LL Flooring Holdings Inc (LL) 2014 Q3 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the Lumber Liquidators third-quarter earnings call. With us today from Lumber Liquidators is Mr. Rob Lynch, President and CEO, and Mr. Dan Terrell, CFO.

As a reminder, ladies and gentlemen, this conference is being recorded and may not be reproduced in whole or in part without permission from the Company. I would now like to introduce Ms. Ashleigh McDermott, Director of Financial Reporting for the Company.

Please go ahead.

Thank you.

Good morning, everyone, and thank you for joining us today. Before we begin, let me take a moment to reference the Safe Harbor provisions of the United States security laws for forward-looking statements.

This conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements regarding the future operating financial performance of Lumber Liquidators. Such forward-looking statements are subject to significant risks and uncertainties.

Although Lumber Liquidators believes that the expectations reflected in its forward-looking statements are reasonable based upon currently-available information, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct. Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in Lumber Liquidators' filings with the SEC.

The information contained in the call is accurate only as of the date discussed. Investors should not assume that the statements will remain operative at a later time. Lastly, Lumber Liquidators undertakes no obligation to update any information discussed in this call.

Now I'm pleased to introduce Mr. Rob Lynch, President and CEO of Lumber Liquidators.

Rob?

Thank you, Ashleigh.

Good morning, everyone. I'm here with Dan Terrell, our CFO. And we appreciate you joining us today for a discussion of our third-quarter 2014 results, the outlook for the remainder of the year, and an update on our progress in implementing our strategic initiatives.

Let me begin with the third quarter which, as expected, was one of transition with the recovery from constrained inventory levels and certain key products; the kickoff of the fall flooring season; and the launch of our new Bellawood assortment. Our results for the third quarter included a net sales increase of 4.6% to $266.1 million, with a comparable store net sale decrease of 4.9%; operating margin of 9.7%; and net income of $15.7 million, resulting in diluted EPS of $0.58.

Overall, we were disappointed that our results were at the low end of our third-quarter estimates. However, we were pleased to see the progressive improvement of operations over the course of the quarter in conjunction with recovery of inventory availability. As a result, we believe our operations are likely to continue to show improvement in the fourth quarter.

We believe consumer demand for large-ticket discretionary projects, such as residential flooring, was weaker in the third quarter of 2014 than it was in the prior year. While we do not expect significant improvement in general customer demand in the fourth quarter, we do believe the improvement we saw in customer traffic to our stores during the third quarter will continue through the remainder of the year. As anticipated, clearance promotions, changes in our sales mix, and increased discounting at the point of sale reduced gross margin in the third quarter.

One of the more significant items impacting our clearance promotions, and therefore our sales mix in the third quarter, was the planned relaunch of our flagship Bellawood collection. As many of you know, we have invested in new finishes to further strengthen Bellawood as an industry leader. And we have broadened the assortment, with new stains and matte finishes which are unique in the industry.

The new products feature a lower sheen gloss, and the products they replace are being cleared from inventory. We expect that clearance to be completed by the end of the second quarter of next year. And until then, we will periodically run special promotions that we expect to drive customer traffic but yield lower-than-average gross margins. While these transitions place additional pressure on our gross margin, we believe this planned investment in our value proposition will further enhance Lumber Liquidators' industry-leading position for high-quality pre-finished wood flooring -- what the Company was founded on.

We have implemented solutions for the short-term challenges impacting our business to date this year. And at the same time, we have remained focus on executing our strategic initiatives planned for 2014. These included continuing to deliver our value proposition to a broader customer base; opening two new distribution centers; re-launching our flagship Bellawood brand, as I just mentioned; and gaining greater control of production, ranging from expansion of our finishing capabilities to vertical integration.

We believe our value proposition and competitive advantages continue to resonate with our customers. And as demand for residential remodeling improves and we progress through the long-term housing recovery, we remain confident in the outlook for the business.

With that, I will now turn the call over to Dan for a detailed review of our third-quarter financial results, and then will return to provide an update on our strategic initiatives and long-term outlook.

Dan?

Thank you, Rob.

Good morning, everyone.

I will provide additional details on our third-quarter results and our outlook for the fourth quarter of 2014. My references to percentage and basis point changes are in comparison to the third quarter of 2013 unless otherwise noted.

Net sales increased $11.8 million, or 4.6%, to $266.1 million, with an increase in non-comparable stores of $24.2 million and a decrease in comparable stores of $12.4 million.

Before I comment on comparable and non-comparable store net sales, I would like to touch on some of the factors that influenced sales at all stores during the third quarter. We estimate an aggregate net sale shortfall in the third quarter of up to $6 million, as constrained inventory in certain laminate, vinyl plank and engineered hardwood reduced our ability to convert customer demand to invoiced sales.

As Rob noted, however, our net sales improved throughout the quarter due to strengthening customer traffic, as products previously constrained were brought back to full availability. Laminates and vinyl plank recovered in August through early September. And engineered hardwood had materially recovered by the end of the quarter. As such, we believe net sales in the fourth quarter will not be materially impacted by the availability of these products.

