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Edited Transcript of LL earnings conference call or presentation 7-Aug-19 12:00pm GMT

Q2 2019 Lumber Liquidators Holdings Inc Earnings Call

TOANO Aug 14, 2019 (Thomson StreetEvents) -- Edited Transcript of Lumber Liquidators Holdings Inc earnings conference call or presentation Wednesday, August 7, 2019 at 12:00:00pm 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

* Timothy J. Mulvaney

Lumber Liquidators Holdings, Inc. - Interim CFO & CAO

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Conference Call Participants

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* Beryl Bugatch

Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research

* Brian William Nagel

Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst

* John Allen Baugh

Stifel, Nicolaus & Company, Incorporated, Research Division - MD

* Laura Allyson Champine

Loop Capital Markets LLC, Research Division - MD

* Nels Richard Nelson

Stephens Inc., Research Division - MD

* Oliver Wintermantel

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

* Robert Samuel Aurand

Longbow Research LLC - Analyst

* Simeon Ari Gutman

Morgan Stanley, Research Division - Executive Director

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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 Second Quarter 2019 Earnings Conference Call. As a reminder, ladies and gentlemen, this conference is being recorded. It 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 law 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' filing with the SEC. The 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 Tim Mulvaney, our Interim Chief Financial Officer.

We have been sharply focused on executing our stated transformation strategy throughout the first half of 2019, with a goal of strengthening our foundation to position our company for future growth. This quarter was our first full operating period without headwinds from legacy product-related legal issues, and in June, we entered into a memorandum of understanding in the Kramer employment litigation case discussed in our SEC filings. We are glad to have taken a meaningful step closer to full resolution of this matter and with these issues behind us, we have been quickly moving to execute our transformation strategy as we work to build momentum and long-term growth.

Our second quarter results were generally in line with our expectations, and we delivered net sales of $289 million, an increase of 1.8% over Q2 of 2018. Comparable store sales were flat in Q2 and improved sequentially from Q1, but we experienced softening traffic trends as the quarter progressed. Merchandise sales declined slightly but were offset by continued growth in installed sales. Additionally, our average ticket grew approximately 2.5% for the quarter. Similar to last quarter, bamboo continues to face a secular shift in the consumer demand that has pressured sales, though to a lesser extent this quarter. We anticipate the impact of the shift away from bamboo will be significantly less of a drag in the back half of the year.

On an adjusted basis, our gross margin improved 20 basis points during the quarter, as various cost-out efforts and favorable mix towards higher margin vinyl products more than offset the current impact of tariffs. We have worked diligently over the past 3 quarters to navigate the challenging and uncertain tariff environment. As we relayed last quarter, we fully offset the approximate $22 million of annualized headwind created by the 10% tariff implemented last September through cost mitigation efforts and other inventory elements. It has been far more challenging to address the incremental $34 million of annualized headwind created by the additional 15% tariff that went into effect in mid-June, but our teams have made great progress. We have doubled down on our mitigation efforts and identified areas to further reduce cost within our existing initiatives. These include continued negotiations with vendors, the evaluation of our multi-country sourcing and supply chain strategy as well as our decision to selectively increase retail prices late in the quarter.

We are also managing our cost structure and reducing SG&A, while continuing to maintain a high level of customer service and improve the experiences in our stores. During the quarter, we underwent a field structure reorganization, reduced overtime in the stores and identified other cost-saving initiatives. This focus on efficiency will continue during the back half of the year with the expectations of near-term benefits stemming from an ongoing deep-dive into costs across the business as efficiency opportunities are realized. As we look back at the first half of the year, we are proud of the progress to date but recognize we have significant work ahead of us to bring Lumber Liquidators to the next level.

With legacy product-related litigation issues behind us, we have been relentless in executing on the transformation strategy. In this quarter alone, we launched new advertising that more effectively reaches consumers early in their flooring project journey; produced new creative content to be deployed across national networks through the back half of 2019; we enhanced digital and technological capabilities; expanded Pro and Installation services; leveraged learnings from our new open concept format; and continued our tariff mitigation efforts, all while delivering great value to our customers and maintaining a strong competitive position. We believe these initiatives will position us well to increase our market share and drive revenue growth.

Moving on to our plans for the remainder of the year. Our strategic priorities remain unchanged as we focus on growing our top line, providing the best possible unique customer experience and optimizing margins in this challenging tariff environment. To this end, we will be making some exciting progress in the second half. We intend to activate new creative advertising content for national distribution, drive traffic with our new floor finder digital tool, prioritize Pro and Install sales growth through our new sales associate training to identify cross-selling opportunities and highlighting Pro needs and test new display tactics to identify where the customers respond most positively, including alternate ways of displaying flooring samples.

First, our new advertising agency has a full quarter under their belt with us, and we have been able to activate some exciting new campaigns. This includes optimized promotional materials which drove our largest ever April sales. Additionally, as we seek to constantly improve the customer experience, we remain focused on building our omni-channel approach and utilizing our digital capabilities to meet our customers' needs at every touchpoint. Our Picture It! floor visualizer tool continues to receive rave reviews, both in the stores and online, and is allowing us to attract new customers to our brand. Second, with driving store traffic as a priority for the second half of the year, we expect to enhance our digital presence, deploy our floor finder tool and build a more robust inventory of product descriptions to ensure our customers have all the pertinent information at their fingertips.

