LL Flooring Holdings, Inc.
Q2 2015 Earnings Call Transcript

Published: 5 Aug 2015

[Operator:]

Good morning, ladies and gentlemen. Welcome to Lumber Liquidators Second Quarter Earnings Call. With us today from Lumber Liquidators is Mr. Tom Sullivan, CEO; and Mr. Greg Whirley, CFO; and Mr. John Presley, Chairman of the board. As a reminder, ladies and gentlemen, this conference is being recorded and may not be reproduced in whole or in part without the permission from the company. I would now like to introduce Ms. Ashleigh McDermott, Vice President, Investor Relations and Financial Reporting for the company. Please go ahead.

[Ashleigh McDermott:]

Thank you, operator. 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 that are subject to significant risks and uncertainties, including the future operating financial performance of Lumber Liquidators. Although Lumber Liquidators believes that the expectations reflected in its forward-looking statements are reasonable, 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. Tom Sullivan, CEO of Lumber Liquidators. Tom, please go ahead.

[Thomas David Sullivan:]

Thank you, Ashleigh. Good morning, everyone. Thank you all for joining us for the Lumber Liquidators' second quarter 2015 earnings call. You will be hearing a couple of new voices today. So, let me speak to that right up front. I'm Tom Sullivan. I founded this company over 20 years ago, and with the help of some great people, we grew it into a strong, respected business. My original idea was pretty simple. Good wood at the best prices with great customer service. Customers appreciated our commitment to these basic principles. And over the years, we've built the reputation as a trustworthy and dependable source for wood flooring deals. When our board of directors asked me to come back and help right the ship, I was very excited. The Lumber Liquidators brand is still strong and I believe we have a bright future ahead. The key in my mind to righting the ship is to get back to basics. The simple things that took us from the back of a trucking yard outside of Boston to now more than 365 locations in North America with millions of satisfied customers. The team here gets it; back to basics, keep it simple, be as efficient as possible, do what we do best, good wood at good prices. That's how we're going to get our company back on track. You're going to hear two additional voices today, so let me introduce them to you now. First, our CFO, Greg Whirley. Greg has a strong financial skill set and a deep knowledge of our business. More importantly, he shares our passion for getting this great company back on track and is fully committed to helping us get there. Second, the Chairman of our board, John Presley. John has been on our board for nine years, and has been instrumental in helping us deal with some major challenges in our business, particularly over the last several months. I invited John to join us today, so that you can hear directly from him regarding how we are handling some of these challenges. So, before we get to this quarter's results, let me ask John to share some of the board's current work with you. John?

[John M. Presley:]

Thank you, Tom, and thank you all for joining us. I'm honored to be here and appreciate Tom's invitation. When we asked Tom to rejoin the company as acting CEO, we strategized at length about how to get Lumber Liquidators back on track. One of our key goals was to make sure senior management could focus on the business without the distractions of the non-operational issues we have faced in recent months. As a result, the board has taken a more active role in managing some of those non-operational issues until we get them resolved. Before I speak to a couple of these matters, I'd like to say, first, we're excited about Tom's return as fresh inspiration for our entire organization while we actively look for a permanent CEO. That process is moving forward rapidly, and we are committed to finding the right candidate to build on the inspiration Tom has brought and to help take us to the next level. Turning to the non-operational matters the board is taking up active role in, through an independent Special Committee, we are working with the Department of Justice to resolve legacy issues related to the Lacey Act, which deals with the importation of certain of our products. The Committee is also working with the Department of Justice and the Securities and Exchange Commission to resolve the corresponding issues that are discussed in our Form 10-Q. As we've previously disclosed, the Committee hired the highly regarded Freeh Group to help us assess and improve our compliance function and to act as an independent compliance advisor. We're already seeing positive results from the help they have given us. Next, the Committee has taken an active role in how we respond to product quality issues raised earlier this year. That includes overseeing and, in some cases, assisting with the interactions with the Consumer Product Safety Commission, the California Air Resources Board, and the EPA. We are eager to continue our constructive conversations with these agencies. As you know from our May announcement, we took Chinese-source laminates off our shelves and we continue to evaluate these products. Tom built this business with the customer at the center. And if there are customer concerns, they become our concerns. While ensuring these products comply with applicable legal requirements is imperative, our customers' confidence in these products is what counts the most. To that end, we implemented our customer in-home air testing program. For those customers with elevated levels of formaldehyde in the air, we are offering additional in-home testing in an attempt to identify the source of the problem. If the testing determines that our product is a material contributor to the formaldehyde levels in a customer's home, we will work with the customer on a solution. In all of these areas, we are committed to doing the right thing. On behalf of our board and the whole Lumber Liquidators team, thank you for your continued support. Now, let me turn the call over to Tom to talk about the business. Tom?

