LL Flooring Holdings, Inc.
Q3 2014 Earnings Call Transcript

Published: 22 Oct 2014

[Operator:]

Good morning, ladies and gentlemen. Welcome to the Lumber Liquidators Third Quarter Earnings Call. With us today from Lumber Liquidators is Mr. Rob Lynch, President and CEO; Mr. Dan Terrell, CFO. As a reminder, ladies and gentlemen, this conference is being recorded and may not be reproduced in whole or in part without permission from the company. I would now like to introduce Ms. Ashleigh McDermott, Director of Financial Reporting for the company. Please go ahead.

[Ashleigh McDermott:]

Thank you. Good morning, everyone, and thank you for joining us today. Before we begin, let me take a moment to reference the Safe Harbor provisions of the United States security laws for forward-looking statements. This conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements regarding the future operating financial performance of Lumber Liquidators. Such forward-looking statements are subject to significant risks and uncertainties. Although Lumber Liquidators believes that the expectations reflected in its forward-looking statements are reasonable based upon currently available information, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct. Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in Lumber Liquidators' filings with the SEC. The information contained in the call is accurate only as of the date discussed. Investors should not assume that the statements will remain operative at a later time. Lastly, Lumber Liquidators undertakes no obligation to update any information discussed in this call. Now I'm pleased to introduce Mr. Rob Lynch, President and CEO of Lumber Liquidators. Rob?

[Robert M. Lynch:]

Thank you, Ashleigh, and good morning, everyone. I'm here with Dan Terrell, our CFO, and we appreciate you joining us today for a discussion of our third quarter 2014 results, the outlook for the remainder of the year and an update on our progress in implementing our strategic initiatives. Let me begin with the third quarter which, as expected, was one of transition with the recovery from constrained inventory levels in certain key products, the kickoff of the fall flooring season, and the launch of our new Bellawood assortment. Our results for the third quarter included a net sales increase of 4.6% to $266.1 million, with a comparable store net sales decrease of 4.9%, operating margin of 9.7% and net income of $15.7 million resulting in a diluted EPS of $0.58. Overall, we were disappointed that our results were at the low end of our third quarter estimates. However, we were pleased to see the progressive improvement of operations over the course of the quarter in conjunction with recovery of inventory availability. As a result, we believe our operations are likely to continue to show improvement in the fourth quarter. We believe consumer demand for large ticket discretionary projects, such as residential flooring, was weaker in the third quarter of 2014 than it was in the prior year. While we do not expect significant improvement in general customer demand in the fourth quarter, we do believe the improvement we saw in customer traffic to our stores during the third quarter will continue through the remainder of the year. As anticipated, clearance promotions, changes in our sales mix and increased discounting at the point-of-sale reduced gross margin in the third quarter. One of the more significant items impacting our clearance promotions and, therefore, our sales mix in the third quarter was the planned relaunch of our flagship Bellawood collection. As many of you know, we have invested in new finishes to further strengthen Bellawood as an industry leader. And we have broadened the assortment with new stains and matte finishes which are unique in the industry. The new products feature a lower sheen gloss and the product they replace are being cleared from inventory. We expect that clearance to be completed by the end of the second quarter of next year and, until then, we will periodically run special promotions that we expect to drive customer traffic but yield lower than average gross margins. While these transitions place additional pressure on our gross margin, we believe this planned investment in our value proposition will further enhance Lumber Liquidators' industry-leading position for high quality, pre-finished wood flooring, what the company was founded on. We have implemented solutions for the short-term challenges impacting our business to date this year. And at the same time, we have remained focused on executing our strategic initiatives planned for 2014. These included continuing to deliver our value proposition to a broader customer base; opening 2 new distribution centers; relaunching our flagship Bellawood brand, as I just mentioned; and gaining greater control of production, ranging from expansion of our finishing capabilities to vertical integration. We believe our value proposition and competitive advantages continue to resonate with our customers. And as demand for residential remodeling improves and we progress through the long-term housing recovery, we remain confident in the outlook for the business. With that, I will now turn the call over to Dan for a detailed review of our third quarter financial results, and I will return to provide an update on our strategic initiatives and long-term outlook. Dan?

