LL Flooring Holdings, Inc.

Good morning, ladies and gentlemen, and welcome to the Lumber Liquidator's third quarter 2020 earnings conference call. As a reminder, this conference is being recorded and may not be reproduced in full or in part without permission from the company. I would now like to turn the conference over to Danielle O'Brien. Please go ahead.

Good morning, everyone, and thank you for joining us. Today, I'm joined by Charles Tyson, our President and Chief Executive Officer, and Nancy Walsh, our Chief Financial Officer. As we begin, let me reference the safe harbor provisions of the US securities laws for forward-looking statements. This conference call may contain forward-looking statements that are subject to significant risks and uncertainties, including the future operating and financial performance of lumber liquidators. Although lumber liquidators believe that the expectations reflected in its forward-looking statements are reasonable, it can give no assurance that such expectations for 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 Liquidator's six filings 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 after today, and Lumber Liquid Clears undertakes no obligation to update any information discussed in this call. Now, I'm pleased to introduce President and CEO, Charles Tyson. Charles?

Charles Tyson Thank you, Danielle. I'd like to begin by acknowledging our team for their continued dedication and focus that enabled us to deliver a very strong quarter. Our transformation is well underway, and our associates demonstrated strong operational execution of our plan by remaining agile and customer-focused through the quarter. Our entire team, from our sales associates to our DCs and support centers, have shown great commitment, flexibility, and perseverance throughout this entire year to deliver both outstanding results and terrific customer service to our flooring customers. I'm very proud to be leading such a dedicated team who are working every day to execute our transformation strategy and are committed to delivering a high-touch consultative experience for our hard surface flooring customers. Turning to our positive results for the quarter. We continue to make strides with our transformation plan, and we saw evidence of progress on multiple fronts. As comp sales increased by 10.9%, the gross margin expanded 320 basis points over Q3. Adjusted SG&A was $4.5 million lower than last year, and we delivered $28.7 million in adjusted operating income for the quarter, a significant $25.3 million improvement in adjusted operating income versus last year. As we continue to navigate the COVID-19 environment, we remain focused on monitoring all factors influencing customer demand, including existing home sales and mortgage rates and consumer confidence. During the quarter, we continued to execute against our strategic pillars of people and culture, improving the customer experience, driving traffic and transactions in our stores and online, and improving profitability. Our first strategic pillar, people and culture, is a critical driving force behind our transformation strategy. Our recently formed culture committee is working to define our promise and mission, as well as build out our company values. Developing the new LL culture is critical to how we will execute our strategy and service our customers. We're working to ensure that we have the right leaders in the right roles to effectively achieve our company's goals. We continue to narrow spans of control in our field organizations by hiring more leaders at the regional level to bring greater concentration to executing a high-touch service model for both our DIY and pro customers. Our field leadership has also focused on developing a more robust store and regional manager training program that promotes both diverse and inclusive leadership, as well as drives greater internal career advancement, building our bench for future store leadership. We've enhanced our merchandising organization with new divisional merchandising positions, adding talent accountable for driving both trend right assortment and category portfolio management to grow sales and profits. Turning to our second strategic pillar of driving traffic and transactions in stores and online. We remain focused on enhancing our digital engagement with customers and continue to allocate our marketing dollars where we believe they are most effective, specifically increasing investment in social and search. We were pleased to see that this work to increase allocation into digital marketing generated positive results by driving new customers to our brand despite our total marketing spend decreasing year over year. On our product portfolio, our goal is to consistently deliver a trend-right assortment of wood and manufactured products. We're extremely pleased with the results that have been driven through the repositioning of our solid wood business to a more trend-right quality assortment with a focus on improved finishes and decors. This effort is centered around the expansion of our Belleau Wood Artesian product portfolio. Along with the continued strength and expansion of our vinyl offerings, these changes were a driver of our comp lift in the quarter. Our field teams are focused on selling a complete solution to our customers, ensuring we meet their end-to-end needs. In the quarter, we emphasized attachment selling, training our associates to sell all the necessary high margin attachments, including moldings and accessories, to complement any flooring purchase. We want our customers to view us as a one-stop shop for their entire flooring journey, and we're pleased by the acceleration in sales we saw in our accessory categories in the quarter. As it relates to transactions, our install and pro customers both improved significantly from Q2 to Q3. While our completed installs were slightly negative for the quarter, there was considerable improvement from Q2 to Q3, and we were pleased to see new installation assessments turning positive in the quarter. This was driven by customers' increasing willingness to allow contractors into their homes for home improvement and installation projects. In pro, we also saw sequential growth from Q2 to Q3, moving into positive territory. We saw changes in segment mix with greater strength from remodelers and installers and weakness in residential property management that we attribute to the impact of COVID-19. Our third pillar is improving the customer experience. We remain committed to creating a uniquely consultative shopping experience across all our platforms, and our goal is to meet our customers at any stage of their flooring project. A significant portion of our customers are changing their preferences and shopping online for their flooring needs, and our organization is quickly adapting. We leveraged our investments in digital to improve our online experience, with unique tools like Picture-It and Floor Finder gaining further traction. Web sales grew approximately 140% over Q3 last year, as our investments in digital drove our results. We began piloting remote video selling with live associates to make it easy for customers who want to shop from their home to do so. We're pleased by the initial results, and we anticipate expanding this capability over the coming quarters. And fourth, improving profitability. Our merchant teams drove our business in the quarter by making changes to our promotional strategy that offer customers new, exciting promotion and yield an improved margin benefit. The work our sourcing and merchant teams have done over the last 18 months continues to deliver margin benefit as we drive our alternative