Summary
- Lumber Liquidators has been prioritizing gross margins above comp sales in recent years.
- As tariffs rise, this strategy will prove more challenging.
- The company is making moves to offset the impact of higher tariffs, but 25% on Chinese imports will deal a heavy blow to margins.
- On the other hand, the company runs a lean, all-weather operation, and we believe it can do well in a variety of economic conditions if it makes certain adjustments.
- The company will likely run another loss in 2019, and share price can easily fall below $10. We see significant upside in the medium to long term.
Like many companies, Lumber Liquidators (LL) is feeling the sting of US tariffs and downplaying it for investors. The company’s Q1 earnings call reflects this tempered optimism, describing the offset of rising inventory costs by "cost mitigation efforts." The company will face a challenging year, and its share price will likely continue to struggle as operating profit remains elusive in a 25% tariff environment.
Despite a bleak prognosis for 2019, the company has several factors in its favor in the long term. It maintains a lean business model and continues to strive to shrink expenses. Its installation business is growing at a rapid clip, representing an ever-growing share of revenue protected from the tariff threat. The company’s business model also demonstrates a resilience to tough economic times, a fact demonstrated by the last recession.
The combination of these factors, in my opinion, translates to a weak near-term and strong long-term outlook for the company. Actions necessary to lean into its advantages include a shift of supply out of China, an increased focused on its tariff-immune installation business, and a sustained effort to continue reducing operating costs where possible.
Tariff Troubles
Lumber Liquidators is certainly not alone in the pain it feels as a result of tariffs. Companies across sectors are preparing investors for a grimmer 2019 than previously forecast. In its Q1 earnings call, CEO Dennis Knowles attributed a 2% hit to gross margins to the tariff increase. Different companies naturally suffer more than others in a protectionist environment, and Lumber Liquidators’ supply chain leaves little cause for optimism.
Per the company’s financial statements, Lumber Liquidators sourced approximately 47% of its products from China in 2018, and “virtually all of these goods” were subject to the 10% tariff. As the aesthetically pleasing table below shows, we can use the 200 basis-point damage to gross margins to infer that, as a percentage of inventory value, Chinese materials comprise about 31%. At 10% tariffs, this amounted to a roughly $5 million hit to gross profit. Holding all else equal in Q3 of this year, the first full quarter of 25% tariffs, the hit to gross profit will swell to more than $13 million. Gross margins, one of the company’s top financial priorities in recent years, would fall by a hefty 5%.
Earnings will obviously be impacted as well, but Lumber Liquidators' unpredictable bottom line figures (unusual expenses related to litigation, volatile SG&A spending, etc), make it difficult to venture a prediction on what exactly net profit will look like. Suffice to say that the company is extremely unlikely to be in the black in 2019. This goes against my previous predictionfor the year, and I’ll eat crow in admitting that I did not properly assess the risk or impact of these tariffs.