[Daniel E. Terrell:]

Thank you, Rob. Good morning, everyone. I will provide additional details on our third quarter results and our outlook for the fourth quarter of 2014. My references to percentage and basis point changes are in comparison to the third quarter of 2013, unless otherwise noted. Net sales increased $11.8 million or 4.6% to $266.1 million, with an increase in non-comparable stores of $24.2 million and a decrease in comparable stores of $12.4 million. Before I comment on comparable and non-comparable store net sales, I'd like to touch on some of the factors that influenced sales at all stores during the third quarter. We estimated an aggregate net sales shortfall in the third quarter of up to $6 million as constrained inventory in certain laminate, vinyl plank and engineered hardwood reduced our ability to convert customer demand to invoice sales. As Rob noted, however, our net sales improved throughout the quarter due to strengthening customer traffic as products previously constrained were brought back to full availability. Laminates and vinyl plank recovered in August through early September, and engineered hardwood had materially recovered by the end of the quarter. As such, we believe net sales in the fourth quarter will not be materially impacted by the availability of these products. We also believe our end-of-quarter promotion resulted in fewer invoice sales than in prior years. As many of you are aware, we traditionally run an end-of-quarter promotion designed to create customer urgency and close a greater number of sales. This year's end-of-quarter event, however, featured the Bellawood assortment, including the introduction of products with new stains and matte finishes as well as additional clearance promotions on certain products which would not be a part of our continuing assortment. Though we were encouraged the promotion drove customer interest in the new products and believe it may lead to stronger sales of Bellawood in the future, the invoice sales for the entire end-of-quarter promotion were below the net sales in the prior-year event. Finally, we believe we remain in a weak consumer demand environment for large ticket discretionary home improvement projects, including flooring. A range of complex factors influence this demand, bearing down to the local level. But overall, we believe the demand for hard surface flooring, which began weakening in the fourth quarter of 2013 remains negative in year-over-year comparisons. Turning now to our non-comparable stores, which include 42 locations opened in the 12 months ended September 30, 2014. Through the third quarter, we have opened 31 new locations, including 5 opened within the quarter. As many of you know, all of our new locations in 2013 and 2014 have featured our expanded showroom format and have a multi-year remodeling plan to provide existing stores with that showroom. We have 61 stores opened with the expanded showroom format and another 37 existing stores remodeled, either in place or through relocation within the primary trade area. Together, these 98 stores represented 28% of the 349 stores we were operating at the end of the quarter. Though an environment of weak consumer demand and reduced availability of key products impacted all stores regardless of age or showroom, we were generally pleased with the performance of the stores in the expanded showroom format and believe continued rollout of these locations will ultimately drive operating margin expansion. Net sales have been disappointing in comparable stores this year as soft demand for wood flooring reduced customer traffic and constrained inventory levels adversely impacted our ability to convert the customer traffic we did see to invoice sales. In our comparable stores, net sales decreased 4.9% in the third quarter with the number of customers invoiced down 2.6% and the average sale down 2.3%. As noted, the percentage change in comparison to the same month of the prior year improved each month during the quarter led by the improvement in the number of customers invoiced, which we believe relates to the recovery of inventory availability. Further, we saw improvement during the quarter in certain areas that had been most severely impacted by the unusually harsh winter weather, including sections of the Midwest and Northeast. Though as a group, these weather-impacted stores underperformed all other stores, we estimate the difference between the two was reduced to 280 basis points in the third quarter. Our average sale for the third quarter was $1,700, generally weakening each month during the quarter in comparison to the prior year due to the following

[Robert M. Lynch:]

Thanks, Dan. I want to reiterate that we have implemented solutions for the short-term challenges impacting our operations. I believe the company has never been stronger or better positioned to take share in our fragmented market and that neither our strong business model nor the opportunities for our long-term growth have diminished. In fact, I believe they are enhanced by our record capital investments and continued focus on executing our strategic initiatives. I can tell you with confidence that our team is energized and ready to deliver on those opportunities for long-term growth. Our operating results in 2014 may have somewhat masked successful implementation of our initiatives, but our people are focused on delivering our value proposition to a broader customer base and providing them with the best assortment of high-quality products led by our Bellawood collection. Our mill-direct sourcing model and the training and development of our flooring experts to best serve our customers represent the foundation of our value proposition. I believe that value proposition remains the best in our industry and that Lumber Liquidators, with our 2 new distribution facilities, expansion of our finishing capabilities and investment in vertical integration, have us structurally better prepared for growth than at any time in the past. We believe we have significant opportunity to grow our customer base within an available market of 74.5 million owner-occupied homes, and that we have only penetrated 1 room in less than 4% of those homes. We look to win customers and sell into these untapped rooms and homes through both store-based growth and increased traffic to our existing stores. We will continue to utilize our market optimization model in targeting annual unit growth in the range of 8% to 12%. We intend to continue to aggressively use marketing and branding to increase awareness of our value proposition within the large demographic of customers who do not consider themselves do-it-yourself or DIY. Our well-trained sales force and the increasing number of stores in retail-centric locations position us well to serve these customers. In addition, we are targeting an increase in average sale by offering the customer a more complete ticket through expansion of both our non-merchandise services, including installation, and our broad assortment of moldings and accessories highlighted within our expanded showroom format, which will soon be in 1/3 of our stores. As we further broaden our base of customers, we are planning a continued rollout of our installation services, now in 73 of our stores. With only 1 in 10 of our customers currently opting for installation services, we anticipate that this offering will grow as we gain greater control of the entire customer-facing transaction. Regarding our supply chain optimization initiatives, we continue to make progress on the consolidation of our existing East Coast distribution facilities into a single larger location. We have taken partial possession of the new facility and are able to ship product into the new distribution center. We remain on plan to begin shipping from the facility late in the fourth quarter and continue to anticipate benefits to operating margin beginning in the second half of next year. We expect our new West Coast and East Coast facilities to enhance our operating income through improved productivity and operating efficiencies. As we look towards 2015, we have a significant opportunity to grow the business, drive continuous improvement and further invest in the customer. Despite a challenging year, we have continued to implement the strategic initiatives in our long-term value proposition, which we believe will successfully position Lumber Liquidators to regain momentum and expand operating margin in the coming quarters and years. With that, operator, we are now ready for questions.

