitors’ P/E. Consider that Home Depot (HD) and Lowes (LOW) are currently trading at 24 and 25 respectively. Lowes is of particular note since they too carried laminate inventory from the same Chinese manufacturer (albeit much smaller quantities) but as of yet have not endured any of the criticism or financial hardship that Lumber Liquidators is currently facing.
Most Recent Performance:
If we agree that predicting the future is hard on a good day and near impossible with potential litigation and fines on the horizon, then are the earnings estimates worth considering at all? Perhaps a better measure of LL’s future worth lies within their most recent Q2 performance. On Monday, August 5th Lumber Liquidators released their Q2 results and financial analysis. Of particular note, was the decrease in sales of just under 6% as compared to the same quarter of 2014. In addition, gross margin had significantly eroded to 25%, as compared to 40% for the same period in 2014. If you were curious how the market interpreted this news, you need only watch for one week as the depressed stock plummeted an additional 30% by Friday.
Personally, I sat mesmerized (as I often am) by the market’s reaction. Pretend for a moment that you are the current, interim CEO and original founding member Thomas D. Sullivan. After watching your company publically destroyed for 5 consecutive months, after losing two of your C-suite executives, after being investigated by the DOJ and after likely being penalized for Lacy Act violations your latest quarterly results are in, and…. You lost 6% top-line compared to last year. Yes, your margins took a beating as a result of promotional pricing to keep customers walking in the doors. Yes, there were a larger than normal amount of product returns. Yes, you’re not out of the woods with litigation. But ONLY 6% sales decline? I’m going around the office high fiving anybody with 5-fingers and a functional arm if I’m the CEO.
In my opinion, there are only three critical problems that could result in Lumber Liquidator’s closing their doors permanently: a big top-line hit, a cash shortage, and litigation. With the latest Q2 results I think the first concern is put to rest. Either the public isn’t concerned about the laminate flooring that accounts for roughly 3% of LL’s inventory. The public doesn’t know. Or perhaps the public just likes cheap flooring at promotional pricing. At the end of the day, customers were still walking through the door and sales had a momentary speed bump on the road to recovery. The second critical problem is cash flow.
Sales took a small hit last quarter and margin took a bigger hit – but does Lumber Liquidators have enough cash and cash flow to weather the storm? First stop on the liquidity-analysis-trail is the quick ratio. The quick ratio = (current assets – inventory) / current liabilities. Based on Q2 results, LL currently has a quick ratio = .58. Meaning their current liabilities outpace their current assets (cash) by a factor of 10 to 6. It’s a somewhat misleading and potentially scary metric unless compared relative to something else. For example, keeping with our previous examples let’s look at HD and LOW for comparison with current quick ratios of .33 and a .17 respectively. Relatively speaking, LL would appear more liquid than its competitors. Also, if we compare LL’s quick ratio to the same metric a year earlier we see that their ratio has actually improved from a value of .54 at the end of Q2 in 2014.
Looking strictly at LL’s bank account reveals over $45MM in cash and an available revolving credit line of over $79MM. It would appear the ongoing controversy has not completely dampened LL’s growth aspirations since according to the most recent 10-Q report, the company still has plans to open between 20-30 new store locations next year as well as renovations to approximately 10-15 additional stores. Factor in a sizeable inventory valued at $262MM and sales figures that we’ve already determined are holding and it would seem that financially-speaking, Lumber Liquidators is in an acceptable position to face its current challenges based on their current outlook. Will that outlook change based on a court decision?
The biggest and scariest unknown for those considering an investment in Lumber Liquidators are the pending lawsuits and fines. If you peruse the same 10-Q report for Q2 referenced above you’ll find enough pending litigation to make an associate business law professor salivate. “Lacey Act Related Matters”, “Securities Laws “, “California Air Resource Board”, “Securities Litigation Matter”, “TCPA Matter”, “Prop 65 Matter”, “Gold Matter”, “Litigation Related to Products Liability” etc, etc. These are not chapters in a corporate law text book; these are subsections of LL’s financial report to the SEC. To be fair, any company selling over a billion dollars’ worth of anything is going to have legal matters. It’s a fact of doing business. But when you combine all of the aforementioned “matters” along with the other “matters” I didn’t include, along with Chinese laminate “matters” it suddenly paints a much clearer picture of why both the CEO and CFO decided to take permanent vacations. Since I’m not a lawyer I’m not going to delve into each individual issue but I would encourage potential investors to do just that – especially the incredibly vague reference in the quarterly report concerning a joint US Attorney’s Office and SEC investigation about compliance and disclosure reporting laws. This could be worth watching. Instead I’m going to touch on the two most publicized legal quandaries that seemingly may have the largest financial impact.