country sourcing strategy. We remained extremely disciplined in managing our expenses to improve our bottom line. Similar to last quarter, we optimized our marketing efforts and pivoted towards more efficient channels like digital. We remain focused on executing our transformation plan and making progress against our strategic pillars to positioning us for long-term success. Now let me update you on our initiatives against each of our four pillars. First, let's start with our people and culture. As I spoke about last quarter, we introduced a fourth pillar to our previous strategic framework focused on people and culture. There will be a key component of our strategy as a specialty retailer providing a high-touch service model with knowledgeable associates supplying flooring expertise. A cornerstone to our people's agenda is our commitment to creating a diverse and inclusive workplace that values and leverages individual differences to accelerate the company's growth. I'm especially proud of our Diversity Inclusion Task Force that includes team members from across our organization. They are developing a set of initiatives, including building and supporting programs aimed at attracting, developing, and retaining diverse talent and promoting an inclusive workplace across our organization. Additionally, each quarter, we continue to make investments in training to deliver a differentiated service experience for both our pro and DIY customers and to give our teams greater confidence in building lasting relationships, particularly with our pro customers. Finally, I'm also excited to introduce Alice Givens as our new general counsel and member of our senior leadership team. Alice's strong retail background and public company experience is a perfect complement to our organization, and she brings over 20 years of compliance, legal, and retail experience. Turning to our objective of driving traffic and transactions, we believe revitalizing our brand will be a significant driver of this pillar. We are moving forward with our pilot of approximately 20-plus stores that have rebranded to LL Flooring in Q4. We are utilizing this pilot as an opportunity to learn and understand customer response to our updated branding. As previously stated, we do not expect any material capital or operating expenses related to the rebranding of these stores in 2020. A strategy to drive growth with the pro customers is a critical component of our transformation. Our field teams are focused on expanding trial, scale, and retention of our best pros. And as I just mentioned, we're delivering consistent training to our associates around pro business development. Additionally, we have created enhanced reporting to allow for a more effective understanding of pro behaviors at the local store level. We are continuing to build out our pro value proposition and look forward to discussing this more fully as we roll out new programs in the first half of 2021. Investments in our digital install platform are enhancing the customer experience and driving install efficiency. We see installation as a core element of our value proposition. We expect these new capabilities across our install experience, as well as testing remote in-home selling, will drive expanded adoption of our installation services. Moving to improving the customer experience, our digital capabilities are reinventing the way we do business, enabling us to interact with customers at a greater number of touch points and ensuring we can do business effectively in a world of social distancing. Whatever a customer's preferences are and how they wish to engage with our brand, we strive for a high touch approach, unparalleled expertise, and a trend right assortment with competitive pricing both in stores and online. Our end-to-end digital experience is essential to executing our transformation. Our teams are laser focused on ensuring a differentiated experience for all our customers. Let me give you one example. Dylan Bendian, a seasoned LL flooring store manager in New Jersey. His customer came into the store to schedule an in-home assessment. And after the assessment was completed, the customer came back to the store multiple times to make revisions to his work order. A team worked diligently to ensure the flooring and installation setup were exactly meeting the customer's needs. The customer himself, a skilled craftsman, was so delighted with the floor and insulation, he posted a five-star review and quoted, the team treated my house like it was their own, and I will be using them to complete the rest of my house. He returned to the store to buy floor care products and show the team pictures of his new home project. This great service story shows how our teams work alongside our customers over multiple weeks to ensure they have a great experience. Great work, Dylan and team. Thank you very much. Know that this is just one of many stories highlighting the fantastic work our teams are doing. Finally, we continue to work on improving profitability, focusing on best country sourcing to mitigate tariffs, driving gross margins, and reducing operating expenses. As we communicated in August of 2020, the Section 301 tariffs on certain vinyl products from China were again reinstated at 25%. We have several approaches to mitigate the impact of the tariffs, including partnering with current vendors to lower costs, alternative country sourcing, and price adjustments. Nancy will provide more information regarding the reinstated tariffs in her remarks. As a reminder, we saw a benefit of $11 million of operating income in the fourth quarter of 2019 as a result of the retroactive exclusion of certain tariffs, which will not be repeated in 2020. Leveraging best country sourcing for our entire suite of products across all of our operations is key to this mitigation strategy. We've significantly reduced the amount of goods we purchased from China from approximately 46% for the full year 2019, with the goal of having a run rate of Chinese purchases to the mid-30s as of the end of 2020. And those efforts will continue in the coming year. Looking to the future, we endeavored to partner with the best vendors to obtain premier quality products, regardless of location, and we're always evaluating alternatives for best country sourcing. Last quarter, we also communicated that we were conducting a comprehensive review of our real estate portfolio. Following the conclusion of this review, we made the decision to close our Canadian operations, including all eight stores in Canada, and six underperforming U.S. locations by the end of 2020. We will continue to monitor store performance on an ongoing basis. We opened one store in the third quarter, and as noted last quarter, our current plans including opening two to three new stores in Q4. This will enable us to expand our reach to serve new pros, DIY customers, and buy online, pick up in store digital customers in key geographies. I'm excited by the work ahead and pleased that our company's transformation is on track. Our teams remain agile and focused, and our strategy is beginning to bear fruit as we evolve into a high-touch specialty hard surface flooring retailer. Before I hand the call over to Nancy, I once again want to thank our associates for their tireless efforts. We could not have this level of success without their hard work and dedication. It's through teamwork and collaboration, both internally and externally, with vendors, landlords, and suppliers, that we were able to deliver strong financial performance and an exceptional experience for our customers. I will now turn the call to Nancy to share the financial details of the quarter. Nancy?