[Thomas David Sullivan:]

Thank you, John. Let's turn to the second quarter. Clearly, Q2 financial results reflect the impact of the recent disruptions in the business. Revenues for Q2 were down 5.8% versus Q2 last year to roughly $248 million. As one might have expected, our sales continue to be impacted by the recent press as well as lower laminate sales. However, we have implemented an aggressive promotional strategy designed to get customers into the store, and we believe this will offset some of the decline. Gross margins moved from approximately 40% in the quarter a year ago to approximately 25% in the second quarter this year. This was impacted by a number of factors including significant promotional pricing, change in our sales mix, our customer air quality testing program, a ruling on antidumping duty rates, and cost incurred while we simplify our business. Our SG&A expenses also increased by about $11.5 million quarter-over-quarter to $90.6 million. Part of this increase was driven by legal and professional fees related to the issues we have been dealing with over the last five months, including an item identified as part of our internal compliance review procedures as well as an increase in payroll and certain expenses recorded as part of our strategy to get back to basics. As a result, we reported a net loss of $20.3 million this quarter versus a net income of $16.6 million a year ago quarter. Amidst all these issues over the last few months, I've been encouraged to see that our customers and employees have stood with us and supported us. We have a great product and a great business. We have a smart, motivated team, intent on getting the business back on course. I'll come back in a minute to talk to you about our plans for the rest of the year, but, first, let me introduce you to our CFO, Greg Whirley, to walk you through the numbers in more detail.

[Gregory A. Whirley:]

