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Edited Transcript of LL earnings conference call or presentation 6-Nov-19 1:00pm GMT

Q3 2019 Lumber Liquidators Holdings Inc Earnings Call

TOANO Nov 10, 2019 (Thomson StreetEvents) -- Edited Transcript of Lumber Liquidators Holdings Inc earnings conference call or presentation Wednesday, November 6, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Charles E. Tyson

Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer

* Danielle O'Brien

Lumber Liquidators Holdings, Inc. - IR Executive

* Dennis R. Knowles

Lumber Liquidators Holdings, Inc. - President, CEO & Director

* Nancy A. Walsh

Lumber Liquidators Holdings, Inc. - CFO

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Conference Call Participants

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* Joshua Kamboj

Morgan Stanley, Research Division - Research Associate

* Laura Allyson Champine

Loop Capital Markets LLC, Research Division - MD

* Oliver Wintermantel

Evercore ISI Institutional Equities, Research Division - MD & Fundamental Research Analyst

* Peter Jacob Keith

Piper Jaffray Companies, Research Division - Principal and Senior Research Analyst

* Robert Samuel Aurand

Longbow Research LLC - Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen, and welcome to Lumber Liquidators Third Quarter 2019 Earnings Conference Call. As a reminder, ladies and gentlemen, this conference is being recorded and may not be reproduced in full or in part without permission from the company.

I would now like to turn the conference over to Danielle O'Brien, please go ahead.

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Danielle O'Brien, Lumber Liquidators Holdings, Inc. - IR Executive [2]

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Thank you, operator. Good morning, everyone, and thank you for joining us. Let me reference the safe harbor provisions of the U.S. securities 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 and 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. This information contained in this call is accurate only as of the date discussed. Investors should not assume that the statements will remain operative at a later time and Lumber Liquidators undertakes no obligation to update any information discussed in this call.

Now I'm pleased to introduce Mr. Dennis Knowles, CEO of Lumber Liquidators. Dennis?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [3]

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Thank you, Danielle, and good morning, everyone. Today, I'm joined by Charles Tyson, our Chief Customer Experience Officer; and Nancy Walsh, our recently appointed Chief Financial Officer. We had a challenging third quarter that included soft demand in July as well as a network security incident in August. These factors led to generally disappointing overall results for the quarter and as a result, we chose to lower our annual guidance, but we are encouraged by the sales trends experienced in September, as we execute our transformation plan and make meaningful progress on many fronts.

First, in September, we took another step towards clearing the distractions caused by legacy product litigation consummating a settlement agreement in the Gold case that is consistent with the previously announced MOU and we now await the court's final approval. As we continue to put those distractions behind us, we're making continued progress in transforming our business and further differentiating ourselves in a dynamic and growing hard surface flooring marketplace.

Second, as we work to drive sustainable traffic to our stores, we developed updated creative content and launched new television ads in mid-September that are more experiential and highlight product quality and differentiated service and the great value we offer.

Third, we continue to make progress in our steps to drive gross margin by building expanded relationships with key vendors and implementing more robust vendor negotiations, identifying alternative sources for supply, and utilizing a portfolio approach to manage retail prices. Finally, we remain focused on optimizing our cost structure to support the business while identifying areas where our cost can be taken out. You'll hear more on these efforts later in our remarks.

Before diving into the results for the quarter, I'd like to share a few comments about the network security incident we previously disclosed. Over the past 2 years, we have made investments in network security, which are aligned with the Center for Internet Security's critical security control standards.

Despite these investments, in late August, we were impacted by a network attack that encrypted certain IT systems and impacted our ability to electronically process transaction for a period of 6 days. Once we learned of the cyber-attack, our risk management team activated our business continuity plans and the entire organization took immediate steps to minimize the impact on the business.

These plans included taking manual steps to record transactions and ship product and allow us to keep our stores open throughout the incident. We also worked closely with third-party firms that specialize in recovery and forensic analysis to restore our systems as quickly as possible, while ensuring we maintain data integrity.