Thanks, Charles. Good morning, everyone. In the third quarter, net sales were $295.8 million, an increase of $32 million, or 12.1% versus last year, due to a 13.9% increase in merchandise sales. Service sales increased 0.3% as our installation sales decreased 3% year over year as consumers reacted to COVID. This was more than offset by an increase in transportation revenue for sales to customers. Comparable store sales increased 10.9% versus a year ago, primarily as a result of continued execution of our transformation plan and healthy consumer demand for home improvement projects. Additionally, as a reminder, the third quarter of 2019 was unfavorably affected by a network security incident in late August, which the company believes negatively impacted total revenue by approximately $6 to $8 million, with an accompanying reduction in gross profit. We experienced a 2.9% decrease in our average ticket due to lower installation sales and a 13.8% increase in transaction count compared to the same period in 2019. From the second quarter to the third quarter, strengthening in our higher ticket installation sales as well as returning pro sales drove an increase in average ticket. Gross profit increased 22% in the third quarter of 2020 to $117 million, from $96 million in the comparable period in 2019. Gross margin increased 320 basis points to 39.4% in the third quarter of 2020 from 36.2% in the third quarter of 2019 due to lower year-over-year Section 301 tariffs, supply chain efficiency, along with pricing initiatives and a larger mix of higher margin manufactured products. These items were partially offset by higher customer delivery costs associated with promotions. As a reminder on tariffs, beginning in September 2018, goods coming from China were subject to a 10% tariff under Section 301, which was increased to 25% in June 2019. On November 7, 2019, the U.S. Trade Representative granted a retroactive exclusion on certain click vinyl and engineered products imported from China. Subsequently, on August 6, 2020, the USTR announced its intention not to extend the exclusion pertaining to those certain flooring products imported from China, and the exclusion expired as of August 7, 2020, which again subjects those products to the 25% Section 301 tariff. At that time, approximately 43% of the company's merchandise receipts originated from China. Approximately 10% of the company's merchandise receipts remain subject to the Section 301 tariff, even during the exclusion period. The remaining 33% are once again subject to the Section 301 tariff. The company has several approaches to mitigate the impact of tariffs, including altering its supply chain to source the same or similar products from other countries at lower costs and adjusting its pricing. The company continues to monitor market pricing and promotional strategies to inform and guide its decision. Following the tariffs being reinstated in August 2020, cash flow was reduced as we began to pay for the tariffs on the product affected by Section 301 tariff reinstatement. As this product is sold beginning in the fourth quarter, the increased cost of the tariffs will flow through the income statement. SG&E expense for the third quarter was $93.4 million, or 31.6% of sales. down 380 basis points compared to $93.5 million or 35.4% of sales in the third quarter last year. SG&A in both quarters included certain costs related to investigations, lawsuits, and certain other legal matters. Final court approval was granted for the gold matter in October 2020. We recorded a final $2 million of expense for in-store vouchers as we now believe the claim threshold in the settlement agreement will be met. We originally recorded expense of $28 million in the fourth quarter of 2018 split evenly between cash and in-store credit vouchers. We expect to fund the remaining $13 million in cash in the fourth quarter of 2020 and anticipate that the redemption of the vouchers associated with gold will begin in the second quarter of 2021. Additionally, SG&A in the third quarter of 2020 included costs related to Canadian and U.S. store closures. We expect to incur expense of between $4 and $5 million to close these stores in the second half of 2020, $2.6 million of which was recorded in the third quarter of 2020. We expect all 14 stores to be closed by year end, although certain transfers of inventory and cleanup activities will not be fully completed until early in 2021. Both period items are adjusted in the non-GAAP reconciliation section of the press release. When excluding these items for both periods, adjusted SG&A expense for the quarter with $88.6 million, or 29.9% of sales, versus $93.1 million and 35.2% of sales in the last year's third quarter, $4.5 million lower year-over-year, and deleveraged 530 basis points on a percent-to-sales basis. In addition to the store closing impact, the reduction in adjusted SG&A was primarily driven by the optimization of our marketing efforts as we pivoted toward more efficient channels like digital and $2.5 million from the settlement of the business interruption insurance claim related to the August 2019 network security incident, partially offset by an increase in credit card fees due to the year-over-year increase in revenue. For the quarter, we recorded operating income of $23.2 million compared to operating income of $2.2 million in Q3 of 2019. After adjusting for the unusual items previously noted, operating income increased by $25.3 million to $28.7 million in the quarter when compared to adjusting operating income of $3.4 million last year. The year-over-year increase was primarily driven by strong sales growth, enhanced gross margin, and strong expense management. For the three months ended September 30, 2020, we recognized income tax expense of $7 million which represented an effective tax rate of 31%. For the three months ending September 30, 2019, we recognized income