Thank you, Tom, and good morning, everyone. I will provide details on our results for the second quarter of 2015. My references to percentage and basis point changes are in comparison to the second quarter of 2014 unless otherwise noted. Net sales were $247.9 million, a decrease of $15.1 million or 5.8% over the second quarter of 2014. Non-comparable stores increased $11.1 million, and comparable stores decreased $26.2 million in comparison to the second quarter of 2014. We believe net sales in the second quarter of 2015 continue to be negatively impacted by unfavorable allegations surrounding the product quality of our laminates sourced from China. The allegations were part of a 60 Minutes episode that aired on March 1, 2015. Within our comparable stores, net sales in the second quarter decreased 10% due to a 2.4% decrease in the average sale and a 7.6% decrease in the number of customers invoiced. We implemented aggressive promotional pricing during the quarter which we believe partially offset these adverse impacts. The promotional pricing reduced our average selling price, but we believe this led to greater units sold per customer invoiced. In addition to overall lower consumer demand, net sales in the second quarter of 2015 were also negatively impacted by the suspension of sales of all laminate flooring sourced from China which we announced on May 7. A mix of total laminate sales in the second quarter of 2015 has decreased in comparison to both the first quarter of 2015 and the prior-year period. Total laminate net sales were 13.6% of net sales in the second quarter of 2015, compared to 18.3% in the second quarter of 2014. Laminates sourced from China were 4% of total second quarter 2015 net sales, compared to 12.2% for the second quarter of 2014. Turning to our non-comparable stores. Net sales benefited from continuing store-based expansion. We opened seven new stores in the second quarter of the current year and 13 stores in the second quarter of the prior year. We remain pleased with the results of our new store openings and believe their success shows the continued strength of our store model. We are also pleased with the results from stores operating in our expanded showroom format. And we have now opened 75 new locations in that format since the beginning of 2013 and remodeled 49 existing locations, including one in the second quarter of 2015. The 124 stores with the expanded showroom format represent approximately one-third of our store base at the end of June. I'd like to note that due to a variety of factors, including customer behavior and competitive forces, determination of the impact of the 60 Minutes episode in the suspension of the sales of all laminate floorings sourced from China on our net sales was impracticable. I'd now like to turn to gross margin, which was 25.1% in the second quarter. And we'll touch on each of the categories in which we have historically segregated drivers of our gross margin, product, transportation, and other. Product primarily represents the cost to acquire or produce products. Our retail sales price of those products as well as the mix of products sold. Overall product margin was down 990 basis points. Our average retail price per unit sold for the second quarter of 2015 was 6.3% lower than the comparable period in 2014. In late 2014, we implemented certain planned reductions in our retail prices to drive customer traffic. During the second quarter of 2015, we utilized promotional pricing on top of those 2014 price reductions to further drive traffic and reduce our inventory levels. We believe the promotional pricing offered to our customers was the right decision as it maintains consumer awareness of our value proposition, brings customers into our stores, and furthered our efforts to rationalize our product offerings. We believe consumer shifted away from laminate and bamboo flooring due to constrained levels of laminate and consumer concerns over the quality of product sourced from China. Reductions in the sales mix of these products were picked up primarily by hardwoods. Hardwood products generally have higher retail price point but lower than average gross margins. In addition, a lot of these products had lower than historical retail prices during the quarter. In July 2015, the Department of Commerce issued the results of their second annual review of the antidumping duty rate pertaining to multi-layered wood flooring from China. I encourage you to read the complete disclosure included within our 10-Q filed this morning. The Department of Commerce finalized the antidumping duty rate at 13.74%. As a result, we recorded a loss of approximately $4.9 million or 200 basis points on purchases through November 2013, the end of the period included in the second annual review. We have not considered any change to the duty rates for periods after November 2013. However, we began paying duties at this rate beginning in July 2015. The preliminary ruling on the third review is expected in September 2015. Partially offsetting these gross margin pressures was an increase in the sales mix of moldings and accessories which we believe drove approximately 70 basis points of gross margin improvement. Transportation cost in total did not significantly impact gross margin as generally lower domestic transportation rates and operational efficiencies were offset by weaker-than-expected net sales. All other costs adversely impacted gross margin by 540 basis points, driven primarily by four factors. First, we incurred approximately $4.9 million of costs or 200 basis points related to our indoor air quality testing program and subsequent follow-up with customers. The administration of the test kits was $3 million in the quarter or 120 basis points and we increased our reserve by $1.9 million or 80 basis points for costs related to additional testing of flooring samples. Second, we had two significant charges related to inventory values that reduced gross margin by approximately 200 basis points. $3.7 million recorded as a lower cost to market adjustment for tile flooring and related accessories due to our decision not to pursue an expansion into the tile flooring business in the near-term, and an increase of $1.1 million for reserves for inventory loss or obsolescence primarily related to moldings. Third, as a part of our strategy to get back to basics, we decided to discontinue certain of our vertical integration initiatives and terminated our prior arrangement. This impacted gross margin by $1.5 million or 59 basis points. Finally, during the second quarter, we recorded an impairment charge of approximately $300,000 related to our laminate flooring sourced from China, primarily those with less than job lot quantities on hand, as we do not currently plan to pursue additional quantities of such product. At June 30, 2015, we had approximately $19.8 million in inventory of laminate flooring sourced from China. We are considering a number of factors when determining the market value of the suspended flooring, including the status of our valuation of the flooring, market conditions, and our alternatives for disposition. Should future events or key assumptions, including the potential channels for disposition of the laminate flooring sourced from China differ from current expectations, we may be required to record a material impairment charge related to this flooring. Turning to SG&A. SG&A expenses for the quarter increased approximately $11.5 million or 14.5% to $90.6 million and, as a percent of net sales, increased to 36.5% from 30.1% in the prior year. Salaries, commissions, and benefits increased $3.4 million to 13.5% as a percentage of net sales as a result of incremental costs related to store-based growth, greater commissions earned by our store management, severance for certain individuals, a one-time adjustment to a payroll accrual, and weaker-than-expected net sales. Advertising expenses decreased approximately $2 million and declined to 8.4% of net sales compared to 8.7% of net sales during the second quarter of 2014 as leverage of our national advertising campaigns over a larger store base was partially offset by greater costs to strengthen our brand messaging and broaden our reach in frequency. Occupancy costs were consistent with those in the comparable period of 2014 due to the opening of our East Coast distribution center which was fully offset by store-based expansion. Occupancy costs as percentage of net sales increased 20 basis points to 4.3% due to weaker-than-expected net sales. Depreciation increased approximately 50 basis points as a percentage of net sales due primarily to store-based expansion and our infrastructure investments including supply chain. Stock-based compensation decreased due primarily to the resignation of our Chief Executive Officer in the second quarter of 2015. All remaining SG&A expenses grew by approximately $11.3 million and, as a percentage of net sales, by approximately 480 basis points. Included in this increase were legal and professional fees of approximately $9.7 million, an increase of $6.3 million compared to the second quarter of 2014 approximately $3.2 million associated with our determination that there were Lacey Act compliance concerns regarding a portion of our engineered hardwood sourced from China. These concerns were identified as a part of our internal compliance review procedures and are not related to the safety of those products. And approximately $1.4 million in fixed asset impairment charges related to our decision not to pursue an expansion into the tile flooring business. The effective tax rate in the second quarter of 2015 was impacted primarily by a decrease in state taxes, offset by uncertainty around the deductibility of certain legal accruals and revised projected pre-tax income for the remainder of 2015. Our net loss was $20.3 million or a loss of $0.75 per diluted share, based on approximately $27.1 million weighted average diluted shares outstanding. Turning to our financial position, liquidity, and capital resources. We believe we continue to be in solid shape. Our cash and cash equivalents were $45.3 million at the end of the second quarter, compared to $20.3 million at the end of December 2014 and $48.1 million at the end of June 2014. We had $20 million outstanding on our asset-based revolving credit facility at the end of the current quarter, and we had $79 million available under this facility. Merchandise inventory was $262.7 million at the end of the current quarter, down from $314.4 million at year-end and $272.7 million at June 30, 2014. Available inventory per store was approximately $670,000 at the end of the second quarter, down from approximately $687,000 at June 30, 2014, primarily due to efforts to simplify our assortment during the quarter and changes made to the carrying value of inventory as previously discussed. Capital expenditures were approximately $14.3 million in the first six months of 2015 and included store base expansion, the remodeling of existing stores, and equipment for the distribution center and finishing operations. We are still not able to provide an outlook for the remainder of 2015 at this time due to our long purchase cycle and uncertainty regarding customer demand trends. As we enter the fall flooring season in late August, the number of months post the 60 Minutes episode increases and our laminate assortment is returned to full in-stock levels, we believe customer demand and our ability to fulfill it will strengthen. We plan to adjust our promotional pricing in response to customer demand. Additionally, net sales of engineered hardwood in the second half of 2015 may be impacted due to constrained inventory levels as a result of the suspension of purchases and sales of certain engineered hardwood products sourced from China. We believe gross margin in the second half of 2015 will be adversely impacted as compared to the second half of 2014 as we continue to invest in our value proposition to drive customer traffic primarily through pricing, increase our sales of laminates sourced outside of China, and modify our assortment of engineered hardwoods to those not subject to antidumping duties. Additionally, we believe gross margin and sales mix trends will continue to be adversely impacted until our full assortment of laminates and engineered hardwood are available. During the second quarter of 2015, we focused on the reduction of our inventory levels and began to rationalize our product assortment which included focusing on our best-selling products and limiting redundant styles or low-performing SKUs. While we are happy with our sell-through of clearance product to date, we expect to continue to simplify our product assortment which may result in an increase in clearance product. As we sell through clearance product, our average selling price could be reduced and our gross margin adversely impacted. With respect to SG&A expenses in the second half of 2015, we expect an increase in payroll as we implement initiatives to retain and motivate our employees, and we expect legal and professional fees to remain elevated while the various legal proceedings and regulatory investigations continue. Looking at the second half of 2015, we plan to open 9 to 14 new stores and remodel up to five more existing stores, either in place or through relocation within the primary trade area. In addition, we are continuing the rollout of installation services where we now expect to provide services to a total of 180 stores by year-end. We now expect capital expenditures between $20 million and $25 million for the year ended December 2015. I'll now turn the call back over to Tom for his closing remarks.