[Operator:]

[Operator Instructions] our first question comes from the line of Simon (sic) [Simeon] Gutman with Morgan Stanley.

[Simeon Ari Gutman:]

It's Simeon Gutman. First, Rob, a big picture question. We're trying to assess whether some of the gross margin problems are cyclical or structural. And based on your forecast, they certainly seem cyclical. And this -- I guess, with the risk of beating a dead horse, can you walk us through the dynamic that led to all this compression? I know you disclosed the product margin in the Q and on the call. But are your sourcing costs, did they go up during this period as well? Can you break out what the discounting was versus some of the Bellawood -- versus some of the promotions? And then I have one follow-up.

[Robert M. Lynch:]

Yes. I'll start and then Dan can kick in with some of the specifics. What I would tell you is, as we said in the past, we've not seen any -- from some of the challenges we've been faced on the constrained product side, we haven't seen any material increase in cost. And as Dan said in his script and as we laid out in the Q, what you really see here are short-term challenges that we are working through and we feel good about. The constrained products are coming back in, the Bellawood transition, that is -- the scope of that, I think, needs to be understood. That's -- we're changing out the entire Bellawood collection, and we've enhanced it and expanded it in every single item even though it's continuing on in the assortment. It has a new finish on it, like we said, which is lower gloss, so we have to clear out that old inventory. This is great product, not inventory that we have to slash and burn, but that we have structured plans to sell through as we talk about it into next year. So I would tell you that with the constraint coming back in, with the traffic pick up in the stores, the confidence level of the field in terms of them having the products now that they need to sell, the constrained product has a kind of a compounding effect when you're out of the potentially high ASP, high-margin item and that the store doesn't have that for the customer and they have to trade that customer off to somebody else. There's 3 scenarios, you either lose the sale, or you trade them off to something else, and what typically happens is that other item has a significantly lower gross margin and ASP. And that's part of the issues here. The other thing is on the customer service side. Our stores did more ad hoc discounting and appropriately so because, again, to take care of the customer, we want to capture that sale. So we would absolutely allow the stores to discount, to entice a customer to wait for the constrained item that's going to be coming in down the road, if it's going to be coming in soon enough and/or to trade to something else. Dan, you got anything you might add?

[Daniel E. Terrell:]

Yes. I mean, I would just reiterate what Rob said on the Bellawood that that's something that's going to put pressure on margin from here on out, that we're really excited about the new assortment, but it does tend to carry a higher-average retail price point and a lower-than-average gross margin. The short-term impacts, clearing the liquidation product, clearing some of the Bellawood SKUs that aren't going to be part of the continuing assortment, certainly compressed margin over the shorter term. And as we look into 2015 and we'll talk about guidance, full guidance for 2015, on the next earnings release, but even in the prepared comments, we expect inventory levels to normalize to the continuing assortment some time in the second quarter of 2015. And we also made reference in the Q that we believe the 41% gross margin we did in aggregate for 2013 is where we will again consolidate around for future expansion of that gross margin. So we still believe the drivers are there, we believe we're working our way back to that 41% as inventory levels normalize and then we'll be able to expand that with the transportation benefits, the re-institution of discipline around ad hoc discounting and some of the other drivers we talked about in the past.

[Simeon Ari Gutman:]

Okay. So the follow-up is you took the $1.5 million reserve, and I think that cost about 60 bps. And that's largely on the Bellawood, if I not mistaken, on the old product that's being written down or discounted. What -- does that capture the, let's say, the full mark of discounting into next year? Or were you going to see additional pressure from that? And then why couldn't you have taken a bigger markdown and just throw it all into this year so that you minimize some risk going into next year?