tax expense of $0.2 million, which represented an effective tax rate of 17.7%. The variability of our third quarter tax rate reflects the timing of deductions as we calculated a discrete provision in 2020 because of COVID-19 uncertainty as compared to using an effective tax rate in 2019. For the third quarter of 2020, net income increased by $14.5 million to $15.5 million, compared to net income of $1 million for the third quarter of 2019. Adjusted earnings, a non-GAAP measure, for the third quarter of 2020 was $19.6 million, a year-over-year increase of $17.7 million, compared to adjusted earnings of $1.9 million for the third quarter of 2019. For the nine months ended September 30, 2020, net income was $30.4 million, a $37.1 million increase versus net loss of $6.7 million in the first three quarters of 2019. And adjusted earnings were $35.4 million, a $36.3 million increase versus an adjusted loss of $0.8 million in the comparable period of 2019. Finally, Earnings per diluted share was 53 cents for the quarter versus earnings per share of 4 cents in the year-ago quarter. On an adjusted basis, Q3 earnings per diluted share increased by 60 cents to 67 cents this year compared to an adjusted earnings per diluted share, a non-GAAP measure, of 7 cents last year. Turning to the balance sheet. Inventory at the end of third quarter was $237 million. $69 million lower than Q3 2019 and $11 million lower than Q2 2020. The 22.6% reduction in inventory from Q3 last year was primarily driven by managing our inventory purchases as a direct result of COVID-19 and better than anticipated net sales growth, particularly in the third quarter of 2020. As we stated last quarter, we are pleased with our ability to manage our inventory purchases and appropriately balance the goals of preserving our liquidity while also supporting customer demand. We ended the quarter with $101 million in outstanding debt under our credit agreement, which is unchanged since we announced our ABL amendment in April. Cash and cash equivalence balance increased by $194 million compared to Q3 2019 and was $199 million at the end of third quarter. The increase in cash came primarily from our focus on maximizing liquidity through expense and working capital management. Despite our strong current position, uncertainty in the near to medium-term environment will require a continued focus on maximizing liquidity. As a result, we have chosen to maintain a high cash balance at this time to provide financial flexibility as we manage through the current uncertain environment. Net cash provided by operating activities was $181 million for the year to date, inclusive of $75 million in the third quarter, an increase of $198 million over the equivalent period of the prior year. The increase in the quarter was driven by strong operating performance along with disciplined working capital management. The working capital benefit included higher accounts payable, a reduction in inventory due to strong sales, collection of tariff receivables, and further growth in customer deposits. The company has a significant amount of inventory in transit as of September 30, 2020, and expects inventory to build to $270 million to $290 million in the fourth quarter. The accounts payable balance was higher at the end of the quarter due to the increased in transit inventory and extended payment terms with vendors and other service providers. We collected more than $11 million in Q3 related to tariff refunds and interest from the US customs associated with the November 2019 retroactive tariff exclusion on click vinyl and engineered products imported from China. That brings the year to date total received to approximately $20 million of the $27 million refund anticipated. We expect to receive payments in the coming months. As of September 30, 2020, The company had $230 million in liquidity comprised of $199 million of cash and cash equivalents and $31 million of excess availability under the credit agreement. This represented an increase in liquidity of $44 million from June 30, 2020. Our team remains dedicated to our transformation with the ultimate goal of improving profitability. We are pleased with our ability to reduce costs manage inventory, and maintain a strong and flexible balance sheet during these uncertain and challenging times. Our focus on liquidity over the past several months has allowed us to build a strong liquidity position to navigate the current COVID-19 environment and our businesses generating solid cash flow. However, significant uncertainty surrounds the duration and extent of the pandemic still remains, making it uniquely challenging to accurately forecast our future financial performance. As a result, we are not providing annual financial guidance. As a reminder, for modeling purposes, we had a benefit of $11 million of operating income in the fourth quarter of 2019 as a result of the retroactive exclusion of tariffs, which will not be repeated in 2020. Additionally, as Charles mentioned, we are planning to open two to three new stores in the fourth quarter. As Charles stated, our entire organization remains focused on continuing to execute our stated initiatives. people and culture, driving traffic and transactions, improving customer experience, and ultimately improving profitability. Our near-term strategy is maximizing financial and operational flexibility while continuing to execute against our strategic initiatives. I would like to reiterate Charles's thanks to our associates, business partners, and many other stakeholders who are working collaboratively with us to navigate this environment. We are all working to weather this pandemic and strengthen our organization. Charles and I are excited about the opportunities ahead for our company and believe the future is bright. Thank you all for your time this morning. With that, I'll ask the moderator to open the call for questions.