We also believe our end-of-quarter promotion resulted in fewer invoiced sales than in prior years. As many of you are aware, we traditionally run an end-of-quarter promotion designed to create customer urgency and close a greater number of sales.

This year's end-of-quarter event, however, featured the Bellawood assortment, including the introduction of products with new stains and matte finishes, as well as additional clearance promotions on certain products which would not be a part of our continuing assortment. Though we were encouraged the promotion drove customer interest in the new products and believe it may lead to stronger sales of Bellawood in the future, the invoiced sales for the entire end-of-quarter promotion were below the net sales in the prior-year event.

Finally, we believe we remain in a weak consumer demand environment for large-ticket discretionary home improvement projects, including flooring. A range of complex factors influence this demand, varying down to the local level. But overall, we believe the demand for hard surface flooring, which began weakening in the fourth quarter of 2013, remains negative in year-over-year comparisons.

Turning now to our non-comparable stores, which included 42 locations opened in the 12 months ended September 30, 2014. Through the third quarter, we have opened 31 new locations, including 5 opened within the quarter. As many of you know, all of our new locations in 2013 and 2014 have featured our expanded showroom format and have a multi-year remodeling plan to provide existing stores with that showroom.

We have 61 stores opened with the expanded showroom format, and another 37 existing stores remodeled, either in place or through relocation within the primary trade area. Together, these 98 stores represented 28% of the 349 stores we were operating at the end of the quarter. Though an environment of weak consumer demand and reduced availability of key products impacted all stores regardless of age or showroom, we were generally pleased with the performance of the stores in the expanded showroom format and believe continued rollout of these locations will ultimately drive operating margin expansion.

Net sales have been disappointing in comparable stores this year, as soft demand for wood flooring reduced customer traffic. And constrained inventory levels adversely impacted our ability to convert the customer traffic we did see to invoiced sales. In our comparable stores, net sales decreased 4.9% in the third quarter, with the number of customers invoiced down 2.6% and the average sale down 2.3%. As noted, the percentage change in comparison to the same month of the prior year improved each month during the quarter, led by the improvement in the number of customers invoiced, which we believe relates to the recovery of inventory availability.

Further, we saw improvement during the quarter in certain areas that had been most severely impacted by the unusually harsh winter weather, including sections of the Midwest and Northeast. Though as a group, these weather-impacted stores underperformed all other stores, we estimate the difference between the two was reduced to 280 basis points in the third quarter.

Our average sale for the third quarter was $1,700, generally weakening each month during the quarter in comparison to the prior year due to the following. The sale of substitute products brought in while portions of our regular assortment were constrained. Greater discounting for customers willing to wait for products constrained. Clearance products, including Bellawood. And increased ad hoc discounting at the point of sale.

Partially offsetting these factors, adverse to the average sale, were increases in the sales mix of our Bellawood assortment; increases in the sales mix of moldings and accessories; and increased attachment of non-merchandise services, including installation. Except for the attachment of moldings and accessories, each of these factors impacting the average sale also reduced product gross margin, where a 220-basis-point decrease led to a total gross margin of 39.2%.

As most of you know, we segregate our gross margin drivers into those associated with our product, including our sales mix; those associated with transportation; and those associated with all other costs. We expect product margin in the fourth quarter to benefit from a return to targeted availability of our continuing assortment. But that benefit to be more than offset by greater clearance promotions, including both Bellawood and products brought in as substitutes for constrained products; greater point of sale discounting; and net changes in the sales mix, including increases in hardwoods and installation services.

In transportation, lower international transportation costs led to a net gross margin increase of 20 basis points. Aggregate international container costs decreased, as rates to our West Coast distribution center were significantly less than rates to the East Coast, benefiting total gross margin by approximately 50 basis points.

Partially offsetting this benefit were higher domestic transportation costs due to increased unit flow, including an increase in the inventory levels in store warehouses and a greater number of customers choosing delivery services. We expect a net transportation benefit in the fourth quarter of up to 50 basis points, as domestic unit flow is expected to more closely align with sales.

All other costs reduced gross margin by a net 60 basis points, as costs related to merchandise obsolescence and shrink, including changes in reserves, increased due to both our Bellawood re-launch and higher levels of inventory. We do not expect costs of obsolescence and shrink to materially impact gross margin in the fourth quarter of 2014 in comparison to the fourth quarter of 2013.

Selling, general and administrative expenses for the quarter increased $5.3 million, or 7.2%, to $78.4 million, due primarily to higher advertising, occupancy, legal and professional fees. As a percentage of net sales, SG&A expenses were 29.5% in the third quarter, compared to 28.8% in 2013's third quarter.

Salaries, commissions and benefits were flat in comparison to the third quarter of 2013, and decreased 50 basis points as a percentage of net sales to 11.5%. Primarily due to lower commission rates earned by our store management and lower accruals related to our management bonus plan.