Importantly, we found no evidence that any sensitive customer, employee or company data was compromised or extracted from our systems. Despite the commendable efforts of the team, the event did impact our reported results in the quarter. While stores did have the ability to process transactions, they were more difficult to execute, especially those that are more complex like those requiring shipments from our DCs or scheduled installation.

Ultimately, some customers chose not to complete the sale. While it is challenging to know the precise revenue impact of the event, we think the approximate net impact to our total sales, after attempting to account for customers who returned when our systems came back up, was approximately $6 million to $8 million in the quarter and roughly 1/3 of that negative revenue impact flowed through to the bottom line. We have insurance that has already reimbursed certain direct expenses related to the incident, and we are in the process of documenting and submitting other cost in addition to establishing a business interruption claim under the terms of our policies.

Before moving to results, I would like to thank our customers for their patience and understanding as we managed through the event as well as our associates and vendors who worked diligently to overcome tremendous obstacles to meet the needs of our valued customers. We experienced a negative 3.6% comp in the quarter, comprised of a 1.7% increase in average ticket while transaction count, which was negatively impacted by the network incident, declined 5.2%.

On our second quarter call, we highlighted a weak performance in July, which was due in part to a shift in our promotional cadence, but we also felt that we saw some evidence of generally weaker industry dynamics, as many housing-related metrics had posted several months of softness. As a result, we chose to lower our full year guidance at the time. In the first 3 weeks of August, we saw improving comp trends compared to July's lows, but on August 21st, we experienced the network security incident, which resulted in a negative double-digit comp for the month.

September trends improved significantly, supported by successful promotions, targeted pricing actions, and to a much lesser extent, recovery from the network incident earlier in the month. On the gross margin front, we made continued progress mitigating the impact of tariffs on the margin performance. Our 3-pronged approach of driving down first cost with our vendors, shifting sourcing to countries less impacted by tariffs and utilizing selective retail price increases as well as a favorable mix of products sold, helped deliver an increase in our adjusted gross margin despite the headwinds of tariffs.

Finally, we have completed a full review of our expense opportunity and are actively executing on our cost out initiative. We remain focused on reducing cost to align our organization with our strategic path and today, with a lot of legacy distractions behind us, we have an opportunity to right-size the organization and increase efficiency for the future. As one example, in late September, I chose to flatten our store ops and strategy organizations, eliminating 2 senior positions and lowering our overall cost structure. I am confident that we can continue to successfully execute our strategy with the scaled back senior management team. As we look ahead, encouragingly, our October yard sale that ran from October 15th towards the 22nd was successful and helped continue the positive sales trends we experienced in September, although at a slower rate. We also see encouraging signs of certain components of our omnichannel strategy launch and begin to gain traction.

In addition, as we have described on past earnings calls, the headwinds from the secular shift away from bamboo continues to abate. We continue to see strong growth in Pro sales as increased stock SKUs to serve same day demand and successful efforts to build stronger and more personal relationships between store employees and Pro customers are generating solid results.

Installed performance also continues to outpace core growth and we are implementing automation in the fourth quarter to aid customers, installers, and employees, with installed project process that will support this momentum. We also see a more supportive macro backdrop, as housing turnover strengthens, home equity levels continue to rise, and mortgage rates tick lower and employment remains strong.

Despite our recent momentum and what we view as a generally improving environment, we are lowering our full year 2019 sales and adjusted operating margin guidance to reflect our weaker-than-expected third-quarter results that included the impact of the network security incident. Nancy will provide additional details in a moment.