We're working to identify customers earlier at the beginning of their flooring journey during their ideation phase and the floor finder does just that. The tool is personalized, quiz-based product that walks customers through several sets of questions to help narrow what flooring samples they may want to explore in the store.

Third, both our Pro and Installed sales continue to drive growth for our business. Consistent with our focus over the past several quarters, we are developing capabilities to be more relevant to both of these customer groups. Both our Pro and Installed businesses delivered double-digit sales growth in the quarter. In the back half of the year, we will be conducting market research focused on these groups, and we'll be launching a catalog for our Pro customers early in the third quarter. Finally, we remain on track to add 10 to 15 new stores during this year, and of that total, expect 4 to 5 to be opened or retrofit into the open concept format as we continue applying the learnings from our Altamonte Springs location. In light of these strategic initiatives, let me take a moment to provide some color on how we're thinking about the puts and takes that contribute to our outlook for the back half of the year.

First it is important to note that the new 10% tariff on list 4 products proposed last week do not apply to products we sell and therefore will not have a direct impact on cost. However, we are conscious of how potential price increases on a broad set of consumer products could impact consumer sentiment and discretionary spending. That said, in the second half, we expect traction from new initiatives. And from a relative perspective, we benefit from easing year-over-year comp sales performance as our second half 2018 comps were approximately 250 basis points lower than our first half 2018 comps. We also benefit from the calendar as the second half of 2019 has 1 fewer Sunday, our lowest volume day, versus 2018, which should result in approximately $2 million in year-over-year benefit.

Finally, as we stated previously, we expect a drag from the underperformance of bamboo to continue to lessen throughout the back half of 2019. Offsetting those expected tailwinds, and as I mentioned earlier, we experienced slowing traffic as the second quarter progressed. With weakness continuing into July, and we believe the hard surface flooring industry is in a period of heightened uncertainty on many fronts. We are mindful of the current moderating growth in many housing-related metrics that we consider drivers of the home improvement spending. Additionally, we see the potential for the uncertainty created by the tariffs to influence consumer confidence, perhaps compounded by the potential 10% tariff on list 4 and ultimately, rising retail prices across a variety of products that could impact consumer demand. Finally, we remain very confident in our competitive position as well as the superior value that we deliver to our customers. As a result of the uncertainty in this environment, compounded by softness in the sales trends to start the third quarter, we are reducing our full year guidance. We now are more comfortable with an outlook for low single-digit total revenue growth, down from mid-single digits previously and approximately flat comp sales, down from our previous expectation of flat to low single digits.

Our operating margin outlook is a range of 1.4% to 1.9%, down 50 basis points from our previous outlook, which would equate to an operating margin of flat to down 50 basis points for the full year 2019.

Our transformational work will drive more transactions in our store, and we are encouraged by the long-term opportunities we see as we execute our plans and our initiatives begin to deliver results. While macro and industry uncertainty remains related to tariffs, the strength of the consumer and the competitive landscape, our ability to successfully navigate the expected and unexpected challenges of the first half of the year give us confidence in our ability to execute our strategic initiatives and continue our progress through the rest of the year.

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. Our teams have continued their work this quarter, improving the customer experience, developing our marketing plan to improve traffic and driving brand awareness of Lumber Liquidators as a national specialty, hard surface flooring provider. With the current higher tariff environment, our teams continue to focus on impacting product cost. The sourcing and merchandising teams have continued to execute strategies to develop alternative country sourcing for both manufactured and wood products to help mitigate the impact to margins and sales. And we've already started moving some production out of China, but uncertainty regarding the future of tariffs has some suppliers cautiously evaluating the commitment of capital required to build new manufacturing facilities. As the tariff issues continue, we see more of them seriously considering building new facilities that could potentially accelerate sourcing from regions other than China. But by the end of 2019, we expect to be in the mid-40% range of products purchased from China, down marginally from 2018. Driving product development at an accelerated rate in this environment is critical. Exciting customers with new styles and trends is core to driving market share. We have an aggressive new product introduction plan for the back half of 2019, building on the launch of our AquaSeal brand in multiple categories as well as expanding a number of tests that are underway in our wood business. This also provides our sourcing team increased leverage as we look to improve longer-term margin performance in this environment.

As Dennis mentioned, we've adjusted prices to help offset the impact of tariffs. Our pricing team is evaluating and executing on opportunities to optimize our promotional positioning by region and category across the country. And we are confident in our current competitive position and continue to monitor the environment closely to ensure we remain competitive, observing both independents and big-box industry participants. Turning to supply chain. We have accelerated initiatives to improve inventory productivity, to offset the impact of rising inventory levels, driven by the 25% tariff. We have worked with strategic vendors to reduce purchase order cycle times, which will enable a reduction in safety stock in the latter part of the year. We've increased our focus on life cycle management to improve inventory performance through product transitions. In addition, we're working to increase the breadth of certain regionally specific in-stock SKUs to drive teakwood sales. We've seen the benefit of stocking these high-velocity market-specific SKUs in our Altamonte Springs store, and this is one example of our teams applying learnings from this prototype to the chain.