[Thomas David Sullivan:]

Thank you, Greg. As we close the books on the second quarter, I would like to reiterate that our results are not reflective of where we want to be. But make no mistake, this recovery will take some time. We will not restore the customer trust overnight, but we can do the right things to make that happen over time. Here is the vision I've laid out for our team. It's simple. First, get back to basics. Second, take care of our customer. Third, fortify operational excellence. Let me take a minute to talk about these three points. We went from zero stores to more than 360 stores and $1 billion in revenue by doing some very basic things. We bought quality wood at a low cost. We passed these savings on to the customer. We gave them great advice and service at the local store level. This is not complicated. It worked. That's what I mean by charging us to get back to basics. We are going to refigure the SKU count, reduce sale inventory, duplicated looks, discontinued products. At the same time, we will add popular North American and European laminates to the mix and increase our assortment of engineered and bamboo Bellawood. This will simplify our showroom, making a better shopping experience for the customer. As we put some unnecessary SKUs on sale, this will help bring customers into our stores and spread the word on the great deals we have at Lumber Liquidators. We will concentrate on doing what we do best, buying and selling wood flooring. We will be phasing out our tile flooring and discontinue our vertical integration initiatives. We will look at each aspect of the business and make sure we are operating the most efficient and best way possible. The second part of the vision is to take care of the customer. There's no doubt about it, we've taken a hit. It hasn't been as big a hit as some had feared because we have built a good reputation over the last 20 years. But, nevertheless, it is something we're taking very seriously. Our people in the stores are the best at what they do. And as our customers interact with them, the relationship builds and improves. We have empowered our store managers to do what's best in their local markets real time. The stores know the customer best and they know their local markets the best. When the customer sees that all the shots don't get called from headquarters and the local store is listening, we'll build relationships and trust. We're also continuing our remodeling program making the stores more accessible to the average retail consumer. We're continuing to open stores around the country. The third part of the vision is to fortify operational excellence. There are opportunities for us to improve execution throughout the organization. For example, we hired the Freeh Group to review our compliance procedures. We are bringing in fresh perspectives on the management team. We're reviewing and improving strategic planning process. We are concentrating on hiring and retaining great employees both in management and at the local level. And as John mentioned, we're using the board and outside expertise to not only help address the current issues, but to put in place best practices in every department across the organization. In summary, we can make Lumber Liquidators what it's known for

[Operator:]

Thank you. One moment please while we poll for questions. Thank you. Our first question is from the line of Dan Binder with Jefferies. Please proceed with your question.

[Daniel Thomas Binder:]

Thank you. You talked about a lot of items that were impacting the gross margin and SG&A this quarter. As we think about the back half of the year, I realized some of those items are difficult to predict. But can you give us a little bit of color on the percentage of inventory that you envision being on clearance, the percentage of inventory that has odd lots or discontinued items and the anticipated discounts on that product to clear it?

[Thomas David Sullivan:]

Dan, this is Tom. We don't have an exact number, but there are a lot of small lots, a lot of duplicated colors and SKUs that we don't really need. So, we're slimming that down to, one, it will make the stores easier for the customer. It'd be – we'll still have the widest variety of flooring available, but it'll make it simpler in the stores and also clear up our inventory over time. And this will happen over the – till the end of the year.

[Daniel Thomas Binder:]

And just as a follow up, I think in prior calls you've talked about – or prior management had talked about how sample requests were a pretty good leading indicator. I was wondering if you could comment on sample requests year-over-year, how that's looking as potentially an indicator of future business?

[Gregory A. Whirley:]

This is Greg. As we've mentioned, right now, because of the many different things that we're dealing with, it's difficult for us to comment on some of those indicators. We are, at this point, focused on driving sales through the promotional pricing that we've discussed.

[Thomas David Sullivan:]

Dan, this is Tom again. I can tell you that the benefit of having these things on sale and at the stores, it gets people excited, it gets the stores excited. When a customer comes in and sees these great deals, they like it, they buy it. They tell their neighbors, friends, and it gets people coming into the store. So overall, it's helping a lot.