Before concluding, I would like to take a minute to officially welcome Nancy Walsh, our new CFO, to the Lumber Liquidators team. Nancy joined in early September and brings an extensive retail background, which has allowed her to quickly come up to speed on the company and our opportunities. We're excited about the fresh perspective she brings to our team, and we look forward to leveraging her experience to make our company stronger. I would also like to thank Tim Mulvaney for his service as our Interim CFO from March to September of this year. Tim has returned to his role as Chief Accounting Officer and remains an important part of the finance team.

Over the past year, we have taken steps to strengthen our executive team, bringing in leaders with the significant, relevant experience to execute our transformation, drive shareholder value, and position us for long-term success and I am encouraged by the opportunities that we see ahead.

I will now turn the call over to Charles.

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [4]

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Thanks, Dennis. As mentioned, after a weak July and a challenging August, we saw evidence of building momentum late in the quarter, as our efforts to drive traffic and transactions began to show progress. As we've highlighted on the second quarter call, we purposefully shifted some promotions out of July into August and September where we felt the ad spend could be more productive. And generally, we were pleased with the net impact of that shift through the quarter.

We believe that shift drove some of the strength in September, but we feel the continued positive comps in October reflects traction with our initiatives and affirming demand environment overall. We remain focused on executing our long-term brand strategy, and we continue to refine our marketing message, as we've been working in partnership with our ad agencies to bring a fresh new message, focused on value proposition and a tailored customer experience. Additionally, our digital efforts continue, and we are working to optimize the tools we use to reach consumers, making tangible progress during the third quarter.

The clearest example was the launch of our new television ad campaign in mid-September. Our new ads emphasized product quality, user experience and consultative service in our stores, while also maintaining a price promotion message. In development for several months in coordination with our agency partners, we're excited to gauge consumer reaction to these ads that are significantly different than the creative you've seen from us in recent years.

Our goal is to reposition our brand towards invested, improved and identified segment of customers who value the high-touch consultative selling environment that is core of what our teams delivered to our customers every day. On the digital front, we continue to be pleased with our online performance, as web order penetration increased year-over-year. We're making progress upgrading and replacing our digital platform and are excited to utilize the additional functionality it provides us to effectively reach customers, while also improving usability of the site.

We expect to roll out the new platform in mid-2020. Utilization of our Picture It! floor visualizer continued to grow in the third quarter, following its broad launch in July. We see customers increasingly exploring hard surface flooring in nontypical rooms, like bedrooms and other second-story rooms in the house. This gives us confidence we can grow square footage penetration in the home and we are utilizing the information gathered from these online users to tailor our marketing programs to be more relevant to those consumers.

In addition, a key benefit from the utilization of the online visualizer tool is its impact on the length of the customers' journey. With the ability to see their new floor in their own home, visualization is far beyond what a small sample can provide. We're seeing a significant shortening of the overall decision-making process. We're also seeing evidence of the effectiveness of the tools through anecdotal stories from the store associates who describe it as a great closing tool for them.

Building on the momentum of the Picture It!, we expect to launch our new Floor Finder tool in the fourth quarter. As we previously described, this tool is designed to help consumers narrow the product selection process by answering a short series of questions that allow us to steer the customer to the flooring type that best fits their desired application. We found that the often complex decision where consumers weigh choices related to flooring material, construction, waterproof characteristics, dimensions and (inaudible), not to mention color and style, can be overwhelming for many. Our Floor Finder helps consumers navigate this decision tree and narrow that choice to a manageable set of options. Similar to the Picture It! tool, we are optimistic that this tool will help consumers shorten their flooring project journey whether they’re shopping online or in our stores.

We also launched a new capability in October that allows customers to purchase an installation assessment online, which is the first step in executing an installed flooring project. After purchasing a project assessment, a professional independent contractor contacts the customer directly to schedule an appointment. Once the assessment is complete, our team will contact the customer with the project quote. If necessary, that can be followed up with an in-store consultation with one of our knowledgeable associates to answer any remaining questions or overcome any last obstacles to closing the sale.

