LOVE - Lovesac: Good Quarter But Cautious After Accounting Issues (Rating Downgrade)

2023-11-09 17:40:17 ET

Summary

• Lovesac's Q2 2024 financials show an increase in revenue and gross margin.
• The company launched a successful new product, the "Angled Side," which has seen positive customer reception.
• Lovesac experienced accounting issues and is under investigation by the SEC, raising concerns about internal controls and future audits.

I reviewed Lovesac ( LOVE ) earlier this year (see prior article ) and at that time gave this company a buy rating. I was of a fan of the company's products and believed in founder and CEO, Shawn Nelson.

Despite the fact, the stock is up nearly 7% this month after posting solid financials for their Q2 2024 reporting period, I am downgrading my rating to hold due to accounting issues.

Let’s dig in the quarter and review the financial results as well as the accounting issues the company experienced.

New Product

Within the latest quarter , Lovesac launched the new “Angled Side.” Lovesac’s CEO, Shawn Nelson had this to say about the Angled Side, “Angled Side offers benefits to augment both aesthetics and comfort, importantly, addressing the number one style gap we identified in our research. By opening the aperture of potential customers we're reaching, more new and existing customers and seeing meaningful contribution every week since the launch of the Angled Side.”

So far, the product launch seems to be going well and customers have been receptive to the Angled Side. Management noted that distribution has been expanded and now the Angled Side is available across the company’s showroom base as well as online. During the summer a media campaign was launched for the Angled Side and this helped drive Angled Side as a percentage of total size sold to over 40%.

Aside from the Angled Side, it was good to hear the company’s COO, Mary Fox, discuss other organization advancements during the Q2 earnings call. Fox mentioned 18 more showrooms and 3 Best Buy ( BBY ) shop-in locations opened during the quarter. Also, the company is seeing a positive impact from their Costco ( COST ) partnership as sales were up 15% in Q2 2024.

Overall, it appears the Angled Side is doing well so far and it’s certainly positive to see the success in various aspects of the business given the challenging macro environment.

Accounting Issues

Management didn’t go into specifics regarding the company’s recent accounting issues on the earnings call but Lovesac had to file a 10-K/A and a 10-Q/A due to recent accounting issues. Based on the company’s internal investigation, which was conducted earlier this year, it was discovered the company incorrectly recorded shipping expenses.

From the 10-K amendment filing the following is a summary of the key restated financials:

Within this filing Lovesac’s auditor mentions the following regarding accounting practices and staff, “ The Company lacked a sufficient number of professionals with an appropriate level of accounting knowledge, training and experience to appropriately analyze, record and disclose accounting matters timely and accurately. Additionally, management did not establish formal reporting lines in pursuit of its objectives.”

This auditor’s report within that same filing goes on to state, “ The Company did not maintain appropriate oversight and monitoring activities over accounting processes related to certain accruals and estimates. Specifically, management did not sufficiently promote, monitor or enforce appropriate accounting policies and procedures, thereby resulting in an inappropriate and unsupported adjustments to shipping expenses, including the accrual methodology and estimates for the accurate recording of last mile freight expenses.”

The company does specifically mention a plan to fix their internal control issues. Much of this strategy relates to the new CFO, Keith Siegner replacing the former CFO Donna Dellomo who retired over the summer. Thankfully, Siegner does have extensive financial experience as he held the CFO role at Vindex as well as senior positions at Yum! Brands.

Also within their internal controls plan, the company mentions improved journal entries practices, enhanced control activities to migrate risks as well as training and evaluating key accounting personnel.

Internal controls are a significant aspect with financial reporting. If you can’t reply on a company’s internal controls, then there is certainly an increased risk the financial statements are materially misstated.

Financials

Lovesac had a solid quarter as revenue for Q2 2024 came in at roughly $154 million which is a 4% increase compared to prior year second quarter. Showroom sales accounted for roughly $98 million which is an increase over 6% compared to Q2 2023. The company had more showrooms this year and also saw an increase in comparable showcase sales which led to higher transactions and less promotional discounting compared to the prior year.

Lovesac’s internet sales came in at roughly $41 million which is an increase of over 16% compared to the prior year period. The rest of the company’s sales for the current were categorized as “Other” such as pop-up shops.

Gross margins increased as the gross margin for this quarter was nearly 60% compared to roughly 53% in the same quarter last year. Management noted this change was due to a decrease in distribution and tariff related expenses.

The company still has a healthy balance sheet with roughly $55 million in cash, nothing outstanding for their current for line of credit and enough current assets to cover all of their current liabilities as you can see below:

Valuation

Lovesac has valuation grade of a “A-” at Seeking Alpha:

I think P/E ratio (forward) is good valuation metric for Lovesac. Given a forward P/E ratio of 11.87 is better than the sector median of 14.71 and this P/E ratio is far below levels in 2021 and 2022 (as you can see below), I believe Lovesac is currently trading a reasonable valuation.

Conclusion

Lovesac had a successful quarter, as revenue grew as well as gross margin. The company’s new product seems to be doing well thus far as does their omni-channel approach with showcase sales growing as well as sales from partnerships such as their partnership with Costco.

I still am a fan of their products. I believe Nelson is a brilliant founder and CEO with a clear focus on the long term.

However, it is tough for me to ignore the internal controls issues. As the company noted in a disclosure on their current 10Q filing, the SEC is investigating the company and this investigation as stated in the 10Q could result in, “ …The SEC seeking various penalties and relief including, without limitation, civil injunctive relief and/or civil monetary penalties or administrative relief.”

Additionally, the company changed auditors in the past year. All of this may be a coincidence and simply an accounting error but I’m not willing to buy shares of this company until the company at least gets a clean audit opinion on their upcoming 10K filing.

I’m hoping Siegner can come in, setup appropriate internal controls and these accounting issues will be a thing of the past. For now, I’m waiting.

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