Advertising expenses increased approximately $1.2 million, or 6%, and increased 10 basis points as a percentage of net sales to 8%. We continued to aggressively broaden our reach in frequency, which was partially offset by leverage of our national spend.

Occupancy expenses increased $2.5 million, or 29%, and a the percentage of net sales increased 80 basis points to 4.2%, due to store base expansion and the opening of our West Coast Distribution Center. Depreciation increased approximately $800,000, or 27%, and as a percentage of net sales, increased 30 basis points to 1.4%, due primarily to store base expansion; our program to remodel existing stores; and the opening of our West Coast Distribution Center. All remaining SG&A expenses increased approximately $800,000, primarily due to higher legal and professional fees.

Operating margin was 9.7% in the current year third quarter and 13.1% in the prior year. The effective tax rate was 38.8% in the third quarter of both years. And net income was $15.7 million, or $0.58 per diluted share, based on approximately 27.3 million weighted average diluted shares outstanding.

Turning to our financial position. Liquidity and capital resources, cash and cash equivalents were approximately $10.8 million at the end of the third quarter, down approximately $70 million over the nine months of 2014. As operations produced $32 million, capital expenditures used $56 million. And net investing activities, including our share repurchase plan, used $46 million.

Available inventory per store was $716,000 at the end of the third quarter, up 4.2% from the beginning of the quarter and up 7% over the end of the third quarter 2013. Increases during the quarter were primarily due to weaker-than-expected net sales; additional products utilized as substitutes for constrained items; and an increase in solid hardwoods and related moldings, including products to launch our Bellawood assortment in October.

Capital expenditures in 2014 are significantly higher than 2013 due to store base expansion; the remodeling of existing stores; property and equipment related to our new distribution centers, now totalling $44 million; and expansion of our finishing capacity and vertical integration projects, which now totals $7.8 million.

During the quarter, we repurchased 257,000 shares of our common stock, using $14.7 million of cash. At quarter-end, we were authorized to purchase an additional $14.7 million. We remain committed to using any excess cash to repurchase shares to reward our long-term shareholders.

Turning now to our revised outlook for the full year 2014. We now expect net sales for the full year in the range of $1.05 billion to $1.065 billion, with a decrease in comparable stores' net sales in the low single digits. This implies a fourth-quarter range of $275 million to $290 million, with comparable stores ranging from a decrease of 2.8% to an increase of 2.4%.

In the fourth quarter of 2014, we plan to open three new stores, all in the expanded showroom format, and remodel two existing stores through relocation within the primary trade area. We plan to end 2014 with 34 new stores and 17 remodeled stores.

We now expect the fourth-quarter gross margin to expand from the Q3 level, but remain under pressure from clearance discounts and net changes in our sales mix, including increased penetration of our Bellawood lines. Based on our more recent sales trends, we expect adverse changes in our sales mix led by clearance of products which are not a part of our continuing assortment, to reduce gross margin by up to 100 basis points in the fourth quarter of 2013. And net transportation costs to benefit gross margin by up to 50 basis points in comparison to the fourth quarter of 2013.

We expect total fourth-quarter SG&A expenses to increase 10% to 11% over the fourth quarter of 2013. We now expect full-year earnings per diluted share in the range of $2.38 to $2.52, based on a diluted share count of approximately 27.5 million shares, which is exclusive of any future impact of the stock repurchase program. This represents fourth-quarter EPS of $0.71 to $0.85 on a diluted share count of approximately 27.3 million shares. I'll now turn the call back over to Rob for additional remarks.

Thanks, Dan.

I want to reiterate that we have implemented solutions for the short-term challenges impacting our operations. I believe the Company has never been stronger or better positioned to take share in our fragmented market. And that neither our strong business model nor the opportunities for our long-term growth have diminished. In fact, I believe they are enhanced by our record capital investments and continued focus on executing our strategic initiatives.

I can tell you with confidence that our team is energized and ready to deliver on those opportunities for long-term growth. Our operating results in 2014 may have somewhat masked successful implementation of our initiatives. But our people are focused on delivering our value proposition to a broader customer base and providing them with the best assortment of high-quality products, led by our Bellawood collection.

Our mill direct-sourcing model, and the training and development of our flooring experts to best serve our customers, represent the foundation of our value proposition. I believe that value proposition remains the best in our industry. And that Lumber Liquidators, with our two new distribution facilities, expansion of our finishing capabilities, and investment in vertical integration, have us structurally better prepared for growth than at any time in the past.

We believe we have significant opportunity to grow our customer base within an available market of 74.5 million owner-occupied homes, and that we have only penetrated one room in less than 4% of those homes. We look to win customers and sell into these untapped rooms and homes through both store-base growth and increased traffic to our existing stores. We will continue to utilize our market optimization model in targeting annual unit growth in the range of 8% to 12%.

We intend to continue to aggressively use marketing and branding to increase awareness of our value proposition within the large demographic of customers who do not consider themselves do-it-yourself, or DIY. Our well-trained sales force and the increasing number of stores in retail-centric locations position us well to serve these customers.