All of these tools support our overarching digital strategy and further our goal of engaging with customers earlier in their flooring project, making the project easier and more convenient by allowing much of the product evaluation process to occur at home, helping minimize any competitive disadvantage resulting from inconvenient store locations.

We look forward to providing updates on customer adoption of these tools in future quarters. From a product perspective, vinyl continues to be the area of strongest growth, with substitution from solid products, including bamboo. To ensure we remain on trend and priced right, we launched several new products during the quarter, including new engineered SKUs to serve that fast-growing part of the market.

Our Altamonte Springs store continues to perform well, and we opened our second open-concept store in Thornton, Colorado, in early September. We learned a tremendous amount from these store prototypes as well as other tests we're performing and are implementing some of those insights across the train to improve the overall shopping experience and drive incremental transactions.

Shifting to margin, we maintained our focus on mitigating the impact of tariffs during the quarter. We continue to work closely with our vendors, strengthening relationships and consolidating supply to allow us to positively impact our [first] costs. Also we've seen growing momentum in production outside of China. As I've described before, many vendors were initially hesitant to make the significant capital investments required to move production from China during the early days of the escalating tariff regime. But as time has passed and as tariffs have grown, more and more suppliers are building capacity in other Southeast Asian countries. We have had success identifying new sources of supply and began receiving shipments from certain suppliers in Q3, but we expect significant additional shifts in supply sources in Q1 of 2020.

Finally, we continue to use a portfolio approach to managing retail price increases as an additional tool to offset tariffs. As we indicated on our second quarter call, we implemented some price increases in June and made some additional refinements in Q3 as we closely monitored consumer reaction and the competitive environment.

We continue to monitor the competitive environment to ensure we are sorted and priced competitively to maintain our position as the value leader in the hard surface flooring industry. In conclusion, we have had a challenging quarter but we're encouraged by recent trends and we remain focused on transforming our brand while delivering unmatched product quality and selection at a great value. We are confident our transformation plan will position us well to finish the year on a solid note as many initiatives gain traction and begin to deliver results.

I will now turn the call over to Nancy to share the financial details of the quarter. Nancy?

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Nancy A. Walsh, Lumber Liquidators Holdings, Inc. - CFO [5]

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Thanks, Charles. Good morning, everyone. I am thrilled to be at Lumber Liquidators at this pivotal time in our journey. I have only been officially on the job for 2 months, but I'm excited about the opportunities we have to better serve customers, strengthen our competitive position, and drive financial results that deliver shareholder value. From a finance perspective, I feel we have a strong organization with the opportunity to build on the solid foundation established in recent years.

In the near term, my focus is on fostering a culture of fact-based decision-making to support strategic management decisions, leveraging tools and processes to drive efficiency and cost savings across the organization and developing the finance organization to promote a culture of stakeholder value and financial accountability. I look forward to sharing more as we make progress.

Now to the results. In the third quarter, net sales were $264 million, a decrease of 2.4% over last year and comparable stores were down 3.6% versus a year ago influenced by a soft July and the network security incident Dennis discussed. The overall net sales decline was driven by a 3% decline in merchandise sales, offset by a 1.8% increase in installation sales. Our comps decline was the result of a 1.7% increase in our average transaction value, offset by a 5.2% decrease in transaction count. From a product perspective, we continue to see strong growth in vinyl products with continuing softness in exotic solid, most notably in bamboo. Gross profit for the third quarter of 2019 declined $5 million compared to the third quarter of 2018 and both periods were impacted by out of period duty-related adjustments.

Without these items, adjusted gross profit declined approximately $1.4 million. Gross margin for the quarter was 36.2% compared to 37.2% in the equivalent quarter a year ago. Adjusted gross margin grew to 36.5% from 36.2% in the prior year period. A more favorable mix toward higher-margin vinyl along with our efforts to reduce first costs with vendors and shipped sourcing to countries less impacted by tariffs in addition to higher average selling prices drove the improvement over the third quarter a year ago.