To drive traffic, our marketing team has been developing new creative assets to highlight our value proposition that is driven by high-quality products, coupled with a great in-store and online service experience. During the second quarter, we launched a new commercial starting our Picture It! floor visualizer tool, that began airing on HGTV at the beginning of July and was rolled out to other national networks later that same month. We're continuously evaluating the best mix of advertising for our business and allocating our marketing spend wisely, which will remain a central pillar of our transformation strategy. We plan to have a new creative content launching this quarter and are assessing new ways to promote store openings. We will expand on this communication strategy in the back half of the year with new creative content and optimized deployment schedules.

Our teams have been focused on the preparation and development of our new e-commerce platform, which will be utilized by our in-store, DIY and Pro customers. The goal of improving our online shopping experience has been central to the work of our digital team and will deliver enhanced performance benefits as we implement this new platform. We expect to start implementation in the fourth quarter of this year. Within this new platform, there are opportunities to incorporate some of our digital advertising initiatives. The marketing team, focused on driving customer acquisition earlier in the purchase cycle, is developing improved content and enhanced digital marketing programs that aim to capture customers effectively, while they're in the ideation and purchase phases of their projects.

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

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Timothy J. Mulvaney, Lumber Liquidators Holdings, Inc. - Interim CFO & CAO [5]

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Thanks, Charles. Good morning, everyone. In the second quarter, net sales were $289 million, an increase of 1.8% over last year, with comparable stores flat versus a year ago. The overall net sales increase was driven by 10% growth in installation sales, supplemented by a 0.7% uptick in merchandise sales. The overall flat comp was the result of a 2.5% increase in average transaction value offset by a similar decrease in transactions. As Dennis stated, we continue to see strong growth in Vinyl products with offsetting softness in exotic solids, most notably in bamboo.

Gross margin for the second quarter of 2019 was 35.5% compared to 35.7% in the equivalent quarter a year ago. Both periods were favorably impacted by out-of-period duty-related adjustments. Without these items, adjusted gross margin grew to 35.2% from 35% in the prior year period. A more favorable mix towards vinyl, along with higher average selling prices, drove the improvement over the second quarter a year ago. Adjusted margin was up 20 basis points despite product costs that were higher due to the tariffs. The 35.2% was sequentially flat with the first quarter of 2019 as seasonally higher promotional activity, particularly during the April sale, offset other margin gains.

As noted earlier, the latest tariff increases were not part of our guidance last quarter. As such, our expectations for the remainder of 2019 have changed. We now expect to see adjusted gross margin improve in Q3 due to higher average selling price and in Q4 be tempered by the flow-through of inventory burdened with higher tariffs costs. This will cause some of the improvement to recede. We expect to incur the full impact of the 25% tariff on COGS late in Q4, as the tariff burdened inventory flows through our supply chain, but our mitigation efforts will not fully offset the latest impact until Q1 of 2020.

SG&A expense for the second quarter was $104 million compared to $102 million in the second quarter last year. SG&A in both quarters included incremental legal and other costs of about $6 million related to the lawsuits, investigations and certain other legal matters. Specifically, we booked a $4.75 million expense in the second quarter of 2019 related to the Kramer employment case that Dennis mentioned. Both periods' items are tabled out in the press release. When excluding these items from both periods, adjusted SG&A expense for the quarter was $98 million or 34% of sales, an increase of $1.9 million and flat on a percentage basis versus the same quarter a year earlier. Higher payroll from new stores and advertising costs were offset by lower legal fees and professional fees.

For the quarter, we recorded an operating loss of $1.4 million compared to an operating loss of $0.9 million in Q2 of 2018. After adjusting for the items noted above, we had adjusted operating income of $3.6 million in the quarter compared to last year's $3 million adjusted operating income in 2018. Improved adjusted gross margin was the single largest contributor.

Before moving on to our expectations for the remainder of 2019, let me address our liquidity which remains strong, as our core operations continue to generate positive cash flow. We paid all amounts related to the DOJ and SEC settlements early in the second quarter. As a reminder, we have also paid the cash portion of the MDL settlement from a year ago. For the Kramer employment case, where we recently reached agreement, we expect to fund that $4.75 million in the second half of this year. Our expectation related to the Gold settlement remains the same with payment expected later in 2019 or into 2020. The mechanics of the payment remain unchanged and are outlined in our Form 10-Q.

As a reminder, we did add $50 million of borrowing capacity at the end of Q1 by amending the company's credit agreement. This also extended the maturity to 2024. As of June 30, we had borrowings that consisted of a base term loan of $25 million and a revolving credit agreement with $64.5 million drawn. We had liquidity of $117 million consisting of availability under our credit agreement of $104 million and cash of $13 million. Inventory at the end of the second quarter was $304 million. However, with the expansion of tariffs on goods imported from China to 25%, we anticipate that inventory will expand in the back half of the year, and we'll end the third and fourth quarters in the $305 million to $325 million range.