In addition, we are targeting an increase in average sale by offering the customer a more complete ticket through expansion of both our non-merchandise services, including installation, and our broad assortment of moldings and accessories highlighted within our expanded showroom format, which will soon be in one-third of our stores.

As we further broaden our base of customers, we are planning the continued rollout of our installation services, now in 73 of our stores. With only 1 in 10 of our customers currently opting for installation services, we anticipate that this offering will grow as we gain greater control of the entire customer-facing transaction.

Regarding our supply chain optimization initiatives, we continue to make progress on the consolidation of our existing East Coast distribution facilities into a single larger location. We have taken partial possession of the new facility, and are able to ship product into the new distribution center. We remain on-plan to begin shipping from the facility late in the fourth quarter, and continue to anticipate benefits to operating margin beginning in the second half of next year. We expect our new West Coast and East Coast facilities to enhance our operating income through improved productivity and operating efficiencies.

As we look toward 2015, we have a significant opportunity to grow the business; drive continuous improvement; and further invest in the customer. Despite a challenging year, we have continued to implement the strategic initiatives and our long-term value proposition, which we believe will successfully position Lumber Liquidators to regain momentum and expand operating margin in the coming quarters and years.

With that, Operator, we are now ready for questions.

Thank you.

(Operator Instructions)

Our first question comes from the line of Simeon Gutman with Morgan Stanley. Please proceed with your question.

Thanks. It's Simeon Gutman.

First, Rob, a big picture question. We're trying to assess whether some of the gross margin problems are cyclical or structural, and based on your forecast, they certainly seem cyclical.

With the risk of beating a dead horse, can you walk us through the dynamic that led to all this compression? I know you disclosed the product margin in the Q and on the call. But are your sourcing costs -- did they go up during this period as well? Can you break out what the discounting was versus some of the Bellawood -- versus some of the promotions? And then I have one follow-up.

Yes, I'll start and then Dan can kick in with some of the specifics. What I'll tell you is, as we said in the past, we've not seen any -- from some of the challenges we've been facing on the constrained products side, we haven't seen any material increase in cost. And as Dan said in his script and as we laid out in the Q, what you really see here are short-term challenges that we are working through and we feel good about.

The constrained products are coming back in. The Bellawood transition, that is -- the scope of that I think needs to be understood. We're changing out the entire Bellawood collection, and we've enhanced and expanded it in every single item.

Even though it's continuing on in the assortment, it has a new finish on it, like we said, with slower gloss. So we have to clear out that old inventory. This is great product, not inventory that we have to slash and burn, but that we have structured plans to sell through, as we talked about, into next year.

So I would tell you that with constraint coming back in, with the traffic pick-up in the stores, the confidence level of the field in terms of them having the products now that they need to sell. The constrained product has kind of a compounding effect when you're out of the potentially high ASP high-margin item, in that the store doesn't have that for the customer and they have to trade that customer off to somebody else.

There's three scenarios. You either lose the sale or you trade them off to something else. And what typically happens is, that other item has a significantly lower gross margin and ASP. And that's part of the issues here.

The other thing is on the customer service side, our store did more ad hoc discounting, and appropriately so. Because, again, to take care of the customer, we want to capture that sale. So we would absolutely allow the stores to discount to entice the customer to wait for the constrained items, as that's going to be coming in down the road, if it's going to be coming in soon enough, and order trade to something else.

Dan, do you have anything you want to add?

Yes, Simeon, I would reiterate what Rob said on the Bellawood. That, that's something that's going to put pressure on margin from here on out, that we're really excited about the new assortment, but it does tend to carry a higher average retail price point and a lower-than-average gross margin. The short-term impacts -- clearing the liquidation product, clearing some of the Bellawood SKUs that aren't going to be part of the continuing assortment -- certainly compressed margin over the shorter term.

As we look into 2015 -- and we'll talk about full guidance for 2015 on the next earnings release. But even in the prepared comments, we expect inventory levels to normalize to the continuing assortment sometime in the second quarter of 2015. And we also made reference in the Q that we believe the 41% gross margin we did in aggregate for 2013 is where we will again consolidate around for future expansion of that gross margin.

So we still believe the drivers are there. We believe we're working our way back to that 41% as inventory levels normalize. And then we'll be able to expand that with the transportation benefits, the reinstitution of discipline around ad hoc discounting, and some of the other drivers we talked about in the past.

Okay. So the follow-up is, you took the $1.5 million reserve, and I think that cost about 60 BPs, and that's largely on the Bellawood, if I'm not mistaken, on that old product that's being written down or discounted.

Does that capture the, let's say, the full mark of discounting into next year? Or we are going to see additional pressure from that? And then, why couldn't you have taken a bigger mark-down and just throw it all into this year so that you minimize some risk going into next year?

Simeon, I'll tell you that it's a reasonable and conservative estimate. We looked forward based on the inventory levels we had, what our plans were. Higher inventory levels of all products always want you to account for shrink, so there is some additional adjustment for that.