Adjusted margin increased 30 basis points despite the growing impact of tariffs on product cost. As described last quarter, we expected margin growth in Q3 as the margin rate benefited from our tariff mitigation efforts, but we expect Q4 margins to be tempered as inventory burden with the high tariff cost flow through our supply chain causing some of our Q3 rate improvement to recede. From a timing and inventory turn perspective, we expect to incur the full headwind of the 25% tariff on COGS late in Q4, but the offset resulting from our mitigation efforts to date will not be fully realized until Q1 of 2020. SG&A expense for the third quarter was $93.5 million compared to $94 million in the third quarter last year.

SG&A in both quarters included incremental legal and other costs related to lawsuits, investigations, and certain other legal matters. And the third quarter of 2018 also included a loss related to certain equipment, as we announced the intention to cease finishing our own floors. Both periods items are adjusting in the non-GAAP reconciliation section of the press release. When excluding these items from both periods, adjusted SG&A expense for the quarter was $93.1 million or 35.3% of sales, an increase of $3.9 million and up 230 basis points on a percent-to-sales basis versus the same quarter a year earlier.

The increase in adjusted SG&A dollars was driven by costs related primarily to 10 new stores compared to the third quarter a year ago. Higher year-over-year incentive and equity accruals driven by a reduction in last year's third quarter to align with lower performance expectations as well as severance expense recognized in this year's third quarter and our corporate headquarters relocation that will occur in the fourth quarter. These expenses were somewhat offset by lower credit card and bank fees in the quarter. In addition, as announced in 2018, the company ceased finishing floors at its facility in Toronto. The net effect of this was to move certain allocated overhead costs from gross margin to SG&A with ultimately no impact on the bottom line, but negatively impacting SG&A relative to third quarter last year. The expense deleverage to sales year-over-year was a function of these same factors but exacerbated by the revenue impact of the network security incident. Certain direct expenses related to the security incident have been reimbursed by insurance while the receivable has been established for other direct expenses for which we expect to be reimbursed in future periods.

We remain focused on identifying expense saving opportunities including rightsizing our corporate staff as Dennis described, but also through finding cost synergies across the business and driving efficiency through everything we do. We expect our ongoing evaluation of costs to deliver savings this year, while also positioning us well for 2020 and beyond.

For the quarter, we recorded operating income of $2.2 million compared to operating income of $6.7 million in Q3 of 2018. After adjusting for the items noted previously, we had adjusted operating income of $3.4 million in the quarter compared to last year's $8.6 million. The year-over-year decline was driven by the higher operating expenses noted earlier as well as the impact of the network security incident.

Turning to the balance sheet, inventory at the end of third quarter was $307 million, up approximately $3 million from Q2 as the impact of higher tariffs added slightly to our inventory. As that impact continues to grow, we anticipate fourth quarter ending inventory in the $310 million to $320 million range. We ended the quarter with $89.5 million outstanding under our credit agreement, which was flat to Q2.

As a reminder, this debt position is inclusive of $55 million of specific settlement-related cash payments made since the fourth quarter of 2018. Looking forward, although expense has been recorded in earlier periods for each of these items, we have a few additional settlement-related cash payments on the horizon. While the exact timing will be driven by the courts, we currently anticipate funding the $4.75 million Kramer settlement and the $1 million of the Gold settlement in the fourth quarter, and we currently expect to fund the remaining $13 million of the Gold settlement in 2020.

Our liquidity position remains strong as our core operations continue to generate solid cash flow. As of September 30, we had liquidity of $114 million consisting of availability under our credit agreement of $108 million and cash of $6 million. Turning to our outlook, we are lowering our full year 2019 sales and operating margin guidance to reflect our weaker-than-expected third quarter results that included the impact of the network security incident. We now expect 2019 total revenue to be flat to slightly positive to last year’s versus low single-digit growth previously, and comparable store sales to be between a 2% decline and flat to 2018 versus an expectation of approximately flat previously.