[Daniel Thomas Binder:]

Okay. Thanks.

[Operator:]

Our next question is from the line of Simeon Gutman with Morgan Stanley. Please go ahead with your question.

[Simeon A. Gutman:]

Thanks. So Tom, I guess one question, I'll put it in two parts. First, you've been in this industry for a long time. So you have a sense of product cost and margin on good quality product. If you take out the Chinese laminate and if you look at this business, maybe pre some of the discounting, assuming that, over time, the discount rate will come down, what is a reasonable estimate of sustainable gross margin? That's part one. And then the second question on the Lacey Act, the charge you took on the engineered hardwood. The question is, the last year the business has had a pretty significant amount of scrutiny. And I guess I'm a little surprised it took till the second quarter to uncover something additional related to the Lacey Act. I realize it's limited what you can say on it, but can you share if there's a difference of opinion? Or is there just a higher level of scrutiny happening now recently in the second quarter? Any comments on that would be helpful.

[Thomas David Sullivan:]

John and Greg can answer the other parts better. But I could tell you, what I'm focusing on is getting the stores back to what they should be, focusing on selling wood, getting rid of tile, concentrating on our main business. So, our business is strong, customers are coming in, and customers like Lumber Liquidators. We have a strong business, the stores are excited, and to just get back to selling wood. Long-term – the margins and all of that, Greg will handle and answer you better on that.

[Gregory A. Whirley:]

Yeah. This is Greg. And we understand the importance of gross margin, and we're focused on that going forward. Look, right now, as Tom mentioned, our primary focus is on simplifying the business and working with our customers. To that end, gross margin for the quarter outside of the special stuff that you mentioned was largely impacted by the promotional pricing and our efforts to drive traffic into the stores. As we stated, we're unable to tell you the impact of the broadcast and the suspension of the Chinese laminates on our operations, but we believe that the shift from laminates and bamboo was picked up by hardwoods which compressed our margin. As we move forward, we'd expect some of this promotional pricing to continue likely through the end of the year. Additionally, as we simplify our product offerings, we may have an increase, an additional increase in clearance product which could also impact gross margin. We may also experience gross margin pressure until we get our laminates back to full stock. The second part of your question, we can't discuss, as you mentioned, specifics of the $3.2 million that we recorded this quarter related to the engineered products, the engineered hardwoods. What we can say is that, under Tom's direction, we are focused on executing. And this is a product. This is something that we identified through our compliance procedures and working with the DOJ, shared it – Department of Justice shared it with them. We're not aware of other things that we haven't accrued at this point. But this was the right period in which to do it.

[Simeon A. Gutman:]

Thank you.

[Gregory A. Whirley:]

Thank you.

[Operator:]

Thank you. Our next question is from the line of Laura Champine with Cantor Fitzgerald. Please go ahead with your question.

[Laura Champine:]

Good morning. So, I noticed in the 10-Q that traffic was still down between 7% and 8%, or at least the number of transactions. How do you get visibility into whether your efforts are working to drive more people into the store? Meaning, did that traffic improved as you move through the quarter? What are you seeing so far in this quarter?

[Thomas David Sullivan:]

This is Tom. I see the stores are very excited. The customers are excited. The business is getting stronger. We're not looking in the past. We're looking to the future. And the way I grew this business from the back of a trucking warehouse outside of Boston was by giving customers a great deal on good flooring and great customer service. And that's what we're getting back to, and that's what's driving the business in the future.

[Laura Champine:]

Got it. Thank you.

[Operator:]

Our next question is from the line of Seth Basham with Wedbush. Please go ahead with your question.

[Seth M. Basham:]

Thank you and good morning. My first question is for you, John. If you could give us some perspective on when we'll have some more color on the CEO and CFO jobs, and whether or not they'll be named permanent at some point in the near future.

[John M. Presley:]

Yes. I can. Again, this is John. We are conducting a national search for a CEO. We're being very thoughtful about it as we are intent on finding the right person for this job. We're looking both through a search firm, through internal contacts that we know, and then we've been approached by a number of other outside candidates. Frankly, Greg has been doing a great job, and we have been focused primarily on the CEO search at this point. That's been the area where we've been focused the most.

[Seth M. Basham:]

Okay. That's helpful. And then, another question around timelines. A number of outstanding investigations and lawsuits, any perspective from your part as to when we'll hear more finalized verdicts from the CSPC (sic) [CPSC] or from CARB?

[John M. Presley:]

All I can tell you is we are continuing to cooperate with all the investigations both CARB and the Department of Justice and the CPSC providing them information as requested. And at this point, we really don't have a good feel for that timeline.

[Seth M. Basham:]

Okay. Last question, if I may. Just regarding the air quality tests, you haven't taken any charges for a Phase III as you're calling it. But have you served any of your customers in this regard in terms of compensating them or replacing their flooring? What's the average cost to do so and what's your projection on how many people that you might have to do that for?