Thank you. At this time, we'll be conducting a question and answer session. If you'd like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question comes from the line of Laura Champagne with Loop Capital Markets. Please proceed with your question.

Thanks for taking the question. It's on tariffs as we all kind of struggle to get a handle, at least I do, on the impact. I know that you have some offsets you're working on, but when do the offsets happen? And at some point, doesn't price just adjust because isn't this an industry issue?

Yeah, good morning, Laurie. You're exactly right. As the merchant teams are working through our strategy of working with our existing vendors on potential additional cost out, new product development is also an opportunity for us to leverage our pricing, and we continue to work on our alternative country sourcing. As the tariff impact for the industry flows through over the turn of the inventory, we do expect there to be some pricing action, and we will look. out over the landscape and look to be competitive. But again, we have multiple strategies in place to work the tariff impact that's come in. And as we said, we buy no laminate from China today, and our total purchases from China have come down pretty significantly over over the year. So I think the answer to your question is yes, pricing will play a component of offsetting tariffs over time.

Got it. And then just quickly, it looks like Ticket was down a bit. My guess is that that's because DIY is still gaining share from Pro. Is that accurate or is there something else going on on that line?

No, the decrease. I'm sorry.

Go ahead, Nancy.

The decrease in ticket during the quarter was due to the lower installation sales, and that's a direct result of COVID. Our customers are still not entirely comfortable having other people in their homes.

Got it. Thank you.

Thanks, Laura.

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

Yeah, good morning, and congrats with the progress. I wanted to ask about the new store opening. You've got two to three opening here in the fourth quarter. What's changing in terms of store design, if anything, as you move forward into 21 with new stores?

Yeah, David, you know, we opened some prototype stores last year, and we're just continuing to monitor those. But we've taken some elements of those, particularly our design center, that's now incorporated into our current format, which stays the same at about 6,500 total square feet. So, you know, I think as we look out over the next 12 months to really understand, you know, how customers are changing their behaviors, clearly their interaction with digital and our digital tools, like the PictureIt tool, They want to actually interact inside the store with those. So we see bringing digital content into the store as part of the experience along with the tools to help customers be able to see exactly what the outflows will look like in their home. So, you know, we constantly look at our prototype, but that's where we sit today, David. Okay.

Okay. And then can you just bring us up to date in terms of your experience with the rebranding? You talked about running pilots. I'm just wondering what you're doing right now to protect traffic on those stores and just support that, I guess, the consumer perception. Sure.

Yeah, that's a good question. So I think we've been pretty transparent around our brand transformation and the revitalization of our brand. We started with new creative last year, and that was the beginning of telling a different story of who LL Flooring is. And the 20 stores were set in the last few weeks, and so it's too early to talk about those results. But certainly initial feedback from our team members, they're excited. And we think that as we build our end-to-end strategy of how we communicate to customers, whether it's online or digital marketing or lineal marketing that will be telling the story of who LL Flooring is. As you see in our advertising today, it says that Lumbar Liquor is now is LL Flooring. And we've been telling that story now for about six months. And so the dual branding story and our marketing is creating the connection between the brand that's retiring and the new name mark that is moving forward.

Is there any way you can sort of give us a sense of if this is successful, which I presume it will be, how we think about the rollout through 2021?

Yeah, you know, to be honest, David, we're evaluating that now, right? But the reason we're doing a pilot is we want to really understand all the drivers. We've got a pretty comprehensive set of KPIs that we're going to look at across our business, whether it's DIY or pro or installation, and in future quarters that we'll give you an update on where we stand.

Okay, last question for me is just you mentioned building out your regional management and your merchandising division managers. How quickly should we expect to see you leverage that?

So let's talk about the merchandising team. We've added a number of new merchants over the last 12 months. And we've really been focused on design and innovation. The new rollout that we did at the end of last year on our wood program that I talked about that has impacted our comp, we believe that the repositioning of Belleau Wood has created a premium wood assortment in the marketplace that we're very pleased with the results. So merchandising is an ongoing process. Our line reviews happen consistently. We have not slowed down through COVID on new product introductions. And so this is just, again, building our bench strength into the future, but a lot of work has been done over the last 18 months to both incorporate design and accelerate new product development, both on the manufactured product and on the solid wood product. On the regional managers, we actually flattened the top of our organization a little bit with less divisional vice presidents and broadened the regional managers to oversee both our pro business and our DIY business. Yesterday we had a second all national training day for the whole organization on the same day. And so the benefit of putting more regional managers on the ground is they're the closest to our customers overseeing, you know, on average 15 to 20 stores and can really help develop our leadership, particularly our store managers that just deliver such an outstanding customer experience. And so we see that as part of our culture change that will continue to be part of our transformation journey over the next 12 to 36 months.