Turning to our outlook. We are lowering our guidance for the year, and our 2019 outlook now assumes a continuation of the 25% tariff on Chinese imports for at least the balance of 2019, which is a change from our previous guidance that only assumed a 10% tariff. We have also experienced slower traffic trends than previously expected. As a result, we now believe total revenue will increase in the low single digits as compared to mid-single digits from our previously issued guidance and comps will be approximately flat for the year as compared to flat to low single digits previously. In terms of adjusted operating margins for the year, we are now anticipating this to be in the range of 1.4% to 1.9%. The expansion of tariffs to 25% has added considerable uncertainty to the back half of the year. The macroeconomic signals are mixed, and how consumers will react remains to be seen. In addition, as the industry fully digests the impact of higher tariff-related costs, we will closely monitor competitive dynamics and hard-surface floor pricing.

Our 2019 guidance reflects an assumption of moderating macro and consumer strength and an uncertain pricing environment in relation to rising costs. However, significant movement in any of these factors could meaningfully impact our outlook. As a reminder, we have included $2.3 million of nonrecurring expenses in 2019 in the back half of the year related to relocation of our corporate headquarters. But we do expect our ongoing evaluation of costs across the business to deliver savings this year, while also positioning us well for 2020 and beyond.

On the investing side, we plan to open 10 to 15 new stores in 2019. We expect capital spending of $15 million to $18 million. We anticipate cash paid for taxes will remain nominal and that the valuation allowance on our deferred tax assets will remain in place for the year. We see cash paid for interest to be in the $3.5 million to $4 million range.

Thank you for your time this morning. With that, I'll 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) Our first question is from the line of Budd Bugatch from Raymond James.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [2]

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I guess the first place I'd like to go is kind of talk a little about the traffic and the concern you have of moderating traffic and whether you can pinpoint any of the causes for that or in talking to consumers what you've learned about that moderating traffic?

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

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Budd, it's -- if you look at our traffic on a 2-year stack, we actually improved in Q2 over the prior year. It actually going against the stronger -- probably our strongest traffic comp from last year. It just -- we started to see things kind of slow down a little bit towards the end of the quarter in terms of traffic. And I think there was a little bit of that was driven by -- we believe what's going on just in the macro environment. There's a lot of noise in the news about interest rates and there always seems to, at least in my experience, is we always see a bit of a pause, waiting to see what's going to happen, seems to have some kind of impact on the bigger ticket. Obviously, especially if somebody's planning to finance that job. So we saw a little bit of that. As we said, we raised some retails towards the end of the quarter, but we don't believe that pricing was a factor. We just saw things kind of slow down a little bit. It was more towards the end of the quarter. We had great April sale and May was down a little bit and kind of more flattish in the month of June, but it was -- it just seemed like the slowdown kind of took place towards the end of the quarter and a little bit into July. Now in July, we had promotional calendar shifts. So we've got some things that are moving -- that moved to the back of the quarter out of July, 2 events, in particular, that won't -- they'll take place, they just -- they won't match up exactly with the -- so we think that probably was the primary driver of what we saw in July. So outside of just macro impacts, nothing material in what we did with the business. We just kind of saw that slowdown. Our merch comps actually improved quarter-over-quarter and we expect that to continue. And I would say we're probably are full -- probably through the biggest impact that we'll see as it relates to installation. As I've mentioned before, when we rolled out installation, we procure that entire transaction for the customer. So they generally might make two or three trips and I think that's just going to get lighter for us as a headwind as the year goes along and Tim has kind of unbundled the way that we did the Pros in the past. So that will be less of an issue for us as well. But I would say probably the primary driver that we saw, just seemed like there was a bit of a slowdown or a pause if you will towards the middle and end of the quarter.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [4]

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Was there any difference -- could you tell any difference in velocity of items on which you raised prices? Was there any noticeable change in the velocity of consumer acceptance of those products? Or did you not see that?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [5]

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Well, we did it -- we did it in the -- as we mentioned, we really did that towards the end of the quarter. So I think it's a little early for us to tell yet. But nothing noticeable at this point.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [6]

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Okay. And Altamonte Springs, you opened that. You talked a little bit about it last quarter, how good it was. You had 3 more months under your belt. What's the early read or the more intermediate term read on Altamonte Springs?

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

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We really like the results. I mean it's driving bigger ticket, it's driving product sales across -- more product sales across to other categories that we quite honestly have struggled in. And we were able, as Charles said, there was a couple of things that we've been able to glean from that store early on that we can apply to our existing store base and then we are planning to open our second open format store in Colorado within the month. So we're still excited about the performance of it and just kind of pulling the things that we're learning from that store that we could roll out to our existing store base as well as tweak -- making tweaks to that. We'll also retrofit a couple this year as well.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [8]

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Okay. And just for me, just 2 more detail questions. Of the $68 million of the accrual on the balance sheet for legal settlements, how much of that's cash? Was that the Gold settlement in there? And I take it the Kramer settlement's in there? Is there anything else in there other -- the MDL's in there, too, but that's noncash right, so Tim?