[Gregory A. Whirley:]

This is Greg. I appreciate the question. We've established that indoor air quality testing program to provide customers with information about the air quality in their homes and provided over 41,000 test kits to customers and received back over 22,000. As we indicated, over 90% of the test kits had indoor air quality levels that were within World Health Organization guidelines. And we've given you that table, which it sounds like you've seen in our MD&A section. I can tell you that as we stand today, we've recorded our best estimate of each of the phases in our financial statements.

[Seth M. Basham:]

Okay. Thank you.

[Operator:]

Our next question is from the line of Matt Fassler with Goldman Sachs. Please go ahead with your question.

[Matthew Jeremy Fassler:]

Thanks a lot. Good morning. My first question relates to gross margin. So, if you back out a lot of the one-time items, really all the one-time items that you called out for write-downs and such, it looks like you get to a run rate of around 31%, which I think is lower than the prior management team had indicated they were tracking at the time of the last communication. So, can you talk about how the cadence of the promotional activity perhaps changed over the course of the quarter and how the mix may have changed also over the course of the quarter, presumably laminates continued to fall? And whether you think the right run rate to understand – kind of ongoing run rate exiting the quarter was – if 31% kind of a good level? Is it materially lower than that, if you think about how the quarter played out from start to finish?

[Gregory A. Whirley:]

Thank you. This is Greg, again. Good question. We're obviously focused on that gross margin. And as I mentioned before, there were a number of things impacting our results. We saw a shift from laminate products, which, as you know, generally carry a higher margin compared to what we saw the shift to go to, which is our hardwood products which generally carry a lower margin. Again, as we get back to being full in-stock with laminates and move past some the engineered constraint issues that we've had in the short term, we expect things to improve. So, I wouldn't view the results from this quarter as where we expect to be.

[Thomas David Sullivan:]

And, Matt, this is Tom. The stores have been instructed to take care of the customer, number one. This is not the gross margin we want to be at. But the most important thing right now is taking care of our customers, getting them satisfied, and in the long run, it'll be a much stronger business by doing that.

[Matthew Jeremy Fassler:]

Great. I'll bunch my follow-ups together for the sake of time, but I want to squeeze them both in. The first real issue is just explaining what you walked away from in terms of vertical integration, it sounds like you made a change there. And the second follow-up, you continue to open stores, it's a moment I would imagine of diminished visibility for the business. I'm sure you had some pipeline that you had to finish up. But what's your perspective on if you had – are you looking for new sites or are you making commitments for 2016? Or is that expansion program for the moment on hold?

[Thomas David Sullivan:]

Matt, this is Tom again. We're very strong financially. We spend our money wisely. Every day, I get e-mails from customers saying will you open a store in our area. So, we will open stores as we see fit.

[Gregory A. Whirley:]

This is Greg. I think Tom hit on it. With respect to our liquidity, we've got the liquidity to weather the risks that we see today. And we've got over $45 million in cash and a revolving credit facility with $79 million available. Our balance sheet remains strong. And we reduced our CapEx in some areas. But our store model and opening stores really is the strength of our company. And I think our continued investment in our stores shows our belief in the company and where we're headed.

[Matthew Jeremy Fassler:]

So you're actually signing new leases now?

[Gregory A. Whirley:]

We're continuing our store growth.

[Matthew Jeremy Fassler:]

Okay. Thank you.

[Operator:]

Our next question comes from the line of David MacGregor with Longbow Research. Please go ahead with your question. Mr. MacGregor, your line is live for the questions.

[David S. MacGregor:]

Yeah. Hi. Good morning. Just a question on the promotional activity and the impact it's having on average pricing. I guess, I appreciate the clearance activity that's underway right now. It's all part of the getting back to basics strategy. It sounds as though you've delegated a lot of pricing authority down to the store level and I'm just wondering how you come out of this from a pricing discipline standpoint. Are you confident that as the clearances conclude that you're going to be able to reestablish sort of a price discipline culture there? Could you talk about that, please?

[Thomas David Sullivan:]

Yeah. This is Tom. The stores have been given the authority to take care of the customer. That's our number one concern. We need to get – if we need to take care of a customer, that's what we do.

[Gregory A. Whirley:]

This is Greg. I'll follow up on that. As Tom mentioned, we have given some authority to the stores to take some discounts if necessary to complete sales. However, pricing is still being determined by the corporate office and follows the overall strategy of the company. We have been more promotional in the current period but we are monitoring the discounts that are being taken at the point of sale. And right now, we think that what's being done is reasonable.

[David S. MacGregor:]

Tom, could you just talk about employee turnover? It sounds as though you've raised some incentives. It looks like an attempt to retain some people. Has there been a pattern of turnover there? Just talk about that.

[Thomas David Sullivan:]

We, from day one, have taken care of our people and the people in the stores and everyone, really, we've set up a retention plan as a bonus over the next 18 months to get us through this stuff. So, long term, we want to keep good people. And that's what's made this business great is the good people that are here and the great people in the stores.

[David S. MacGregor:]

Thank you.

[Thomas David Sullivan:]

Thank you.

[Operator:]

Our next question is coming from the line of Peter Keith, Piper Jaffray. Please go ahead with your question.