Obsolescence for us relates more to stranded inventory levels. There are always some cost mitigation strategies that can reduce the impact of less than [job lock] quantity, but you take that into consideration.

And then there's the ultimate sales process. Do you believe you're going to sell any of this at a lower-than-average cost?

So we've taken a very disciplined approach, very regimented approach. And what we have in the third quarter we think is reasonable and conservative.

It does mean that there's some potential for future impact. It certainly will not be as great as we've seen in the third quarter. It's unlikely that 2015 will see anything like what's in the third quarter or maybe potentially in the fourth.

So worst impact in the third, perhaps some impact in the fourth as we actually do our physical inventories, look at what the actual shrink comes in at, and do our final year-end close. That is probably the end of the material impact, but certainly some opportunity for it to continue into first quarter of 2015.

Right, but to clarify, the pace of it, and facilitates by the second quarter, once that inventory is all gone, then it should largely disappear.

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

Okay, thanks.

Thank you. Our next question is from the line of Matthew Fassler with Goldman Sachs. Please proceed with your question.

Thanks a lot. Good morning.

My first question relates to the discounting at the point of sale. It sounds like that's been happening a lot as you've worked through your supply chain issues. How do you wean yourself off of that?

One of the big advancements you had made in protecting gross margin was improving pricing discipline. It sounds like your organization has moved in the other direction.

I'm not sure if that's happened by way of directive, or if it's happened spontaneously. But how do you tighten that up again? Because that was a big factor behind the gross margin improvements that you had shown.

Yes, Matt, we have very good visibility to that. In fact, I can report I see it every day by store. And we actually track it by person.

So to go back to one of the earlier questions, though, it absolutely is something that we want to have available for the stores. And the fact that they were doing it was not that it was out of control; it was because it was a tool for the stores to mitigate the impact from a constrained inventory perspective to take care of a customer and keep a sale.

So what we saw in the ad hoc discounting was expected. It was allowed and approved by us. We have great visibility on it.

And we also have a multi-year plan. We have selling training and all kinds of disciplines around it, and I'm confident that it's where it needs to be.

It's even realtime this quarter; we're looking at it daily. It's about where it needs to be. It's improving slightly compared to last quarter. And I think over time, I can confidently say that it's something that will be a contributor to margin enhancement over the next three to four years, as we gradually tighten down on it appropriately, but still leave the stores the ability to be competitive and never walk a sale.

Got it. And then a second question, if I could. I'm trying to understand the new Bellawood product, and why now and what the differences are. Obviously, this is a moment in time when your supply chain has had issues related presumably to working through some of the compliance dynamics that you wanted to [earn fence] earlier in the year. It seems like in addition to the other challenges you have, you are now having to write down a substantial -- or take write-downs or mark-downs on a substantial portion of your inventory to introduce this new line.

So what's the thought process on that? Because in the short run, certainly for several quarters and I think longer than we initially thought, given the comments on promotions through spring, it seems to be weighing on the profitability of the business.

Well, Matt, it's a great question, and I appreciate that. The problem is, the train had left the station. This is something we've been working on for over 18 months, and it was part of our multi-year strategy for us as we were planning the growth of the business and the investment into the -- specifically, investing into the value proposition on quality, and Bellawood being our premier brand and our statement of quality out there in the marketplace.

So again, this is something that entailed a year and a half of work, multiple months of line reviews with our finishing vendors, the development of the new technologies into the finish, and the testing and the applying of that to all of it. And then the planning out and the transition of all the assortments of the new finish. And then we also expanded on top of it.

So it's a very significant undertaking, absolutely, and if we had known what we were going to be walking into this year, we probably wouldn't have done it. But it was something that, in hindsight -- and I was touching on it in my prepared comments is, I'm extremely proud of the team on all of the major strategic initiatives that we've stuck to our strategy on this year. And I think we're all going to be very pleased as we get into next year and we've got Bellawood in place.

Because the initial acceptance by the customer is incredible. The customers are loving these -- the new finish across the board on any old floor species. And then they are loving the new expansion into these matte finishes.

And so I think when you combine that with two new distribution centers investing in the availability part of our value prop, you put that on top of our best people and the training and development and the upgrading of our field organization and the flattening of that, with me being closer to it. And then the vertical integration projects and the finishing line investments. So, very tough year, absolutely.

A lot of initiatives along the way that have been very difficult for us to handle while dealing with these challenges, but we're dealing with them. We're getting them behind us, and these initiatives are being implemented. Again, I think as we come out of this and get our traction at the end of this year and into 2015, we are going to leverage off all of those investments, including Bellawood. So it's absolutely the right thing to do for the Company.

Thank you.

Thank you. Our next question comes from the line of Peter Keith with Piper Jaffray. Please proceed with your question.

Hi. Good morning, everyone.

Good morning.