As a result, we expect to deliver adjusted operating margin of 1% to 1.4% of revenue versus an expectation of 1.4% to 1.9% previously.

Our current outlook also continues to assume the 25% tariff on Chinese imports, extends for at least the balance of 2019. While we were encouraged by recent momentum in the business as well as signs of a more supportive macroeconomic outlook, we feel it is prudent to lower our outlook at this time. On the investing side, we plan to open 11 new stores in 2019. We expect capital spending of $15 million to $17 million. We anticipate cash paid for taxes will remain nominal and that the valuation allowance on our deferred tax assets remain in place for the year. We see cash paid for interest to be in the $3.5 million to $4 million range. Before we open the call for questions, I wanted to let you know that we have chosen to postpone the analyst conference that we had tentatively planned for the fourth quarter. While I have learned a tremendous amount about the company in my first 2 months, additional time will allow me to entrench myself in the business and have a deeper understanding of the expected long-term financial expectations of our strategy execution.

The delay will also allow us to make additional progress on our initiatives and provide a long-term financial outlook that is more informed by the trajectory of the business. In addition, we will potentially have a clearer view of the macroeconomic and tariff landscape. We will provide additional information when appropriate.

Thank you all for your time this morning. With that, I will hand it back to the moderator to open the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Simeon Gutman with Morgan Stanley.

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Joshua Kamboj, Morgan Stanley, Research Division - Research Associate [2]

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This is Joshua Kamboj on for Simeon. Can you please talk about the trends in October during the weeks without the yard sales? Did you also comp positively in those weeks and did they meet your expectations?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [3]

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Yes. We saw strength across the entire month, but it's, you know, as we've had in our prepared remarks, the October yard sell was such a big portion of the month. Undoubtedly, it impacts the entire month, but yes, we did.

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Joshua Kamboj, Morgan Stanley, Research Division - Research Associate [4]

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Okay. And maybe can you talk about how promotionally you were in the yard sale relative to prior years? Was it more or less promotional?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [5]

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This is Charles. Yes. We were very comparable with both the breadth of the assortment and the depth of the assortment. What was different from last year was creative positioning based on the new advertising work that we've done and a difference in the channels in terms of what we pushed to online and digital radio and connected television versus linear television.

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Joshua Kamboj, Morgan Stanley, Research Division - Research Associate [6]

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All right. And I'll just squeeze one more in quickly. You're already seeing signs of the favorable housing data you're talking about and everybody's monitoring, having a positive impact on your business or is that just more an expectation going forward?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [7]

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I think it's probably a little more of the latter. However, it seems like we talked about this extensively in Q2, when we talked about kind of the trajectory of the business. We felt like there were things on the horizon to impact the momentum, but -- that we had, you know, the interest rates for example. We had a lot of several months of, I won't call it bad, but not real favorable news on the macro, as it relates to housing. We started -- at the end of Q2, we started -- we had an interest rate drop, we’ve had another interest rate drops, and I said in my remarks the employment remained strong -- one measure that -- we look at the remodeling industry, a great deal for our kind of understanding the trajectory of our business and we've started to see some positive momentum in things like cash out refis. Those are big driver for us and as we've always said, the 2 biggest home improvement projects are painting the floors and -- are painting the walls and changing the floors out.

So we feel like what we've seen in momentum in September and October, albeit October was a little slower than September, we feel like -- it feels to us that there is a shift in the consumers' direction towards doing more home improvement projects that lends well for us. So we're cautiously optimistic. We feel like we've probably seen -- in the year, we've probably seen the worst part of the economic impact behind it. So we're cautiously optimistic about what we've got in front of us.

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Operator [8]

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Your next question comes from the line of Oliver Wintermantel with Evercore ISI.