[Daniel E. Terrell:]

I'd tell you that it's a reasonable and conservative estimate. We looked forward based on the inventory levels we had, what our plans were. Higher inventory levels of all products always want you to account for shrink, so there are some additional adjustment for that. Obsolescence for us relates more to stranded inventory levels. There are always some cost mitigation strategies that can reduce the impact of lessened job like [ph] quantity, but you should take that into consideration. And then there is the ultimate sales process, do you believe you're going to sell any of this at a lower than average cost? So we've taken a very disciplined approach, very regimented approach. And what we have in the third quarter, we think, is a reasonable and conservative. It does mean that there is some potential for future impact. It certainly will not be as great as we've seen in the third quarter. It's unlikely that 2015 will see anything like what's in the third quarter or maybe potentially in the fourth. So worst impact in the third, perhaps some impact in the fourth as we actually do our physical inventories, look at what the actual shrink comes in at and do our final year-end close. That is probably the end of the material impact, but certainly some opportunity for it to continue into first quarter of '15.

[Simeon Ari Gutman:]

Right. But to clarify, the pace of it, once -- so let's say, by the second quarter, once that inventory is all gone, then it should largely disappear.

[Daniel E. Terrell:]

Yes. Once inventory levels normalize to our continuing assortment -- and our continuing assortment has always included some percentage of liquidation product -- we'll be able to consolidate around that 41% and then start building in advance of that in the second half of the year.

[Operator:]

Our next question is from the line of Matthew Fassler with Goldman Sachs.

[Matthew J. Fassler:]

My first question relates to the discounting at the point-of-sale. It sounds like that's been happening a lot as you've worked through your supply chain issues. How do you wean yourself off of that? One of the big advancements you'd made in protecting gross margin was improving the pricing discipline. It sounds like the organization has moved in the other direction, I'm not sure if that's happened by way of directive or if it's happened sort of spontaneously, but have you tighten that up again because that was a big factor behind that -- behind the gross margin improvements that you had shown?

[Robert M. Lynch:]

Yes, we -- Matt, we have very good visibility to that. In fact, I get a report and I see it everyday by store and we actually track it by person. So to go back to my earlier -- one of the earlier questions though, it absolutely is something that we want to have available for the stores. And the fact that they were doing it was not that it was out of control, it was because of -- it was a tool for the stores to mitigate the impact from a constrained inventory perspective to take care of the customer and keep the sale. So what we saw in the ad hoc discounting was expected. It was allowed and approved by us. We have great visibility on it, and we also have -- we have a multiyear plan. We have selling training and all kind of disciplines around it. And I'm confident that it's where it needs to be. It's even realtime. This quarter, we were looking at daily, it's about where it needs to be, it's improving slightly compared to the last quarter. And I think, over time, I can confidently say that it's something that will be a contributor to margin enhancement over the next 3 to 4 years as we've gradually tightened down on it appropriately, but still leave the stores the ability to be competitive and never walk a sale.

[Matthew J. Fassler:]

Got it. And then a second question if I could, I'm trying to understand the new Bellawood product and why now and what the differences are. Obviously, this is a moment in time when your supply chain has had issues related presumably to working through some of the compliance dynamics you wanted to ring-fence earlier in the year. It seems like, in addition to the other challenges you have, you're now having to write down a substantial -- or take write-downs or markdowns on a substantial portion of your inventory to introduce this new line. So what's the thought process on that because, in the short run, certainly for several quarters, I think, longer than we initially thought given the comments on promotions through spring, it seems to be weighing on the profitability of the business?

[Robert M. Lynch:]

Matt, a great question, I appreciate that. The problem is the train had left the station. This is something that we've been working on for over 18 months, and it was part of our multiyear strategy for us as we were planning the growth of the business and the investment into the -- specifically investing into the value proposition on quality, and Bellawood being our premier brand and our statement of quality out there in the marketplace. So again, this is something that entailed 1.5 years of work, multiple months of line reviews with our finishing vendors, the development of the new technologies into the finish and in the testing, in the applying of that, so all of it, and then the planning out and the transitions of all the assortment to the new finish. And then we also expanded on top of it. So it's a very significant undertaking, absolutely. And if we had known what we were going to be walking into this year, we probably wouldn't have done it. But it was something that, in hindsight, and that I was sort of touching on in my prepared comments is, I'm extremely proud of the team on all of the major strategic initiatives that we've stuck to our strategy on this year. And I think we're going to be -- we're all going to be very pleased as we get into next year and we've got Bellawood in place because the initial acceptance by the customer is incredible. The customers are loving these -- the new finish across the board on any old floor species. And then they are loving the new expansion into these matte finishes. And so I think when you combine that with 2 new distribution centers, investing in the availability part of our value prop, you would put that on top of our best people and the training and development and the upgrading of our field organization and the flattening of that, with me being closer to it, and then the vertical integration projects and the finishing line investments, so very tough year absolutely. And a lot of initiatives along the way that have been very difficult for us to handle while dealing with these challenges. But we are dealing with them, we're getting them behind us and these initiatives are being implemented. So again, I think, as we come out of this and get our traction at the end of this year and into 2015, we are going to leverage off of all those investments, including Bellawood. So it's absolutely the right thing to do for the company.