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

Yes, Peter, that's a good question. Again, not to blame everything on the constrained products, but I will tell you that one of the issues was, as we were constraining some of our other products, our initial plan in the Bellawood transition was to clearance out and sell through a lot of that inventory in the distribution centers. But as a way to ensure the stores had everything else that they could sell, we allowed the teams to push out a little bit more of the old Bellawood product from the DC into the stores.

So we had more of -- what we ended up having was more of that out there to sell through in clearance. And it's a little bit more difficult to clearance it out in a store -- depending on the volume and the project quantity levels -- than it is to sell out of a DC. So that is a bit of a technical, specific reason why the Bellawood is taking a little bit more of a hit on gross margins right now, and why we're protecting it to also into Q4.

Dan, do you have anything to add to that?

Peter, let me just add to be very clear that when I reference clearance in the fourth quarter, it includes Bellawood, but it's also clearing the substitute product that we brought in for the products that were constrained. Now that we're fully back in stock, we need to clear that product. Part of it will become part of our continuing liquidation inventory, but we are going to need to run some more aggressive promotions to clear that product as well.

The good news is we're back in stock. There is customer acceptance of the new Bellawood. But if we were not in as low a traffic environment as we're in, we might not have gone after either as aggressively as we plan to in the fourth quarter.

Okay. To follow up on that, would the clearance -- it looks like there's two dynamics. You're talking about you're clearing out the old Bellawood product; you're also now clearing out some substitute product from the inventory shortage period.

Right.

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

They are probably fairly close to equivalent as far as their impact on making up that 100 basis points in Q4. Our thought is that Bellawood is probably going to run through our April sale in the second quarter of next year. Obviously, diminishing inventory levels will reduce the impact that it will have on sales in 2015.

I would love to be able to say that we'll be done with the substitute product in the fourth quarter. I believe we will from a materiality standpoint. But I do think there's some opportunity for that to go into parts of Q1.

Okay. Thank you very much.

Thank you. Our next question comes from the line of Matt McGinley with ISI Group. Please proceed with your question.

Good morning. My first question is on the pace of the comp over the quarter. How different was that comp over the course of the quarter? You ran a negative 4.9%.

Where did it start and about where did it end? And most importantly, given we tend to focus a lot on momentum is, where are you at quarter-to-date, and is it around that zero midpoint you implied for the fourth-quarter comp?

Yes, the second quarter ended with one of the worst months I've seen in a decade, in June, and July wasn't nearly as weak. It then improved quite a bit in August, and September continued to look good from a traffic perspective.

We began to see -- the traffic improved each month during the quarter. Average sale weakened a little bit as the quarter went on, as we started offering those discounts and had some clearance product in there.

The end-of-quarter event -- I think September would have been stronger if we had run a campaign that created the same level of customer urgency that it did in the third quarter of last year. But instead, we chose to feature our Bellawood product assortment, which included an introduction of the product.

And because of the long sales cycle, you really can't introduce that in event and expect a customer to close it all within the same time period. So our sales were a little bit down year over year as we closed the quarter, due to that event. But growing traffic during the quarter and slightly weakening ticket during the quarter.

And Matt, the thing that I would add is, I think that was the thing that was positive to us, was that the traffic continued to improve, and that particularly, as you got into September, continued to improve. And I would say, to Dan's point, the combination of the Bellawood event and still lingering impacts from constrained issues is really what didn't give us as good of a September as we would have liked.

But again, still better than the prior months in the quarter, but promising because of the traffic. And with the constraints now continuing to come in and be where it needs to be, it gives us a good feeling going forward with our guidance for Q4.

But just to hone in on that, the traffic looks good in October to-date?

Yes, we're please with what we've seen so far.

Okay. My second question is on the bigger picture, with what happened with the gross margins over time. I think one of the material concerns for people that don't maybe buck it out and look at the drivers of your gross margin over time is that a lot of the increase that you had over the past three or four years is largely unwound as you invest more in quality control and the thought that the Asian sourcing initiatives that drew so much of the gross margin in 2013 and 2014 will largely unwind.

If you could help us buck it, how much of the expense or how much of gross margin over time do you think will need to be invested, or has been invested rather, in the quality control or more US production? How much of an impact will that ultimately have on the gross margin over time?

Matt, I'll start and let Rob finish that. As I've said, I think we're coming back to the 41% we got to in 2013, which was roughly about a 600-basis point improvement over a couple-year period against 2011 numbers. We have certainly given back a couple hundred basis points in this quarter because of what we think are some short-term events, not really increases in the costs that we think are going to stay with us.

So there's no question we've been investing in quality since 2011, and we'll continue to do both quality control and quality assurance. But we're still fairly confident that when we get through some of these short-term issues around our inventory assortment, that we're going to get back to that normalized gross margin of roughly 41%, and we can then start to field on that again. So I don't think we've permanently given back any of the increase that we saw through 2013.

And I'll add a little color to that, too. To your specific question about cost increases through the Asian sourcing. As we've said, nothing material there as you look at any of the price increases that we have seen, some from the domestic side based on what's been going on here the last couple of years.