[Peter J. Keith:]

Hi. Thank you. Good morning. So, I was going to ask just two questions. I'll bunch them together into one. First off, as I'm kind of reading between the lines, you've put the Chinese laminate on hold and it sounds like you're shifting hardwood and bamboo to Bellawood, which I assume is North America. Is this an effort to get out of China entirely from a sourcing standpoint? And then secondly, and unrelated, just on your advertising message, at least what we can see, there really has been no change overall to advertising since the 60 Minutes segment ran. And I guess, as you're thinking about rebuilding trust of the customer, why haven't you pushed more of a safety message to some of your advertising to rebuild that confidence? Thank you.

[Gregory A. Whirley:]

This is Greg. You asked a number of different things. The first was our strategy with respect to sourcing in China. We source product from China today. A portion of our product is sourced from China today, and we'll continue to evaluate our sourcing needs where we get our material from. It really will boil down to what customers want. If our customers want it and we can get it following the execution strategy that Tom has set forth, we will go get it to sell it. And the second part of your question, to be honest, I can't remember.

[Thomas David Sullivan:]

Well, I can. This is Tom. As far as Bellawood that we are expanding that line somewhat is – what I feel is the Bellawood look has been – is a great brand. People know it. People respect it. But in our new stores, it's kind of been lost, and we're expanding that and displaying it better in the stores, especially the newer stores. And we will be adding to that. People want the Bellawood quality, the Bellawood warranty. So, we're expanding that. That's not getting rid of other products. It's expanding the Bellawood into other categories.

[Peter J. Keith:]

Okay. And I'm sorry if I caused confusion with two questions, but could you also talk about the advertising and why you haven't pushed a safety message with the products since the 60 Minutes segment ran?

[Thomas David Sullivan:]

Well, our job is to sell the wood, good wood at a good price. And that's what the customers want.

[Peter J. Keith:]

Okay. Thank you.

[Operator:]

Our next question comes from the line of Brad Thomas with KeyBanc Capital Markets. Please proceed with your question.

[Bradley B. Thomas:]

Thank you. Good morning. I want to ask about in-stocks and your assortments. And if you could maybe just give us a little more quantification perhaps of today how much you do not have at the availability level that the customer really warrants.

[Thomas David Sullivan:]

This is Tom. I mean, my goal and our goal is to eliminate unnecessary SKUs, clear out some stuff that's duplicated and so forth, and to make the shopping experience better for the customer and better for our inventory control and all that. And we will have in-stock on everything we need is our plan. And as we get rid of SKUs, that will be a lot easier.

[Gregory A. Whirley:]

And I would add to what Tom said. This is Greg. To clarify, these are not products simply that customers don't want, these are products that can look good, but based on a company decision, we've decided to rationalize our SKU count. So, these are good products that we expect to be able to sell.

[Thomas David Sullivan:]

Yeah. These are not bad products, not bad quality, nothing wrong with them there. And in some cases, we have six or seven SKUs that all look very similar, and it's confusing for the customer and unnecessary. So, we're getting the store back to be as efficient as possible with all the products that are needed without duplication and without confusion.

[Bradley B. Thomas:]

And just to follow up on that, inventory has been a nice source of cash for you all thus far this year. Greg, could you give us a sense of maybe what the opportunity is on working capital going forward?

[Gregory A. Whirley:]

Again, I think I mentioned a little bit before, we have the liquidity that we need. We've got cash as well as availability under our revolver. The promotional pricing that we've set out is working. So, we're continuing to drive and reduce inventory levels. Our balance sheet is strong, and we have a significant amount of owned assets including our East Coast distribution center available to us if that need were to arise. And again, we've reduced our CapEx, but we're still investing in our store model.

[Bradley B. Thomas:]

Thank you.

[Operator:]

Our next question is from the line of Keith Hughes of SunTrust Robinson. Please go ahead with your questions.

[Keith Hughes:]

Thank you. My question is on the engineered wood. Two parts. One, what was the same-store sale number on engineered wood in the quarter? And number two, you talked about new sources to avoid the CVD and AD duties. Would those be different sources in China or would you look to other countries to avoid that.

[Gregory A. Whirley:]

This is Greg. With respect to sourcing of those products, we will look at all options, whether that'd be sources in China that don't carry the same anti-duty rates as well as here in the U.S. and other sources.

[Keith Hughes:]

And the same-store sale number on the engineered wood in the quarter?

[Gregory A. Whirley:]

We aren't providing that level of detail. I appreciate the question, though.

[Keith Hughes:]

Okay. Thank you.

[Operator:]

Our next question is from the line of Budd Bugatch with Raymond James. Please go ahead with your questions.

[Beryl Bugatch:]

Good morning and thank you for taking my question. I think you were asked on it, but I didn't hear the answer to what were you walking away from, from vertical integration? Could you provide some color for that, please?

[Gregory A. Whirley:]

This is Greg. In – early in 2014, we started to partner with a company that would be able to dry and help provide some hardwoods to the company that we could finish on our line here, essentially moving closer to the forest, if you will. In the short-term, we've determined that having that drying and milling capability was not what we wanted to focus the organization.

[Thomas David Sullivan:]

This is Tom. I mean what we need to focus on now and in the future is our stores. Our stores are very strong. We have a good model and we don't need to get side-tracked with other stuff like that. We focus on buying wood at a good price and selling wood at a good price. And that's our business and that's what we're going to focus on.