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Timothy J. Mulvaney, Lumber Liquidators Holdings, Inc. - Interim CFO & CAO [9]

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That's correct. The remaining MDL that's in there which is $14 million is noncash. The Gold has $14 million of noncash as well.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [10]

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So what's the cash portion of that $68 million that has to roll off?

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Timothy J. Mulvaney, Lumber Liquidators Holdings, Inc. - Interim CFO & CAO [11]

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Well there's still $21 million that we have as a liability -- $21.5 million related to the MDL but we have a corresponding asset on the asset side of the balance sheet. So it's still in the liability, but it's -- there is a corresponding asset, so no further cash would go for it.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [12]

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Got you. And lastly for me, on the inventory, how much of the inventory is now tariff? Can you quantify what, of that $304 million of inventory, is really tariff inside that inventory?

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Timothy J. Mulvaney, Lumber Liquidators Holdings, Inc. - Interim CFO & CAO [13]

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I don't have a specific number. But as you think about the impact on us, the 10% tariff as of June 30 had largely run through. That was approximately $22 million. And we turn it a little over 2x a year. So a little bit less than half of that had been sitting on the balance sheet.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [14]

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Okay. And so then we would have the -- of the additional $30-some million will -- think about the same way and kind of figure that maybe something like $15 million of that winds up on the balance sheet?

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Timothy J. Mulvaney, Lumber Liquidators Holdings, Inc. - Interim CFO & CAO [15]

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Yes, somewhere between $12 million to $15 million, I think would be a good estimate.

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Operator [16]

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Our next question is from Simeon Gutman with Morgan Stanley.

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Simeon Ari Gutman, Morgan Stanley, Research Division - Executive Director [17]

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My first question is on the merchandise, the product comps. Just high level, can you talk about why you think they haven't turned yet? It sounds like it's a combination of things, but want to hear your thoughts on it?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [18]

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Yes. I would say that bamboo is probably the single largest contributor beyond a doubt for us. It's been our biggest headwind. And as Tim mentioned on the call, that will become less of a headwind for us in the second half. We'll have fully cycled what I believe will be more normalized trends in Q4. But it's been, Simeon, a significant headwind for the company.

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Simeon Ari Gutman, Morgan Stanley, Research Division - Executive Director [19]

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Okay. Fair enough. My follow-up is on the gross margin guidance. Q3, you said up. Can you clarify, is that up year-over-year? Or is that up quarter versus quarter? And then related for -- to the fourth quarter, can you give us a sense of the magnitude of the compression that you're expecting?

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Timothy J. Mulvaney, Lumber Liquidators Holdings, Inc. - Interim CFO & CAO [20]

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Yes. This is Tim. In terms of your first question, it should be up to both. In terms of -- we're expecting that expansion to both top and continue the quarterly progression that we have started this year as well as top the prior year. It will -- in the second half -- probably the way to think about the second half is combined with the first half, we'll probably get back to about the same level as we had for 2018 for the full year, which was a little north of 36%.

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Operator [21]

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Our next question is from Oliver Wintermantel with Evercore ISI.

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Oliver Wintermantel, Evercore ISI Institutional Equities, Research Division - MD & Fundamental Research Analyst [22]

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I had a question regarding the ASP drivers. It looks like you were up about 2.5%. What was the split, was that -- how much of that was tariffs? How much was installation attachments and all of that, if you could clarify that, please?

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

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I would say, I don't really have how much of the -- I'd say most of it was probably ASP. There was a large contribution from installation. The installation mix, it's at 13% penetration and grew double digits for the quarter. So that's a -- that was a pretty large driver of our ASP as well.

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Oliver Wintermantel, Evercore ISI Institutional Equities, Research Division - MD & Fundamental Research Analyst [24]

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Okay. And from -- if you could update us on the Pro penetration? And then maybe related to that, if traffic was down about 2.5%, was that mostly -- do you have that, was it DIY or was there also a Pro component to it?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [25]

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I would -- no, as the Pro continues to penetrate north of 30% and the Pro traffic was up year-over-year as well. I would say, it was primarily the DIY traffic.

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Operator [26]

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Our next question is from John Baugh with Stifel.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [27]

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So I was wondering, Dennis, Charles, there was a final determination on engineered wood flooring out of China that raised rates significantly for many companies in China. Does that have any impact on you all, prospectively?