[Operator:]

Our next question comes from the line of Peter Keith with Piper Jaffray.

[Peter J. Keith:]

I wanted to follow up on the Bellawood transition because I can't quite get my arms around the clearance-impacted gross margin. So if we just step back to early September, you had thought that the Q4 gross margin would be about 41.2%. Now it looks like maybe 80 basis points lower, and you're calling out Bellawood clearance. Why wouldn't that be something that you have had visibility on for the full year? It seems like it's something that would have been in plan [ph] months in advance.

[Robert M. Lynch:]

Yes, Peter, that's a good question. Again, not to blame everything on the constrained products, but I will tell you that one of the issues was, as we were constrained in some of our other products, our initial plan in the Bellawood transition was to clearance out and sell through a lot of that inventory in the distribution centers. But as a way to ensure the stores had everything else they could sell, we allow the teams to push out a little bit more of the old Bellawood product from the DC into the stores. So we have more of -- what we ended up having was more of that out there to sell through in clearance. And it's a little bit more difficult to clearance it out of the store depending on the volume need, the project quality levels and there is the sellout of a DC. So that is a bit of a technical, specific reason why the Bellawood is taking a little bit more of a hit on gross margins right now and why we're projecting it to also into Q4. Dan, you want to add to that?

[Daniel E. Terrell:]

Peter, let me just add to be very, very clear that when I referenced clearance in the fourth quarter, it includes Bellawood, but it's also clearing the substitute product that we brought in for the products that were constrained. Now that we're fully back in stock, we need to clear that product. Part of it will become part of our continuing liquidation inventory, but we are going to need to run some more aggressive promotions to clear that product as well. The good news is we're back in stock. There is customer acceptance of the new Bellawood. But if we were not in a as low a traffic environment as we're in, we might not have gone after either as aggressively as we plan to in the fourth quarter.

[Peter J. Keith:]

Okay. And maybe sort of a follow-up on that, Dan. With the clearance, it looks like there's 2 dynamics you are talking about. You are clearing out the old Bellawood product, you're also now clearing out some substitute product from the inventory shortage period.

[Daniel E. Terrell:]

Right.

[Peter J. Keith:]

Were one of those a bigger impact than the other? And then it sounds like Bellawood clearance is going to continue into next year. The substitute product issue, does that wrap up in Q4 and does not continue into 2015?

[Daniel E. Terrell:]

They are probably fairly close to equivalent as far as their impact on -- making up that 100 basis points in Q4. Our thought is that Bellawood is probably going to run through our April sale in the second quarter of next year. Obviously, diminishing inventory levels will reduce the impact that it will have on sales in 2015. I would love to be able to say that we'll be done with the substitute product in the fourth quarter. I believe we will from a materiality standpoint, but I do think there is some opportunity for that to go into the -- into parts of Q1.

[Operator:]

Our next question comes from the line of Matt McGinley with ISI Group.

[Matthew McGinley:]

My first question is on the pace of the comp over the quarter. How different was that comp over the course of the quarter? You ran a negative 4.9%. Where did it start? And about where did it end? And I guess, most importantly, again we tend to focus a lot on momentum as where are you at quarter to date, and is it around that 0 midpoint that you implied for the fourth quarter comp?

[Daniel E. Terrell:]

The second quarter ended with one of the worst months I have seen in a decade. In June and July was nearly as weak. It did improve quite a bit in August. And September continued to look good from a traffic perspective. We began to see the traffic improve each month during the quarter. Average sale weakened a little bit as the quarter went on as we started offering those discounts and had some clearance products in there. The end-of-quarter event, I think, September would have been stronger if we had run a campaign that created the same level of customer urgency that it did in the third quarter of last year. But instead, we chose to feature our Bellawood product assortment, which included an introduction of the product. And because of the long sales cycle, you really can't introduce that in an event and expect the customer to close it all within the same time period. So our sales were a little bit down year-over-year as we closed the quarter due to that event, but growing traffic during the quarter and slightly weakening ticket during the quarter.

[Robert M. Lynch:]

And the thing I would add is that I think that -- that was the thing that was positive to us was that the traffic continued to improve and that particularly began in September, continued to improve. And I would say, to Dan's point, the combination of the Bellawood event and still lingering impacts from constrained issues is really what didn't give us as good of a September as we would have liked. But again, still better than the prior months in the quarter, but it's promising because of the traffic. And with the constraint now, it's continuing to come in and be where it needs to be. It gives us a good feeling going forward with our guidance for Q4.

[Matthew McGinley:]

But just counting on that, the traffic looks good in October to date.

[Daniel E. Terrell:]

Yes. I mean we're pleased with what we've seen so far.