Lacey Act Related Matters – essentially the Lacy act protects the import or acquisition of protected plants and animals. The DOJ executed search warrants against LL back in September of 2013 which led to the DOJ pursuing criminal charges. The estimated penalty that was already put on the books in Q1 of 2015 is $10MM. Management admits that the final fine could be more or less but given the only other recent fine levied under the same act was to Gibson Guitar back in 2012 for the amount of $300k – so $10MM seems reasonable if not conservative. After being searched and indicted by the Feds, LL management decided to do an internal review and self-reported an additional $4.1MM worth of product that also was sourced illegally. From where you ask? China (shocking). The additional inventory generated another $3.1MM in fines which hit the books in Q2 of this year.
Chinese Laminates – the Chinese laminate flooring issue is too complex for this very brief article but there are few interesting points that often go unreported in the media that I think are important to consider.
First, Lumber Liquidators is accused of selling laminate flooring (representing 3% of their inventory) that exceeds the air quality standards set by the State of California for formaldehyde emissions – this is not a federal regulation yet. While the EPA is currently drafting similar regulations, LL is not in violation of any federal standard for formaldehyde emissions. Anyone familiar with consumer protection laws in California knows just how rigorous they can be – some might say, overly-rigorous. According to LL management, their flooring is compliant with standards set by the World Health Organization (WHO). What standards should be measured against?
Second, testing is a fickle beast. The 60 Minutes test were arranged by Denny Larson (environmental activist) and Richard Drury (an environmental lawyer) who were backed by hedge fund manager Whitney Tilson (who self admittedly had a large short position in LL). The test used a sample of 31 boxes of Chinese laminates from the state of California – already not the largest sample size in the history of recorded testing. The testing method involved “deconstruction”, or cutting the flooring apart, which Lumber Liquidators argues is an unfair method due to the fact most homes aren’t going to install the laminate flooring only to rip it to pieces. Of the 31 samples tested, 30 failed the test by as much as 20 times the allowable limits. Time for more tests. In response to the formaldehyde claims Lumber Liquidators voluntarily shipped over 40,000 home testing kits of which about half were returned. Of the 22,000 returned tests over 90% were within the allowable limits as set by the WHO. Who’s tests do we believe?
Third, what damage has been caused. I don’t know much about corporate law but I do know in order for a civil penalty to be levied there typically have to be damages caused. To date, I don’t know of a single instance of a person claiming any specific health-related damages as a result of living in a house with the Chinese laminate floors. I’m not trying to understate the potential for serious long term affects if left unresolved. ie asbestos/tobacco. But I don’t think we’re currently looking at situation where LL would be responsible for millions in health related bills. But for argument’s sake what if LL had to replace every single Chinese-sourced piece of laminate flooring? What dollar amount are we talking about? According to the Wall Street Journal, Chinese sourced laminates accounted for 13.1% of sales during 2014 and about 10% of sales in 2015 before the discontinuation of the product. That equates to roughly $170MM in sales revenue and potentially a door-shutter for LL.
Buy, Sell, or Wait?
There is only one thing certain about Lumber Liquidators stock in the short term – it’s going to move. Accurately choosing the direction is the challenge. Based on Q2 results I think it’s safe to say that their core business appears healthy considering the circumstances. Financially they are well positioned for a fight and they are prepared for litigation. The biggest wild card is the pending litigation. If the Chinese-sourced laminate flooring was the only issue, estimating the potential financial impact would be far easier. With each additional class action lawsuit or federal inquiry the pattern of negligent management is harder to ignore. Successful investors make their living knowing when the market has overreacted to adverse news but are also cognizant of a company in dire straits.
Is it time “to be greedy when others are fearful”? Or is continuing to invest in Lumber Liquidators “throwing good money after bad”
Personally, I think I’ll wait.