Great. Thanks for the detail. Good luck.

David.

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

Thanks. Good morning. For Charles or Nancy, can you just talk about the tariffs again? Is there the right way to look at it in terms of a basis point impact to gross margin? And then how do you look at gross margin? What is the underlying right way to think about gross margin at this point and into 2021?

So in terms of tariffs, the hierarchy is, you know, tariffs came on 18-19 last year. The tariffs came off, so we've had almost a full year of no tariffs, and now they've been reinstated again back at the 25%. As Charles mentioned, we've done a great job of attempting to mitigate the tariffs using three strategies. One is alternative country sourcing. The second is partnering with vendors to reduce our costs, and then pricing adjustments. As we said in the prepared remarks, we have from the end of 19 where we were at 46% of product sourced from China. By the end of this year, we're expecting to be in the mid-30s, and we continue to work against that. So we are seeing that the mitigation is working. The great work that the team did starting a couple of years ago when the tariffs first came on, that they kind of hit all those results, those were clearly evident this year until the tariffs went back on again. So, you know, we've learned a lot from this is now the second time dealing with tariffs. And we believe that we are going to be able to mitigate the tariffs going forward. And, you know, what we are expecting in terms of gross margin is to continue to put all the effort into improving that area along with expense management to drive profitability.

And at some point, will you be able to share a basis point impact? I think because it feels like there could be a change in the absolute level into 21. And then if so, I don't know if there's a number that you guys can provide, if it's a profound change in the underlying run rate, or is the gross margin that we're looking at today the right way to think about the business?

Yes. So, Simeon, I would say that as we go into the spring, we'll be able to update more on the efforts that we have that are comprehensive in terms of working our overall profitability. Remember, inside our strategic pillars, long-term profitability improvement is part of our strategy work. And so as we think about whether it's new product innovation, new product introductions, All of those play into how we think about where we can position products as a specialty retailer. I've been very happy with the results that are coming out of the premium end of our business that obviously affords us the opportunity to make more money on those premium products. And again, as I said before, You know, we have multiple levels that we are going to be able to work here. And I think as we move into the spring season, we'll be better informed to give you that basis point number that you're looking for.

Okay. And then just one follow-up. SG&A per foot was great during the quarter, down a good amount. Can you talk about, you know, let's say we roll into 21, demand for flooring continues to improve and the pro gets better and the top line grows. The SG&A per foot, how are you managing that, and should it start to grow, especially as, Charles, you're building out regional management, et cetera?

Nancy, I think you're on mute.

Excuse me. With the change from Q2 to Q3, we really saw the temporary actions that we took as a result of COVID and managing our liquidity change. those have been reinstated. So the things that we talked about during second quarter, marketing, we have not returned to historical levels yet, and we're optimizing the marketing. So the spend of that is changing a little bit as we move toward more efficient channels like digital. We had also offset in the variable costs that came into Q3 with the increase in sales from Q2. We had a couple of one-time events that hit in Q3 as well. But if you think about Q3 to Q2, you know, a lot of the change you're seeing in the increase in SG&A is a function of the temporary measures that we took during Q2. Having said that, you know, we continue to very effectively manage our overall SG&A and look to, as Charles mentioned, you know, look at all the factors going into profitability. So while we manage gross margin, we're also continuing to manage very effectively the the SG&A and would expect that both of those are going to contribute as sales grow to an increase in profitability.

Simeon, there is just one thing that I would add. The regional managers, it's a really small impact on the total SG&A. I think what's more important for us as we think about productivity overall across our field organization and as we start to utilize some of these new tools. So virtual selling, a customer is able to video into a store and make an appointment to actually have a live appointment without actually visiting the store. All of those are designed to help us be more productive in terms of how we think about planning our labor over the week. And again, I just want to make sure it's clear that the regional changes we've made are really important culturally to us, but not a major impact to the P&L. There are other work that we're doing to think through productivity from a workforce management perspective. Okay?

Yep, thanks.

Thanks, Timmy.

Thank you. Ladies and gentlemen, as a reminder, if you'd like to join the question queue, please press star 1 on your telephone keypad. Our next question comes from the line of Brian Nagel with Oppenheimer. Please proceed with your question.

Good morning. Very nice quarter. Congratulations.

Thanks, Ryan.

So I have a couple of questions that are maybe a little bit longer term in nature. I mean, the first with regard to looking at sales here in the quarter, I mean, very nice acceleration quarter to quarter. As you look at the data, is there a way to really parse out, you know, what portion of that acceleration in your business reflects the internal initiatives versus just an improving backdrop for your space? And then my second question, you know, just I guess it ties to SG&A, but specifically with regard to marketing. I think, Nancy, you talked a lot about some of the initiatives that are there to improve the marketing efficiency. How far are we into that effort? I guess another way to say the question is what should we expect going forward to further improve the marketing effectiveness? Thank you.