[Beryl Bugatch:]

Okay. And the other question that I think was asked that I didn't hear an answer to was kind of a description of what happened to monthly progression for sales, could you see any evidence that there's been abatement of the effects of the 60 Minutes broadcast?

[Gregory A. Whirley:]

Again, I'd tell you as we move forward to the rest of the year, I think we believe that market understands our value prop, we're competitively priced. In the near-term, we'll continue to invest in that value prop and drive customers into the store while we're clearing some of these products and monitor those prices as we move forward. As we move farther away from the 60 Minutes broadcast and some of the other issues that we are dealing with, we'd expect improvement, but we'll work towards that.

[Beryl Bugatch:]

Well, Greg, I appreciate that, but have we seen any evidence of that in the second quarter, in the three months? And maybe, we'd get a little bit of a better feel in the public market that that belief has some weight of evidence behind it.

[Gregory A. Whirley:]

Yes. I think we have seen that. And we've seen some positive signs. As we've looked out in or looked at the sales, we can see that volume per ticket is actually up compared to prior periods. So although our selling prices have dropped 6%-plus, and our average sale is only down 2% which indicates to us that we've seen an increase in volume. Customers are understanding that value. And again, as we move farther away from that 60 Minutes episode, we'd expect that trend to continue.

[Beryl Bugatch:]

So, just the last part of that. Did the comp progression get less bad during the quarter?

[Gregory A. Whirley:]

Yes, I think we've been trailing – we've been tracking better as we move through the quarter.

[Beryl Bugatch:]

Thank you very much. Good luck on the balance of the year.

[Gregory A. Whirley:]

Thank you.

[Thomas David Sullivan:]

Thank you.

[Operator:]

Our next question is from the line of Brian Nagel with Oppenheimer. Please proceed with your questions.

[Brian W. Nagel:]

Hi. Good morning. Thanks for taking my question. Maybe a couple of quick ones. First off, with respect to competition, as Lumber Liquidators has been working through its issues, have you seen any of your competitors, in any form, step up their own efforts in order maybe to take share from you?

[Thomas David Sullivan:]

This is Tom. Yeah, our focus is running our business the best we can. We will and we always have been the best price in the market, and the best product at the best price and with great customer service. And I don't think anyone can beat us with that.

[Brian W. Nagel:]

Okay. And then the second question, I think just kind of a follow up to maybe a question was asked previously. But you're continuing to open stores. I guess the question I have is with all this going on in the areas you're focusing on, the retrenchment here, what's the strategy behind continuing to open stores? And I guess why I'm asking is are you opening new stores now or are you working through a backlog of stores that you've previously got – opted to open?

[Gregory A. Whirley:]

This is Greg. Our expectation is to continue to open stores. I think we've discussed in prior periods, our store model is probably is the strength of the company. Our investment to open a new store is relatively small and has a very quick payback to the company in terms of return on investment. So, we consider that to be a good use of our assets today.

[Brian W. Nagel:]

Okay. Thank you very much.

[Gregory A. Whirley:]

Thank you.

[Thomas David Sullivan:]

Thank you.

[Operator:]

Our next question comes from the line of Nick Zangler with Stephens. Please go ahead with your questions.

[Nicholas Todd Zangler:]

Hi. Yeah. I was just wondering, anecdotally, if you could kind of talk about what kind of – what percent of customers are asking about formaldehyde levels or at least expressing some interest in that topic when they come into the store. And then, what the sales team and managers in the stores are equipped with as a pitch to combat that issue and put the customers at ease?

[Gregory A. Whirley:]

This is Greg. I'd respond to that answer by telling you our store managers, as Tom mentioned earlier, are the best at what they do. And we have asked them to focus on selling the products that we have today. Those products, as you know, aren't sourced or don't have the same issues with the formaldehyde from China because we've, at this point, pulled those products off of the shelves. So, we're allowing those store managers to talk through, discuss it. We've provided them with some key information, key talking points so that they have information to discuss with our customers. But again, our customers are coming into the stores because we are providing good products at good prices. And we believe they're more focused on moving forward with us.

[Nicholas Todd Zangler:]

Great. And then, if – can you provide any detail at all on maybe some of your conversations with the Consumer Product Safety Commission, anything that they request, just any further progress that has been made on that regard?

[John M. Presley:]

This is John. Only thing I can comment there is that we're cooperating fully with them. If they ask for something, we give it to them. And we will continue to work with them in the future.

[Nicholas Todd Zangler:]

Thank you very much. Good luck.

[John M. Presley:]

Thank you.

[Gregory A. Whirley:]

Thank you.

[Operator:]

At this time, I would turn the floor back to management for closing comments.

[Thomas David Sullivan:]

Hi. This is Tom. Thank you again for joining us on the call. I want to thank the Lumber Liquidators team for all their hard work and our customers for their continued support. Also, one important number you all need, the most important number of this call is 1-800-HARDWOOD, if you need any great hardwood flooring deals. Thank you very much.

[Operator:]

Thank you. Today's conference has concluded. Thank you for your participation. You may disconnect your lines at this time.