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Oliver Wintermantel, Evercore ISI Institutional Equities, Research Division - MD & Fundamental Research Analyst [9]

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Yes. Welcome, Nancy. I had a question regarding the improvement in September and then into October, was that mostly driven by ticket or transactions?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [10]

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Actually both, we had strong transaction growth. I'd say there is a myriad of factors that Charles talked about, we had the new creative, we continue to get traction with the visualizer. We've seen sequential improvement in the consumers' interaction, our web activity was up, Charles, and I think it's pretty much what you saw in October as well.

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [11]

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That’s correct.

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Oliver Wintermantel, Evercore ISI Institutional Equities, Research Division - MD & Fundamental Research Analyst [12]

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Okay. And my second question was regarding gross margins or actually inventory. I think in the 10-Q, you said that you sold through most of the inventory that you bought ahead of the 25% tariffs. And I think, Nancy, you touched on it on the Q4 gross margin line. Could you maybe give us a little bit more detail of how much you sell-through? And is that 25% tariff now hitting you mostly in Q4?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [13]

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Yes, Oli, this is Charles. From an inventory turn perspective, as you know, we turn around inventory about twice a year. The category that took the most amount of tariff was the Vinyl category, which is one of our fastest turning categories, but we don't expect the full impact of the 25% to roll through all of inventory until first quarter. So there is still some headwind, as Nancy talked about in her earnings script, to gross margins that is going to roll through the back half of Q4, based on where the tariffs have landed.

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [14]

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But our mitigation will start to hit, too.

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [15]

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Correct.

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [16]

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At [nice] in the first quarter.

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [17]

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I think what Oli wanted to understand was, have we fully seen the impact of tariffs through the turn of the inventory, and that is not the case. We do have risk mitigation, that I talked about in my remarks, that will impact us specifically with shipments increasing in Q1.

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Operator [18]

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

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Peter Jacob Keith, Piper Jaffray Companies, Research Division - Principal and Senior Research Analyst [19]

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So just to follow up on the gross margin pressure from tariffs, understand that it will be late Q4 when the full pressure hit, but then you'd also made reference about mitigation efforts picking up in Q1. So if we just look forward a couple of quarters, what quarter is probably going to be the worst quarter from a tariff gross margin pressure perspective?

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Nancy A. Walsh, Lumber Liquidators Holdings, Inc. - CFO [20]

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We expect Q4 to be the worst in terms of taking the impact, 100% of the impact of the tariffs and then starting to see the mitigation impact in Q1 going forward.

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [21]

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Peter, I think I might have even talked about this a little bit on the second quarter call. There wasn't much chance to go out and pre-buy for the leg up from 10% to 25%, so pretty much any POs in flight were going to be impacted by the tariffs and most of that is, I think Charles said in his remarks too, is that's we'll see the -- that’s when we’ll see -- Nancy said it too, I think that the biggest impact's going to be in Q4 and all of our mitigation, moving out of country and negotiations with our vendors, all of those will roll into POs we think starting -- well, should start rolling in the Q1 where we start to see that benefit.

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Peter Jacob Keith, Piper Jaffray Companies, Research Division - Principal and Senior Research Analyst [22]

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Okay. And then Dennis, a separate question for you. I just want to talk about compensation at the store level. So in the past, the Lumber Liquidators had a commission-heavy compensation structure where I know store managers in the past could even make 6-figure annual incomes. I guess we're just seeing some posts online that it seems like you have moved away from the commission structure to more of a store bonus dynamic. I was hoping if you could just update us on where the historic compensation stands today and how it's evolved and maybe even if you're thinking about tweaking it going forward?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [23]

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Great question. As you may remember, back in 2016 there were some legislative changes that were pinning, they actually never materialized, that we're going to challenge the qualification for an exempt status and we would not have passed that qualification test. So proactively, we chose to invert. We did a lot of testing on our commission structure and a lot of this was in flight before even I got here. To determine whether we had some opportunity to change how the commission works.