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Timothy J. Mulvaney, Lumber Liquidators Holdings, Inc. - Interim CFO & CAO [28]

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Prospectively it shouldn't have much impact. We've mitigated that. For what had previously run through, we have about a $800,000 item that -- if it goes and sticks because it probably will be appealed, if it sticks, we would have an additional $800,000.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [29]

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Okay. And then your 6 months molding and accessories is down a little bit more, I think close to 6% versus the year prior. And I'm wondering, is that the LVT? Or what's driving molding and accessories, which I think have high margins, lower?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [30]

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Two things are the driver that and primarily one item is the driver, is the adhesives that we sell or used to sell with our solid bamboos. As -- there's a -- it's riding the same comp performance as the solid bamboo. Another driver that we'll see as an impact for the next year or so will be, there's more of a -- there's a conversion from product without pad to product with pad attached, both in the LVT and in the laminate business. So that's a significant headwind for us. But it's driving most of the attachment erosion.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [31]

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Okay. And then lastly, I don't expect you to discuss your pricing strategy going forward. But could you at least tell us what you took pricing on late in the June quarter? And what the rough magnitude is? I assume, Dennis, we're kind of in a wait-and-see mode, because so many retailers have not yet seen the higher costs flow through. I'm just kind of wondering if you will offer any about how you think about pricing going forward as well as what you've taken so far?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [32]

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You bet. It's a great question. You think about, there was a fair amount of pre-buying that could -- where it could be bought, prior to the tariff. And I think different companies bought at different levels, so that probably impacted why you might see others move before others. But we were very conscious of that as we saw these tariffs roll through the quarter. And really Charles and the pricing team had kind of developed -- we had done a lot of competitive intelligence, both with the independents as well as the national chains to understand kind of where everybody was -- if there was any movement. So we wanted to make sure that we were competitive. And we applied those learnings to how we thought about adjusting price increases. Now the difference between the 10% and the 15%, as I said, earlier, everybody had time to prebuy, where for the 15% there was really wasn't any time. It was talked about and executed really within a short window and so with an order cycle that's north of 100 days, I doubt anybody buying anything out of China was able to prebuy. So we believe that there will be a lot quicker reaction to that tariff increase and the subsequent price increases will probably, I would say, accelerate through the second half of the year. So we continue to monitor it on a daily basis, literally looking at where the competitors are. We have seen a pretty significant uptick from the independents, while the national chains have been slower to move, depending on just the mix of their product. I think obviously you can imagine there's some products from China that have a shorter order cycle and there are some that have a much longer. Manufactured products, in particular, are primarily manufactured in China, so I think are going to hit everybody pretty quick. And again, we're fortunate enough we don't source laminate from China, so it's not something we've really had to focus on a great deal other than just making sure we were competitive. So we'll continue to apply those learnings through the back half of the year and adjust our retails as needed. We want to remain competitive. And I remind you, again, we're a high-low retailer, so we'll maintain our competitive posture in our promotional events anyway, but our day-in, day-out pricing's where we'll really make sure that we're paying attention to the -- to the cost, the inbound cost from the tariff increase. I mean because they're hitting us today, so.

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Operator [33]

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(Operator Instructions) Our next question is from Laura Champine with Loop Capital Markets.

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Laura Allyson Champine, Loop Capital Markets LLC, Research Division - MD [34]

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I just want to make sure that I understand the full potential impact from tariffs. Your 10-Q calls out a $50 million hit at the current tariff rates. Is that from what has -- is there any potential upside to that number if we go to list 4 or are all your products on list 3? And does that include the impact of slightly reducing your exposure to China from the 45% to 50% range to the mid-40s?

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Timothy J. Mulvaney, Lumber Liquidators Holdings, Inc. - Interim CFO & CAO [35]

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So as far as the latest list goes, no, we are not on that list. Our products are already fully impacted there. I think Dennis called that out on his notes. As far as the mitigation from moving to alternate country sourcing, no, that is a gross number before our mitigation efforts. So we're not expecting to see that $50-plus million come through our income statement because we've taken significant steps to mitigate it. That is the gross bill that the tariffs have put onto the company based on where we were buying.

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Laura Allyson Champine, Loop Capital Markets LLC, Research Division - MD [36]

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Can you give us more of a split on mitigation versus price increases, meaning if $50 million is gross, what do you think you can offset with mitigation efforts working with vendors? And what do you think you need to pass through in pricing?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [37]

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We haven't disclosed that. But I think it's a fair mix of everything we've talked about in the prior calls, Laura. There is -- there'll be a fair amount of it, taking in cost-outs through our vendors. There will be an additional portion, albeit smaller, a piece of it that we're moving or have already moved. And then we'll adjust the rest with retail. We currently believe we have everything in place to mitigate that cost.

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Operator [38]

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Our next question is from Rick Nelson with Stephens.

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Nels Richard Nelson, Stephens Inc., Research Division - MD [39]

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Do you think that the independents source as much from China as Lumber Liquidators? And if you can comment on the big box home centers also?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [40]