Yeah, so let me take your first question, too, in terms of how do we think about sales growth from an industry perspective and that transformation. Clearly, we have indicators of the places we've made investments. particularly in digital, where we can see what's happening to new users and traffic that are a direct result of both people investments we've made, systems investments we've made, content, and really wanting to position ourselves to be where the customers want to be. through this environment, more and more customers have adapted online. They're more and more comfortable with buying high-ticket items online, and that includes our installation service business, which we're now able to conclude selling from in-home. So there are definitely places that we see, through the transformation work, The creative rebranding that we've done online and the feedback that we're getting from customers around the recognition of where our brand is getting repositioned. Our product portfolio is far superior. The merchant teams have really done an outstanding job. across both the manufactured and the hardware business, and we're seeing that. And our field teams have done a lot of work in terms of looking at selling the complete solution, and we're seeing attach rates go up. Inside our business, we feel really good about all of the elements of the transformation where we can see numbers that are driving. Externally, where I'm still very optimistic, carpet is still ceding share to hard surface flooring. From a macro perspective, obviously none of us know what COVID is going to do in the short term as we go over the winter. but clearly low mortgage rates are a benefit to our industry. Millennials will be the largest component of mortgage riders this year, and the outlook, at least today for existing home sales, looks very encouraging going forward. So I think we're encouraged by the macro events, that are out there beyond even the impact of COVID and people, you know, working from home, schooling from home, and wanting to figure out ways to better utilize their homes and take on home improvement projects. They take a little bit longer to plan than, say, painting or buying furniture, and so I think You know, there are three real elements that we're encouraged by, our transformation work where we can see the data points that we're very encouraged by and will continue to grow into, and then the macro environment as it relates to hard surface flooring. So hopefully that takes care of question number one. Question number two, we started this marketing work probably at least 18 months ago. And there isn't an easy answer to your question because we're really looking at how are consumers adapting their media consumption. And we're continuing to learn ourselves around the improvement and efficiency of how we've moved that media mix, particularly into digital. So, you know, we'll continue to evaluate that journey. We've made some pretty dramatic changes recently. this year, as Nancy talked about, but it will just be part of our hygiene in terms of looking at driving the best ROI we can out of every dollar of marketing spend that we put into the marketplace. Okay?

Thanks, Charles. Appreciate all the color.

Appreciate it. Thanks.

Thank you. Our next question comes from Seth Basham with Wedbush Securities. Please proceed with your question.

Thanks a lot, and good morning. My first question is regarding cadence. Your primary competitor provided in-front sales cadence throughout the quarter into October. Could you do the same?

No. No, Seth. As we've said, our stated policy is we're only going to talk about our performance in the quarter, and we'll be judged by that performance in the quarter.

All right. Fair enough. Secondly, as it relates to merchandise margins, last time when we had Section 301 tariffs go into effect, first from 10%, I think it was initially, there's a very negative impact on your margins. Why should we not think that's going to happen again in the next couple of quarters?

Well, I think a couple of things. One, we clearly stated that our reliance on product from China has decreased than the original timing of the tariffs going into place. And, of course, Laminate for us, does not have any impact from a tariff perspective. We've done a lot of work around product development and we've continued to introduce a number of new products both in Q2 and Q3 that's helping with our overall strategic agenda around profitability. And we're continuing to look at logical pricing in the marketplace. I think one competitor specifically called out what the expectation may be for pricing in the marketplace. And so we're going to evaluate all of our options around the risk mitigation. And, you know, we have a balanced product portfolio, a solid wood business that we've repositioned that isn't impacted very minimally by tariffs. uh, is, is really growing. Uh, and we're very happy with that. And, and again, the premium end of that business, uh, around the Bellowood artesian product, uh, affords us room for, uh, for growing and profitability. So I think we've learned a lot, Seth, in the last 18 months and our teams have got smarter and wiser on how to do the work and, uh, and, and, You know, tariffs will have some headwind that teams will mitigate over the turn of the inventory, but I think we're much smarter than we were 18 months ago.

Got it. So should we be thinking about merchandise margins increasing year over year still in the next couple quarters?

Yeah, we're not going to predict. Our margins are going to go into the future. That is, we have a solid agenda around long-term improvement of profitability for our business along with top-line growth, and we've got multiple levels. We're not going to get into the specifics of how those are going to sequence. As the work gets completed, we'll come back to you and report on our outcomes that we deliver.

Fair enough. Last question, if I may, just regarding transportation costs. We've seen a marked increase in domestic trucking costs as well as international container costs. Can you give us some insight into how that's affecting your P&L now and how you expect it to impact your margins in the future?

Yeah, so there's a couple of elements there, right? So both on the domestic side and on the international side, we have contracts in place that are longer-term contracts. I think what is going to be interesting, Seth, particularly on the international side, will be what happens from a carrier perspective when most of these contracts get renegotiated next year. And we're going to have to wait and see based on what does the demand environment look like. Clearly, there's a huge bubble of inventory coming back into the U.S. today that's driving demand and particularly increases on the spot market. We've seen a little bit of increase on the international freight side on the spot market where we've pulled in some extra containers because obviously we've reported a lower inventory number that we're catching back up on. On the domestic side, I think it's going to be interesting. I think dependent on COVID, and the availability of drivers, what does that environment look like? So there's a lot of external factors to really be able to accurately predict. Clearly, we negotiate longer-term contracts for a reason, but there's unpredictability that I think COVID is bringing into the marketplace that we're all going to have to watch very carefully to understand what does that input look like coming out of 20 to 21 and 22.