[Matthew McGinley:]

Okay. My second question is on the, I guess, the bigger picture with what happened with the gross margins over time. I think, one of the material concerns for people that don't maybe bucket out and look at the drivers of your gross margin over time is that a lot of the increase that you had over the past 3 or 4 years is largely unwound as you invest more in quality control and the thought the Asian sourcing initiatives that drove so much of the gross margin in 2012 and 2013 were largely unwound. If you could help us bucket how much of the expense or how much of gross margin over time do you think will need to be invested in -- or has been invested rather in the quality control or more U.S. production? How much of an impact will that ultimately have on the gross margin over time?

[Daniel E. Terrell:]

Matt, I'll start and let Rob maybe finish it. As I said, I think we'll be coming back to the 41% we got to in 2013, which was roughly about a 600 basis point improvement over a couple of year period against 2011 numbers. We have certainly given back a couple of 100 basis points in this quarter because of what we think are some short-term events, not really increases in the costs that we think are going to stay with us. So there is no question we've been investing in quality since 2011 and we'll continue to do both quality control and quality assurance. But we're still fairly confident that when we get through some of these short-term issues around our inventory assortment that we are going to get back to that normalized gross margin of roughly 41% and we can then start to fill on that again. So I don't think we've permanently given back any of the increase that we saw through 2013.

[Robert M. Lynch:]

And I'll add a little color to that, too. I mean, to your specific question about cost increases through the Asian sourcing. I mean, as we've said, nothing material there. And as you look at any of the price increases that we have seen, some from the domestic side, based on what's been going on here the last couple of years. But relative to over there, I want to take you back in time, if you remember, as we started these social initiatives in 2011, I think in the past, we've actually bridged some of these benefits to break it down for you which would, I think, would give you some color on that, But there was a significant amount of it created just by eliminating the middlemen and getting back to the direct relationships with the mills, so the acquisition of Sequoia. The taking out of the middlemen in -- I mean we had distributors serving the company pretty much across the board in all the Asian product, all the South American product, and even in the bamboos we were buying from over in China. So that was a significant improvement when you took out that markup from those distributors. On top of that, as we started doing the line reviews, if you recall, our first line review was in the laminate category. Dan, right? Where -- and given the fact that we had these middlemen in between, as we started doing these line reviews, we were quick to realize that there was a significant opportunity for us to get closer to market pricing with our purchases, and how we're renegotiating because that wasn't really being done through the distributors. So those discussions and negotiations and line reviews is really what added -- continued to add to the benefit in the margins, getting us competitively where we may not have been over time because it was being done by an intermediary. So -- and on top of that, as you recall -- as we got closer to these mills, we started getting other help from them in terms of sample, systems and marketing assistances. We continue to drive margin through things in, like, operations in the business here. So again, I would just give you some color and some history around where the benefits came from. And I think that, to Dan's point, I strongly believe that us getting back to a steady state of 41% and then filling off of that, getting -- shooting for a number like that next year. And then over multiple years, leveraging the investments that we put in the last couple of years, including vertical integration, including the DCs, including the pricing disciplines with the field and the benefits we think we can have there. We think that, that will create a higher foundation for us, and then we're going to build off of that over multiple years is our expectation.

[Operator:]

Our next question comes from the line of Keith Hughes with SunTrust.

[Keith B. Hughes:]

Turning back to Bellawood, is this a complete relaunch of Bellawood? Percentage of products you're taking out, putting back in?

[Robert M. Lynch:]

100%. And then we added a number of SKUs, we expanded the assortment. So -- for example, if we had a 3/4 inch Brazilian cherry Bellawood item core to our assortment before, we're still buying that same wood underneath, but the finish has completely changed. It's a completely new finish. And we've gotten rid of the old one. So we have the gloss and the look and the sheen, everything is different about the look of it, even though the material underneath is the same. So in that effort, you have to remake every single item and give it a different SKU number and put it into the assortment and then sell through and get rid of all the old. And along with that includes the moldings, the accessories, the stair treads, the grills, you name it. So that's a very big undertaking.

[Keith B. Hughes:]

And refreshing products, that's part of the business. But why such a large, just a complete turnover of the products in just a fairly short period of time? Why take some of [indiscernible]?

[Robert M. Lynch:]

Well, because it was a strategic investment in the finish itself, which is what makes up -- that creates a competitive advantage and is the true investment in the value proposition for the customer. So we took an industry-leading finish and we enhanced it significantly. So as you compare and contrast to the old one and to anything in the marketplace, it gives us a very significant advantage in the market on quality in terms of scratch-and-scuff resistance, the look -- the look of the sheen and the gloss, the ability -- how durable it is for the customer. And we put on it a 100-year warranty on top of it. So that's the reason why. It's because when you change the finish, you have to change it on everything and because it goes with the whole line.