But relative to over there, I want to take you back in time. If you remember, as we started these social initiatives in 2011 -- and I think in the past we've actually bridged some of the benefits to break it down for you, which would give you color on that. But there was a significant amount of it created just by eliminating the middle man and getting back to the direct relationships with the mills. So the acquisition of Sequoia, the taking out of the middle man.

I mean, we had distributors serving the Company pretty much across the board in all the Asian product, all the South American product, and even in the bamboos we're buying from over in China. So that was a significant improvement when you took out that mark-up from those distributors.

On top of that, as we started doing the line reviews -- if you recall, our first line review was in the laminate category, Dan, right? Given the fact that we had these middle men in between, as we started doing these line reviews, we were quick to realize that there was a significant opportunity for us to get closer to market pricing with our purchases and how we were negotiating, because that wasn't really being done through the distributors. So those discussions and negotiations and line reviews is really what continued to add to the benefit and the margin, is getting us competitively where we may not have been over time because it was being done by an intermediary.

And on top of that, as you recall, as we got closer to these mills, we started getting other help from them in terms of sample assistance and marketing assistances. We continued to drive margin through things in the operations in the business here. So again, I would just give you some color and some history around where the benefits came from.

And I think that, to Dan's point, I strongly believe that us getting back to a steady state of 41% and then building off of that next -- shooting for a number like that next year and then over multiple years, leveraging the investments that we've put in the last couple years. Including vertical integration, including the DCs, including the pricing disciplines with the field and the benefits we think we can have there. We think that, that will create a higher foundation for us and that we're going to build off of that over multiple years, is our expectation.

Okay. Thanks a lot.

Thank you. Our next question comes from the line of Keith Hughes with SunTrust. Please proceed with your question.

Thank you. Turning back to Bellawood, is this a complete re-launch of Bellawood? What percentage of the products are you taking out and putting back in?

100%. And then we added a number of SKUs; we expanded the assortment.

So for example, if we had a three-quarter-inch Brazilian cherry Bellawood item -- a core to our assortment before -- we're still buying that same wood underneath, but the finish has completely changed. It's a completely new finish, and we've gotten rid of the old one. The gloss and the look and the sheen -- everything's different about the look of it, even though the material underneath is the same.

So in that effort, you have to remake every single item and give it a different SKU number and put it into the assortment, and then sell through and get rid of all the old. And along with that includes the moldings, the accessories, the stair treads, the grills, you name it. So that's a very big undertaking.

Refreshing products is part of the business. But why such a large, just complete turnover of the products in a fairly short period of time? Why not keep some of it out (inaudible)?

Well, because it was a strategic investment in the finish itself, which is what makes up -- creates a competitive advantage and is the true investment in the value proposition for the customer. So we took an industry-leading finish and we enhanced it significantly. As you compare and contrast to the old one and to anything in the marketplace, it gives us a very significant advantage in the market on quality, in terms of scratch and scuff resistance, the look of the sheen and the gloss, the ability -- how durable it is for the customer.

And we put on it a 100-year warranty on top of it. That's the reason why, is because when you change the finish, you have to change it on everything, because it goes with the whole line.

And on your -- you had mentioned earlier the 73 stores that have installation ability now. I assume those are all stores of the future. Is that correct?

No, no. Some of them are the old format as well.

We're rolling out -- now, the thing about it, Keith, installation is still coming through HSS as well, our third party business partner. So all of our stores have installation services. Those 73 are where we're doing the customer-facing part, and we're going in market by market to do that. So when we run into, or enter into a new market to put those services in that will do the customer-facing impact, that will have both new and older stores, and not all of them will be in the store-of-the-future format.

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

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

Is that communicated to store employees? Because, I'll be honest with you, they're pretty quick to discount when you go into your stores.

Absolutely, it's communicated to them on a regular basis. There's training around it, and they have gross margin plans. And then the specific discounting is reported and looked at daily. So we follow up on anybody that's going outside the reservation.

So there's standards and procedures for them. When they can do it, they're supposed to be verifiable for competitive reasons only, typically. But we do know we have some folks that are more apt to wheel and deal, depending on how long they have been with the Company. So this is a discipline we're changing over time.

Okay. Thank you.

Thank you. Our next question comes from the line of Dan Binder with Jefferies. Please proceed with your question.

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

It absolutely was planned out to go over time and to extend into next year. So it is pretty much going according to the terms of the timing of the transition, the bringing in of the new product and the transitioning out of the old. That plan has been in place and we've been executing around it.

Some of the complicating factors were, again, some of the other issues we were having in the supply chain around availability, and constrained products in other areas was putting that burden on the supply chain and on our resources in those areas. So that kind of bottlenecked itself and created some of the issues.

Okay. Is there just the --

Again, just the managing of big chains like this on top of these -- as these constrained items came in, it kind of all snowballed and created a lot of short-term challenges for us that we had to work through. The good news is that we've got our arms around them now. I'm going back to just some of the earlier discussions where we've seen traffic picking up.