Approximately how long are your contracts and when are they going to be renegotiated?

Yeah, we don't share that level of detail. They are longer-term contracts, and they are renegotiated on an annualized basis.

Annual. Thank you.

Thanks, Seth.

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

Hi, thanks. Good morning. Nice results, guys. I'm intrigued with ad spending running down year on year. Is that a dynamic of you just slowly building it back for Q2, or do you think that ad spend can continue to run down year on year for the foreseeable future?

So let me give you some context, Peter. I think if you went back traditionally to how LL managed their advertising, it was heavily leveraged into national television and very underdeveloped from a digital perspective. And so for the last 18 months, we've been doing a lot of work on how we've looked at different channels, the efficiency of those channels and our ability to optimize our marketing spend. And we're happy with the results that we've seen through that optimization. And we believe that, you know, The ability for us to drive our revenue through our strategy is heavily leveraged on as much our people as it is our advertising. That's why we're spending so much time on training, on making sure we've got the right people in the right roles, on adding new technology, our virtual selling for both our install business, which is allows customers to not have to come back into the store but to buy from home, allows us to drive productivity. And so we're not going to say whether we're going to make any major changes to our marketing spend. What we've said is we're comfortable with the moves we've made in terms of reducing our overall advertising spend over the last 18 months. And we want to watch and see how consumers' behaviors adapt. I'm very bullish on where the digital will continue to go and think that that's an incredibly efficient and targeted method of bringing customers into our brand. And if we find new places to put those dollars to work more efficiently than other places in our business, then we will look at that. Our marketing teams have done a wonderful job both on the creative side and on the optimization side with new channels to deliver results for us.

Okay, that's helpful. Maybe I'll ask a follow-up. So historically, LL has run pretty high at about 8% of sales allocated to advertising, much higher than your competitors run, 2% to 3%. With the shift to the new model that's more consultation-ish and more digital marketing, Charles, do you think you should be closer to industry peers as a percent of sales for ad spend?

Yeah, I think if you were to do an analysis, Peter, of retailers that are EDLP and retailers that have some level of promotion, you'll see a slight discrepancy in the level of advertising spend between EDLP and non-EDLP. As you know, we are not an EDLP house today from a retail perspective. Clearly, we saw an opportunity to leverage down way below the 8%. I think the fact is that we've been consistent in this work. We're testing. We're looking at the results. If we like the results, we're continuing to further drive optimization into the digital channels, and that's what we're going to continue to do over the next six months, and we'll report out on where that spend level ultimately rests.

Okay. That's helpful. Thanks. I'll ask one more question. You've closed or announced several store closures here. Do you feel like a bulk of the closures that will be occurring, or do you feel like this will be ongoing work throughout 2021? And as a related question, is there also opportunity for you to reduce rent on stores that you're going to keep open?

So I'll take the first part of that question, and Nancy will answer the second part. So we said we'd done a pretty comprehensive piece of work from a real estate perspective, and that work we'd completed. And from that, we've said that, unfortunately, we made the decision to exit Canada and a limited number of U.S. stores. Now, we will always evaluate a store portfolio from an overall profitability. You know, with 420 stores, you know, Economics can change, but we believe we've done the majority of the heavy lifting from a real estate evaluation perspective, and that's why we made the decision from an efficiency and profitability perspective to make the changes that we announced today. From an ongoing real estate perspective, maybe, Nancy, you want to hum a couple of bars on how you're thinking about that longer-term work.

You don't want to hear me sing. I'll stick to speaking for a while. As Charles mentioned, we did a comprehensive review of the entire portfolio, and as we've mentioned previously, there's a very small percentage of them that are not cash flow positive. So that has been a plus for us. But having said that, as we continue our expense management, we are targeting rent as well. We've done a lot of analysis in this area and are looking at a number of different factors that impact the profitability of the stores and look to see if we can improve those But as Charles mentioned, we're going to continue keeping an eye on the profitability of the stores and make those decisions as they occur. But at this point in time, after we finished the comprehensive review this quarter, we took those difficult actions of closing Canada and a handful of stores that had been unprofitable for a period of time.

Peter?

Thank you. Thank you, ladies and gentlemen. This concludes our question and answer session. I'll turn the floor back to Mr. Tyson for any final comments.

Thanks, everyone, for joining us today. I want to reiterate that we're excited about the strong sales growth and profit performance in the quarter. There remains a great deal of uncertainty in this operating environment, but we are confident in our strategy. We're wishing everyone good health and safety, and we look forward to updating you on our performance next quarter. Have a great day. Thank you.

This concludes today's conference. You may disconnect your lines at this time.