I’ve been getting emails on the Lumber Liquidators subject so to save time, I thought I’d just put a post together on it. The emails essentially boil down to this:

“Lumber Liquidators has seen its price drop from $100 to $29, is it time to start looking at is as a long?”

For me? No. Now some may play the news induced price bounces up and down but as far as taking an investment in the company, I think the risk is far too great.

Why?

Let’s look back(summaries) at some of the crisis era investments we made for a better understanding first:

Bank of America (2011) and $AIG (2012)

$BAC was mired in litigation and shares slumped as low as $5 when we were buying. The thought process at the time was that their current legal liability was going to exceed their ability to pay and the bank and its shareholders would lose everything. But, if one examined historical financial crisis legal settlements, one quickly found that this type of litigation took years to settle (they almost always settle) and did so for pennies on the face amount of the lawsuit.  Some pretty easy math told you that their most likely legal bill would be but a fraction of the amounts the media were throwing around and that those amounts would be paid over many years (still happening today).

So, far from desperate times, $BAC in late 2011/12 presented a compelling opportunity

$AIG faced similar circumstances. It was 79% owned by the Federal government and in order to buy back the government’s share, they and the Fed had to liquidate the Maiden Lane MBS portfolios held from the $AIGbailout.  Most assumed there would be no market for these securities and since MBS in the market was only trading at $.50-$.60 on the dollar, the Fed would never want to or be able to sell them. The flaw in that of course was that the Fed had taken them from $AIG at the height of the panic and was holding them at levels far below even the depressed levels of 2012. Couple that with a recovering housing market and you had plenty of demand for these cheap securities that the Fed willingly sold. $AIG was able then to buy back the government stake and the stock has more than doubled since then.

Even holding onto $HHC when it was spun in 2010, when housing nationally looked incredibly bleak and a major asset was in LasVegas, the epitome of everything wrong with housing from 2002-2009 wasn’t all that risky. Simple demographics told you the US was adding 1MM households and >3MM people annually. We also knew that virtually no new housing was built from 2008 and that at some point, that equation would necessitate a housing recovery (I did not know “when” this would happen, just that it would).  People do need places to live. Additionally, they had prime assets in Houston, NYC and Hawaii, and those markets were already recovering from the housing crash. Finally, $HHC was holding these assets at virtually zero due to the $GGP Chapter 11 bankruptcy so their true economic value was being masked.  Shares are up ~5X their spin price.

I viewed these investments when I made them very, very low risk in part because the “risk” the investment had was overblown due to the market misunderstanding it and the price I was paying for the stock reflected an even worse outcome than the headlines fretted about.

So now lets look at Lumber Liquidators

What is the risk for Lumber Liquidators?

1- CARB rules their flooring violates regulations

2- They have to replace it or compensate homeowners in some way for it

3- State AG’s begin looking into possible criminal actions

4- Class Action suits (have already begun)

5- The DOJ criminal action is really something serious (disclosed on last 10K). This is separate from the formaldehyde issue and involved the sourcing of the wood in China

6- Reputational

The question we have to ask is “can we place a value on these potential outcomes and does the current price compensate us for them?”

Lets look at each

1- CARB has already said and Lumber Liquidators has admitted that recent tests found elevated formaldehyde in its laminate flooring but true to form, $LL says “the test is the wrong test”

It is impossible from here to now anticipate what CARB will do. We do know however they have found elevated formaldehyde.

2,3,and 4 go to together. The company has already said that they will offer free air quality test kits to worried homeowners. Early tests in Tampa by testing services found each home with $LL laminate had elevated formaldehyde levels in it. The question now is, “what’s next?”  What is Lumber Liquidators going to do? Since we have no idea, we cannot place a value on this

5- DOJ…… This could range from a hefty fine ($100M +) to criminal charges and the outcome or repercussions of that are impossible to tell since we do not not know what the DOJ will want but it is clear based on the company’s disclosure something is coming

6- Lumber Liquidators already admitted SSS were down 24% since the 60Min piece ran so it is clear it resonated with consumers but it is too early to tell if this is a temporary thing or a new trend

In short, there are simply too many unquantifiable variables here to determine an outcome with any reasonable certainty. When you add to that Lumber Liquidators is not a “necessary institution” like a bank the size of BAC or co like AIG, regulators/DOJ could easily just cripple it to make a point. While they punished BAC and AIG badly, at the end of the day was in their best interest to allow it to live so the gov’t could get paid back. There is no such incentive here and that matters.

Lumber Liquidators may or may not come out of this unscathed, who knows. Some will jump in long here and possibly do well but at this point I’d consider that not much more than betting everything on black or red on one round of roulette.  It is inconceivable to determine the outcome of all the above scenarios so soon. Typically “valueplays” come from the market’s misperception of an event or a risk. Here there is not really an “event” to misperceive yet. We do not know what CARB or the DOJ will or will not do so how can we perceive the risk in it?  We do know customers are fleeing but after only one month, is that permanent?

Who knows but I think the risk being long here is pretty large…….

Whitney-Tilson Lumber Liquidators
Lumber Liquidators LL