We have ultimately ended up inverting whereas we made more of a solid base, a higher base and less commission structure and that was done in 2016. We always make tweaks to our commission, based on vendor funding, or if we choose to have a promotion aimed at a certain category with vendor support. We look at this all the time. In fact, we're in the middle of working on compensation plans for next year, but we want our store employees to make maximum income and to be motivated to sell and, at the same time, make sure that they're preserving the bottom line.

So it's a delicate balance. I would tell you that we constantly look at this and we do a review even with our Compensation Committee, on our Board, on an annual basis and we're in the middle of that review right now. I don't anticipate huge structural changes. But we always want to make sure we've got the most motivated sales force in our stores. We're a selling company and we look at that, we do an annual review as well as we have quarterly incentives and contest to help increase the store managers' incentives. So I wouldn't say we've got any dramatic restructuring plans, but we look at it every year to make sure that we've got that in place.

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Operator [24]

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(Operator Instructions) Your next question comes from the line of Laura Champine with Loop Capital.

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Laura Allyson Champine, Loop Capital Markets LLC, Research Division - MD [25]

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So as you look at 2020, what are your thoughts in terms of store openings and what is driving your expectation for new store openings next year?

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Nancy A. Walsh, Lumber Liquidators Holdings, Inc. - CFO [26]

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I think at this point, we are right in the planning process. I've been here, 2 months, as my notes say, so we're diving deep into a bottoms-up plan and I prefer to talk about 2020 when we do the Q4 earnings call, so that we're not doing this piecemeal and I can prepare a consolidated view of 2020 looks like.

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [27]

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I don't think, Laura, we're thinking anything dramatically different from what we did this year, but to Nancy's point, we're right in the middle of the throes of our 2020 planning.

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Operator [28]

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Your next question comes from the line of David MacGregor with Longbow Research.

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Robert Samuel Aurand, Longbow Research LLC - Analyst [29]

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Rob for David here. I wanted to ask you about sourcing from China. You talked about vendors increasingly moving and building outside of China. The past year you talked about you're getting down to a mid-40's percentage by the end of this year. I guess with more vendors moving outside of China, do you have any update on maybe where that could be next year?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [30]

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Rob, this is Charles. Based on actions that we've taken, as I said, we're already starting to move shipments in the third quarter out of China. I believe that by the middle of 2020, we will be in the high 30s. So we continue to see improvement of moving that number down. Obviously, our compliance team has done a great job in helping us work through making sure that these new vendors are on board at the right way to meet all our stringent quality requirements, and we probably take a little bit more time than others to do that, but we want to make sure that, when we execute, we are absolutely confident in the quality of our products. So we'll update next quarter on other work that we have underway, that we feel will continue to improve our gross margins as we move product to other parts of Southeast Asia.

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Robert Samuel Aurand, Longbow Research LLC - Analyst [31]

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Okay. And then just on the selective price increases you talked about. Are you seeing any elasticity of demand? Are you seeing any mixing down as a result?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [32]

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Yes. So a couple of things, in the quarter, we did move promotional events and so obviously, that had some impact. I was happy on what happened in September, as we moved some of that spend out of July. We optimized our pricing continually. We're shopping across regions. We're looking at what competitors are doing from a reaction perspective, and just by natural course of business, if we see elasticity opportunities to improve gross margin dollars and top line sales, we will adjust prices both up and down and we did some of that during the quarter.

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Operator [33]

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Ladies and gentlemen, we have reached the end of the question-and-answer session. I would like to turn the call back to Mr. Dennis Knowles for closing remarks.

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [34]

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Thank you, operator. Let me say thanks again to the LL team, our vendors and our customers and our shareholders for your continued support. We look forward to updating you next quarter. Thanks again for your interest in Lumber Liquidators and have a great day. Thanks.

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Operator [35]

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Thank you. This concludes today's conference. You may disconnect your lines at this time and thank you for your participation.