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It's a great question. We believe -- we do our own competitive analysis and believe that everybody is pretty much in the same boat as we are. I mean LVT, all the vinyl products, I would say, probably -- and this is my guess, but I would say probably north of 80% of the production currently comes out of China. So there is not much choice to move that product in the short term and there is a fair amount of emerging production in the U.S., but not enough to satisfy the demand. So I would say that probably everybody is sourcing that from China. The problem for a -- I would say the challenge, for an independent is that most of them don't buy direct. They buy through either a cooperative purchasing group or they buy from a distributor. And we have seen that the distributors are passing that additional cost on to the independents, and therefore, they have no opportunity to mitigate. That's what we suspect is happening. And I think we've even heard that on another call this week. So also I think the big-box stores by size are typically -- they seem to be challenged across more product lines than just flooring. So I suspect that they are bringing the same product in that we are. The vinyl is primarily coming out of China. Laminate, there's a fair amount of U.S. production now on laminate and has been for the last couple of years. We buy laminate from Europe and the United States, and I think most of our competitors buy -- I know one competitor buys a significant amount of laminate out of China. So I'd say everybody's probably in the same boat. As it relates to tile, we don't -- porcelain tile, we don't buy any tile out of China. So we're not -- we don't have to worry about that business. So -- and I know, we carry a small amount compared to everybody else. So it's not a problem for us. I would say that it's probably pretty even with the distributors -- or the independents kind of being at the mercy of their distributor. I suspect they buy some domestic solid wood and some engineered wood in the United States. But even that a lot of the components come from China.

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Operator [41]

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Our next question is from David MacGregor with Longbow Research.

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Robert Samuel Aurand, Longbow Research LLC - Analyst [42]

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It's Rob Aurand on for David this morning. I wanted to ask you about the alternative country sourcing. You alluded to getting China down to a mid-40% level by the end of the year. But I was hoping you could maybe talk about moving past the end of this year, maybe where that number could get to or maybe share what percent do you think can't be moved from China?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [43]

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Yes, so Rob, it's Charles. As I said on my remarks, we're working with a lot of our vendors who are looking at where they could potentially move production to out of China. But I think this is going to be moving quarter-by-quarter in terms of the insights we're going to get because many people are looking at pretty significant capital investment whether it's in Vietnam or Cambodia or other parts of Asia. And it's a dance, right? If the tariffs come off, then China still will remain the lowest-cost production. So even moving to Vietnam on a net basis may not be completely beneficial if tariffs come off. So we've got a good view of where we think our balance of sale is going to end by the end of the year. We are working with a number of suppliers, one of which has already broken ground, we close this in 2020, to move more production out of China. But at this point, we're not prepared to give a number below where we're sitting at the end of 2019 because, as you know, production lead times are pretty long on some of these manufacturers. And we need to make sure that they get all their licenses, that they're going to be compliant in the countries at which they're going to operate. We spend a good amount of time doing our due diligence around compliance and quality. And we need to be very careful that when we make a move, that move is to a new supply that's going to meet our compliance reg -- requirements. So we have a team that's been very diligent and has good work in the last 18 months on both the cost-out component with existing suppliers, which we continue to work with; new product introductions, which gives us an opportunity to leverage across our supplier base to further improve gross margin performance; and then work strategically with vendors where they intend to make commitments, whether here -- it's here in the United States, where some are looking at additional capacity to build here, or if they continue to build in Asia.

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Robert Samuel Aurand, Longbow Research LLC - Analyst [44]

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Okay. And I was hoping to ask you about mix. Just with the pricing, you put in late in 2Q, to what extent are you seeing customers trading down as a result of that?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [45]

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Yes. I mean that's interesting. I mean today we haven't seen any material change in mix between our good, better, best assortment. And so again, as Dennis said, this is early. We just put those price changes in at the end of June, and we drive a significant portion of our business on promotional mix. And so it will be a number of months before I think we see the insights into that to decide are customers actually trading down when they look at the -- their total cost of acquisition. I think the other thing that's important to bear in mind too on this cost side, we have a good growing installation business. And when you think about installation costs, it's basically half the price of the project. Those costs aren't moving. And so when you take the total project cost between material and installation, and our installation business is less impactful because you're not getting cost increases across the whole transaction, you're only getting cost increases on half the transaction. So again, it's not just looking at raw good, better, best in the product itself, it's looking at the mix across both our installation business and our DIY business.

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Operator [46]

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Our next question is from Brian Nagel with Oppenheimer.

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Brian William Nagel, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [47]

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So my first question, and a bit of a follow-up to the prior question, but just trying to understand better, the sales trajectory through the second quarter and into July, any -- sort of two questions with that. One, anything you could call out geographically? And then, second, I just want to make sure I understood correctly before, but I think I heard you say that at this juncture, you do not think that weaker sales or weaker traffic has been a function of actions taken as a result of tariffs, is that correct?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [48]

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Right. That is correct. The trajectory was -- we had a solid April and again, that was the best April sale we've ever had and I would attribute that to we had a good plan and our agency was new, and they did a really nice job for us. So May was down and then we started to rebound a little bit in June and then it tailed off more in July. And so we didn't see anything from a geographic perspective. This made us feel like this was more of a macro impact than just a pause, if you will, kind of it just seemed like -- we look at several factors, Brian. We look at the number of measures that we do for installation, we look at the number of visits we have to the site. We look at -- our conversions, our samples and none of that seem to fall off dramatically. It just seemed like there was a purchase pause, if you will. And so I just -- we saw this a bit in the fourth quarter when the interest rates went up and there was -- it seemed like the pause before the action seemed to resonate with our consumer. So -- but nothing from any geographic perspective. Outside of the hurricane wrap, but we also had lift in the panhandle of Florida where the hurricanes had hit earlier this year. So it's kind of our take on how the quarter progressed and what we think were the impacts.