[Keith B. Hughes:]

Okay. And on your -- you mentioned earlier the 73 stores that have installation ability now. I assume those were all stores of the future, is that correct?

[Daniel E. Terrell:]

No, no. Some of them are the old format as well. We're rolling out -- the thing about it, Keith, installation is still coming through HSS as well, our third-party business partner. So all of our stores have installation services. Those 73 are where we're doing the customer-facing part. And we're going in market-by-market to do that. So when we run into a -- or into our new market to put those services in that will do the customer-facing impact, that will have both new and older stores. And not all of them will be in the store of the future format.

[Keith B. Hughes:]

And final question on the stores of the future. Rob, you talked about pricing discipline a lot in this call. Is the pricing authority, pricing range, however you want to phrase it, is it different in the store of the future versus an existing store? Or is that a blanket-wide kind of control you put in?

[Robert M. Lynch:]

It's the same. But I will tell you, it's easier for the -- one of the benefits of the store of the future is it's easy for the stores to hold price because the customers will be less apt to walk in. When they walk into a store, an older store in an industrial area, they may have more of the feel of, "Hey, I can wheel and deal in here." So one of the benefits of the store of the future is it's in more of a typical retail-centric location and it's a professional selling environment. So the customers ask less. It's less frequent when they're asking off the bat for a discount.

[Keith B. Hughes:]

Is that communicated to the store employees because, I mean, I'd be honest with you, they're pretty quick to discount when we go into your stores.

[Robert M. Lynch:]

Absolutely, it's communicated to them on a regular basis. There's training around it and there's -- they have gross margin plans and then the specific discounting is reported and looked at daily. So we follow up on anybody that's going outside the reservation. So there are standards and procedures for them, when they can do it, it's supposed to be verifiable for competitive reasons only, typically. But we do know we have some folks that are more apt to wheel and deal depending on how long they have been with the company. So this is a discipline we're changing over time.

[Operator:]

Our next question comes from the line of Dan Binder with Jefferies.

[Daniel T. Binder:]

I just wanted to go back to the clearance process. Since you've been working on the Bellawood launch for 18 months, I'm just trying to understand how come the transition wasn't smoother in terms of taking down the old Bellawood inventory more gradually versus having this massive clearance, which is now extending over multiple quarters?

[Robert M. Lynch:]

It's -- I mean, it was -- it absolutely was planned out to go over time and to extend into next year. So it is pretty much going according to -- in terms of the timing of the transition, the bringing in of the new product and the transitioning out of the old. So that plan has been in place and we've been executing around it. Some of the complicating factors was -- were, again, back to some of the other issues we were having in the supply chain around availability and constrained products in other areas was putting a burden on the supply chain and on our resources in those areas. So that kind of bottlenecked itself and created some of the issues. Again, just managing a big change like this on top of these -- as these constrain things came in, it kind of all snowballed and created a lot of short-term challenges for us that we had to work through. And the good news is that we've got our arms around them now. I'm going back to just some of the earlier discussions where we've seen traffic picking up, these constrained items are in stock, the Bellawood items are -- the new Bellawood items are all available and in the warehouse and they are not constrained, the customers appealing to it very nicely. And I think that as we move forward, we're going to see these challenges get behind us and -- in our guidance is we've thoughtfully put markdowns in there, as Dan talked about, for some of the substitute products and for the Bellawood.

[Daniel T. Binder:]

So if the clearance is, more or less, on track from a timing perspective, it still sounds like the magnitude of the margin hit is greater than expected. Is that simply just the function of weaker sales overall?

[Robert M. Lynch:]

I would say it's a function of weaker sales, some of the compounding issues from the constrained products. As I mentioned earlier, I don't know if everyone picked up on it, but we also -- in an effort to make more product available for the stores, we did push out more of the Bellawood that we would typically sell out of the warehouse. So some of that got trapped and it's -- takes a little bit more of a discount to get it out of the stores. So that is something that we didn't contemplate. But again, we did that in response to some of the constrained products and opening up some of the ordering, so that the stores can have availability of -- have enough availability of other products so they can -- as they were trying to shift customers to other items, they had that with them in the stores so they could satisfy a customer that might have been there for something else.

[Daniel T. Binder:]

And just from a compliance standpoint, you recently appointed a new compliance officer. Just curious, are all vendors -- one, are all vendors now compliant? Number two, has the new compliance officer found any issues with the processes or anticipate other changes?