These constrained items are in stock. The new Bellawood items are all available and in the warehouse and they are not constrained. The customer is appealing to it very nicely. And I think that as we move forward, we're going to see these challenges get behind us. And we'll -- in our guidance is, we've thoughtfully put mark-downs in there, as Dan talked about, for some of the substitute products and the Bellawood.

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

I would say it's a function of weaker sales, some of the compounding issues from the constrained products. As I mentioned earlier -- I don't know if everyone picked up on it, but we also, in an effort to make more product available for the stores, we did push out more of the Bellawood that we would typically sell out of the warehouse. So some of that got trapped, and it takes a little bit more of a discount to get it out of those stores. That is something that we didn't contemplate.

But again, we did that in response to some of the constrained products in opening up some of the ordering so that the stores could have availability of -- have enough availability of other products. So they can -- as they were trying to shift customers to other items, they had that with them in the store, so they could satisfy a customer that might have been there for something else.

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

Yes, he's been here since, I believe, February. So we've recently promoted him to a larger role as to the change that we've made. And then we've been building out his team as an overall investment in quality and assurance and compliance.

And those teams are in place, they are helping us continue to -- just like everything we've done over the last several years, we've had a philosophy in the Company of continuous improvement. So we absolutely feel that, as we said before, that our controls and our compliance efforts were absolutely appropriate and where they needed to be.

But with the addition of the team and these new resources, we have them looking and investing and helping us raise the bar and getting better, raising the standard. Which I think we are excited about and feel good about as we go forward. We see it as an investment in the long-term value proposition of the Company, just like the distribution centers.

In fact, some of the investments we're making relative to vertical integration in the distribution centers in these new finishing lines are going to give us the ability from a compliance perspective to control more of our products and to give us the flexibility and the redundancy. So that if we think -- say we run into an issue down the road with a particular vendor or what have you, we have the capacity to take that in-house and not run into another constraint, other future constraint issues like we've seen recently.

So we're excited about that. Those operations, as they get up and running, it's really one big integrated project. The excess DC frees up space here, lets us put these new finishing lines in.

And then the vertical integration initiative -- where we actually are going to be buying raw material, drying it and cutting it and profiling it to feed into our finishing line, really gives us -- I see that as an investment in compliance and sustainability as a Company. So all a part of that effort in terms of bringing them in.

Thanks.

Thank you. Our next question is from the line of Laura Champine with Canaccord. Please proceed with your question.

Good morning. Could you comment, Rob, on whether or not you think you gained or lost market share in the quarter? And what the competitive dynamic is like today?

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

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

Yes, Laura, there's no question it's higher than we anticipated it being. And it is going to take us probably into the spring to normalize that level.

We tried to put in the Q where we thought the normalization would be. I think as maybe as low as [6.50, 6.60], and as high as [6.90]. So you might be talking about $30,000 per store from here that we need to work off, $30,000 to $40,000 per store. And you can think of that as including the clearance product for substitution, as well as some of the older Bellawood.

We do hope to get rid of the lion's share of it in Q4, certainly of the substitute product. The Bellawood transition is going to continue on into the spring, run through the April sale. Certainly will not impact gross margin to the degree it has, but may have some small impact in the first quarter.

Thank you.

Thank you. Our final question comes from the line of David MacGregor with Longbow Research. Please proceed with your question.

Good morning. Not to beat the discounting issue to death here, but can you just remind us how the RSA's compensation is tied to discounting?

Are you talking about the store manager?

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

Yes, their compensation is based on their sales plans, and then they have some gross margin budgets and plans that they are held accountable to, but it does not drive their commission. But it does for the regional managers, their boss. What we do there is we keep the stores focused on the top line with, again, within the overall budget, which obviously dictates their overall performance level and their performance ratings and their annual increases and how they're doing.

So obviously, you are not compensated on your discounting, but you can be terminated for it if you get too much out of line. And then on top of that, the regional managers have a material part of their bonus structure tied to the gross margin, and therefore the discounting levels within their stores.

A second question just on installation deliveries. To what extent is this impacting your fourth-quarter margin expectations?

And then, is it just purely a cost avoidance benefit versus what you're doing with HSS? Or are there noticeable improvements in those 73 stores on closed rates and comp growth, so on, so forth?

It is going to be a factor not only in the fourth quarter, but as we look forward. And just to really quickly back up -- delivery -- we have about -- as that increases, we only have a slight mark-up to the customer. So that may have a gross margin as low as 10% on that, really just to try and cover the administration of the program.

Installation may be in the mid-30%s, as far as a gross margin, so that it is less than the average. That will put some pressure as that program expands.

We do believe there's overall benefit to the program, as far as attachment rate and our ability to interact with the customer from the beginning of the transaction to the end. It doesn't mean, though, that the experience is not good with HSS; it certainly is. We just believe that our investing ourselves in the customer-facing part of the transaction will increase the attachment rate over time.

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

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