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Brian William Nagel, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [49]

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Got it. The second question I have, when looking at tariffs and assuming that, in some cases, you will try to put -- push forward higher prices to mitigate the effects. But if you look at the product continuum in your stores, is there a way to generalize where the tariffs hit it? Is it mostly the lower priced product? And if that is the case, could you see a dynamic where this would actually push consumers maybe into a -- what had been a higher-price, higher-quality product that could essentially be higher margin for you?

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [50]

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Potentially, yes. And we are cognizant of that as we think about our pricing through our product price progression. So something that was a big gap in the past might not be such a big leap for a customer to go from an engineered to a solid, so to speak. There's not much in our mix, except for us, the laminate, that -- a lot of our engineered comes out of China. We have a lot of solid domestics that don't -- won't have the 10 -- or now the 25% impact. So it's highly likely that we could see that. And we've seen an improvement in our solid business. So just at the 10%. So it's highly likely that, that product that might have been out of reach for somebody before, just not in our consideration, might put it within reach. So we definitely have thought about that and think about that as we price competitively.

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Brian William Nagel, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [51]

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And then just one final question, shifting gears a bit, but -- Charles, can you talk a lot -- you've been talking about some of the new initiatives on the digital side, marketing side. How should we think about, as we're looking at our models and trajectory or expense trajectory for lumber over the next or several quarters or so, the extra investment needed to start to really fund and drive these initiatives forward?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [52]

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I think there are two major pieces of work that we have underway. One is the enhancement of our digital platform, which does not have significant incremental expense. It's a replacement of an existing platform. We've been working on that for a year. And that will have material impact on both the customer experience within the site and give us greater capability on driving greater efficiency on how we drive our current digital marketing spend. We're in the middle of looking at our 2020 plans today in terms of how we will make greater investments in driving our brand. Activation is a very important part of our strategy. But we have to add a mix as we start to utilize our new creative. You could see us applying more of our working media into that element of the funnel. And so when we think about the purchase cycle for our customers, 6 months lead time, we need to make sure that we are capturing them at the point of ideation and we are putting greater investment, particularly in the digital side, with social and the impact that social has as people are out looking at how they're going to make a decision on just what kind of flooring project are they going do before they even get to think about the location that they end up planning. And we are also looking at the efficiency of our media and how to reallocate out of -- which we continue to do this year, self-fund out of unproductive mediums into more productive mediums to drive an overall improvement in our advertising return on investment.

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Operator [53]

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We now have a follow-up question from Budd Bugatch with Raymond James.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [54]

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If I could just -- getting a little bit into the weeds, but in the stores I have seen some new product that was on solid polymer core, the wood veneer, which I see some of the majors starting to introduce too, I think it's under your AquaSeal brand, but this is a different product and pretty exciting product. Have you had any early read on the acceptance of that?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [55]

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Yes, Budd. Glad you're in our stores seeing all our new innovations, that's -- thanks for doing that. Look, we're excited. It allows us to really combine 2 platforms, right, which is a water-resistant and waterproof capability with a real wood veneer. And the feedback, I was in our stores last week and the feedback from our teams is that customers are excited about being able to now put those 2 together, allowing us to develop a new value proposition for customers. For sure that SPC core that you saw is a strong driver of waterproof, and the vinyl category we see as continuing to be a very strong category out through the balance of this year and into next year. And this just adds incrementality of us being able to be more creative with our engineered business and our bamboo business with adding that water-resistant capability on the SPC core.

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Beryl Bugatch, Raymond James & Associates, Inc., Research Division - MD & Director of Furnishings Research [56]

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And now the product that actually is all oak, is there -- are you going to be able to do that in some other veneers? And the product looks like it's made in China as well. So what's the capability of moving A, out of China, and B, to other -- to expand that to other products?

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Charles E. Tyson, Lumber Liquidators Holdings, Inc. - Chief Customer Experience Officer [57]

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So as I said before, on the moving out of China, we're looking at that on a daily basis. And there are suppliers that are looking at SPC capacity that would allow them to do this kind of production. And obviously, we will engage with them when they are ready. From a changing choice of product, yes, we're looking at multiple types of veneer that we could put on to this product to do different kinds of finishes.

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Operator [58]

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We have reached the end of our question-and-answer session. I would like to turn the call back over to Dennis Knowles for closing remarks.

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Dennis R. Knowles, Lumber Liquidators Holdings, Inc. - President, CEO & Director [59]

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Thank you, operator. Let me say thanks, again, to the LL team, our vendors, our customers and our shareholders for your continued support. Weak traffic has led to a slow start to the third quarter. But in this period of significant uncertainty, we remain focused on executing our transformation plan and proven initiatives to position the company for long-term success, while also working on the drivers of near-term financial results. We look forward to updating you next quarter as well as sharing the details on our longer-term strategic plans and financial outlook at our analyst conference planned for the fourth quarter. Thanks, again, for your interest in Lumber Liquidators, and have a great day.

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Operator [60]

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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.