[Robert M. Lynch:]

Yes, he's been here since, I believe, February. So we've recently promoted him to a larger role, it's the change that we made. And then we've been building out his team as an overall investment in quality and assurance and compliance. So -- and those teams are in place, they're helping us continue -- just like everything we've done over the last several years, we've had a philosophy in the company of continuous improvement. So we absolutely feel that, as we said before, that our controls and our compliance efforts were absolutely appropriate and where they needed to be. But with the addition of the team, these new resources, we are -- we have them looking and investing and helping us raise the bar and getting better -- raising the standard, which I think we, our side, feel good about as we go forward. Again, we see it as an investment in the long-term value proposition of the company, just like the distribution centers. In fact, some of the investments we're making relative to vertical integration, in the distribution centers, in the new finishing lines are going to give us the ability from a compliance perspective to control more our products and to give us the flexibility and the redundancy so that if we think -- say, we run into an issue down the road with a particular vendor or what have you, we have the capacity to take that in-house and not running to another constraint -- other future constraint issues like we've seen recently. So we're excited about that. That -- those operations, as they get up and running, it's really one big integrated project that access DC, frees up space here, lets us put these new finishing lines in and then the vertical integration initiative, where we actually are going to be buying raw material, drying it and cutting and profiling it to feed into our finishing line, really gives us -- I mean I see that as an investment in compliance and sustainability as a company. So all part of that effort in terms of bringing him in.

[Operator:]

Our next question is from the line of Laura Champine with Canaccord.

[Laura A. Champine:]

Could you comment, Rob, on whether or not you think you've gained or lost market share in the quarter and what the competitive dynamic is like today?

[Robert M. Lynch:]

I would tell you that I think the overall market was down. And that, we, most likely, maintained share and didn't gain share as we typically would because of the issues and challenges that we were facing. I think it handicapped us from our ability to typically, with our value prop and our people and our marketing, advertising and all and our strategies, that we were not taking share because we didn't -- we weren't -- we didn't have all of the systems firing within the assortment.

[Laura A. Champine:]

And then for Dan, could you break the inventory growth year-on-year into buckets and, call it, excess inventory from the Bellawood transition, excess inventory from sales missing goals and so forth?

[Daniel E. Terrell:]

Yes, Laura, there's no question it's higher than we anticipated it being, and it is going to take us probably end of the spring to normalize that level. And we try to put it in a key where we thought the normalization would be. I think it's may be as low as 650, 660, and as high as 690. So you might be talking about $30,000 per store from here that we need to work off, $30,000 to $40,000 per store. And you can think of that as including the clearance product for substitution as well as some of the older Bellawood. We do hope to get rid of the lion's share of it in Q4, certainly of the substitute product. The Bellawood transition is going to continue on into the spring, run through the April sale. Certainly, it will not impact gross margin to the degree it has, but may have some small impact in the first quarter.

[Operator:]

Our final question comes from the line of David MacGregor with Longbow Research.

[David S. MacGregor:]

Not to beat the discounting issue to death here, but can you just remind us how the RSAs' compensation is tied to discounting?

[Robert M. Lynch:]

Are you talking about the store manager?

[David S. MacGregor:]

The retail sales associate and the manager for that matter as well. You said you've got a report showing by person, so...

[Robert M. Lynch:]

Yes. Their compensation is based on their sales plans and then they have gross margin budgets and plans that they are held accountable to, but it does not drive their commission. But it does -- for the regional managers, they're boss. So what we do there is we keep the stores' focus on the top line with -- again, within their overall budget, which obviously dictates their overall performance level and their performance ratings and their annual increases and how they're doing. So obviously, you can be -- you're not compensated on your discounting, but you can be terminated for it if you get too much out of line. And then on top of that, the regional managers have a material part of their bonus structure tied to the gross margin and, therefore, the discounting levels within their stores.

[David S. MacGregor:]

And I guess, second question, just on installation deliveries. To what extent is this impacting your fourth quarter margin expectations? And then is this just purely a cost avoidance benefit versus what you do with HSS? Or are there noticeable improvements in those 73 stores on close rates and comp growth, so on and so forth?

[Daniel E. Terrell:]

It is going to be a factor not only in the fourth quarter, but as we look forward. And just to really quickly back up, delivery we have about -- as that increases, we only have a slight markup to the customers, so that may have a gross margin as low as 10% on that, really just to try and cover the administration of the program. Installation may be in the mid-30s as far as the gross margin, so that it is less than the average. That will put some pressure as that program expands. We do believe there's overall benefit to the program as far as attachment rate and our ability to interact with the customer from the beginning of the transaction to the end. It doesn't mean, though, that the experience is not good with HSS. It certainly is. We just believe that our investing ourselves in the customer-facing part of the transaction will increase the attachment rate over time.

[Robert M. Lynch:]

Thank you for joining us on today's call. As we look forward, our team is more committed than ever to drive the growth that we believe is achievable long-term for Lumber Liquidators. We look forward to speaking with you on our year-end earnings call when we expect to provide our initial outlook for 2015, including outlining our store opening plans and reviewing continued progress in executing our strategic initiatives to achieve our long-term objectives.

[Operator:]

This concludes today's teleconference. You may disconnect your lines now. Thank you for your participation.