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Whitney Tilson On Why Lumber Liquidators (LL) Is A Zero

The following is from an email which Whitney Tilson sent to investors on Monday night – the email comes following a massive drop in shares of Lumber Liquidators.

Whitney Tilson On Why Lumber Liquidators (LL) Is A Zero

Following up on my email last night (below, which I only sent to a few friends at the time), in which I outlined why I think Lumber Liquidators is a zero, here are some additional comments (my own and others’):

 

1) In response to questions from a journalist:

 

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The three funds I manage are currently short 44,676 shares of LL (a $2.3 million position based on Friday’s closing price), making it a 2.6% position (it was well over 3% before the stock got whacked last week).

 

I first shorted it on 10/9/13 at $102.69. My last trade was shorting more on 10/6/14 at $56.06.

 

I have never bought or sold options on LL – I have only shorted the common stock.

 

If you’re wondering why I didn’t short a lot more recently, when I knew the 60 Minutes story was going to air and would likely be very negative, the answers are:

 

1) It might have been illegal for me to do so (the laws around insider trading are very vague, so it’s best not to be anywhere in the gray area);

2) Even if I’d gotten a clean legal opinion, I wouldn’t be comfortable with the optics/ethics (I try to live my life keeping in mind the front-page-of-the-NYT/WSJ test); and

3) I promised 60 Minutes, once I brought the story to them, that I wouldn’t trade the stock until after the story aired (or they told me they decided not to do it).

 

Although the risks are less than they once were, I know from long, hard experience that if you’re a short seller and go after a company publicly, as I’ve done in this case, you should expect to be sued by the company and/or investigated by the SEC or other regulators, so I wanted to make sure there were no questions about my trading. Thus, once I got the results from the tests I commissioned on three samples of LL’s laminated wood (and the formaldehyde levels were very high), which confirmed to me that I had the story right (that LL was poisoning its own customers and knew – or should have known – this fact), I established my full (~3%) short position, gave all the information I had to 60 Minutes, and let them run with it.

 

2) My most recent presentation on LL, which includes slides I presented at the Robin Hood Investors Conference on 10/21/14, as well as some from my original presentation at the same conference a year earlier, is posted at: www.tilsonfunds.com/LL.pdf

 

3) There’s been a ton of publicity about the LL story today – here are some of the links:

 

 

4) I’m sick and tired of people bashing short sellers – and I hope the 60 Minutes story helps rectify this. Yes, some short sellers do illegal and/or unethical things, but this is very rare in my experience (it’s FAR more common on the long side). In general, short sellers do much better research than long investors – they have to be much better to survive! – and, as last night’s story showed, can play a critical role in exposing wrongdoing. As we’ve seen over and over again, regulators, investors/analysts and the media are not sufficient. It was short sellers (including myself) who figured out the housing/financial crisis and tried to warn everyone. Ditto for all the China frauds, Enron, Herbalife, World Acceptance (I’m currently short the latter two) – the list goes on and on.

 

I can’t say it any better than my friend Chris DeMuth of Rangeley Capital in this email he sent me this morning (shared with permission):

 

Whitney,

 

Well done and congratulations! It was a terrific and compelling piece. The LL founder was evasive and deceptive. I replayed his comments several times. He knew.

 

This is an important and favorable development for short sellers. Shorting and exposing truth is not a conflict of interest – it is a confluence of interest. Ethics involves not lying/cheating/stealing; we cannot rely on the cheap substitute of listening only to people with nothing at stake. Modern investment management has often tried to rely on both thinking substitutes and ethics substitutes. Thinking substitutes such as diversification and volatility minimizing have fared poorly but have not yet been abandoned. Ethics substitutes (“listen to me because I promise that I have at no time and in no place ever even thought about doing with my own money what I now tell you to do with yours”) have fared just as badly but are still in daily use. Your 60 Minutes segment is a big step towards real morality in business and investing. Sure, you are invested in the outcome, but you are invested because your view – and the evidence you lay out – supports that outcome. That is a bigger deal than whatever ultimately happens to LL.

 

Finally, it serves the interest of free enterprise and free trade to have markets self-policed. Pieces such as this can protect markets from inevitable calls to have endless central planning and control. The best way to counteract the self-interest of cheaters is with the interest of short-sellers. While the government may have the resources, it never seems to have the speed to act when it counts. You have both and did something about it.

 

Chris DeMuth Jr.

 

5) Check out these two tweets to understand why the stock is a zero. Is there a judge or jury on the planet that won’t side with people like this once they understand what LL has done?

 

 

 

6) For more on why I believe the stock is a zero, here are some comments a lawyer sent to me:

 

I watched the 60 minute piece. It was riveting, damming and thorough.

 

I try not to appear strident and dogmatic in public utterances, but this stock will go to zero.

 

The assessment must be that the report is accurate and that those responsible face unlimited fraud claims, civil and criminal, with likely incarceration.

 

The cost of what appears to be inevitable, compelled remediation, many times the sale price of the lumber, will be astronomical.

 

The legal recovery theories will attack the preferences taken by the executives who have cashed out. The timing is too fast. They are toast as well.

 

7) With the stock just under $39, it’s STILL not cheap. Even if you assume NO impact on the company’s revenues or expenses, it’s trading at more than 14x this year’s estimates of $2.74. I could understand some folks bottom fishing this stock at, say, 5x pre-crisis earnings, but 14x?!

 

8) The company just released a statement that says, in part: “We believe that 60 Minutes used an improper test method in its reporting that is not included in CARB’s regulations and does not measure a product according to how it is actually used.”

 

This is nonsense. In fact, it’s I, 60 Minutes and others that used the correct CARB testing protocols, and it’s LL that’s using its own made-up tests. It’s a complex story, but briefly, the generally accepted and used test is to sand off the outer layer of the laminate and then test it – this allows for an accurate reading of the formaldehyde that’s embedded in the product. LL, in contrast, tests the laminate without sanding it, which is, in fact, how the product “is actually used.” But:

 

  1. a) CARB, scientists, etc. all do it the other way; they could do it LL’s way, but then they’d set a much lower exposure/detection threshold – pick your poison (pun intended) but it’s incumbent upon LL to do the tests the way the regulators do or the results are meaningless (as are the claims LL makes that their products are all CARB 2 compliant, blah, blah, blah; in short, you can’t do the tests a different way than CARB – which minimizes the amount of formaldehyde detected – and then proclaim that your flooring complies with CARB standards); and

 

  1. b) just because the formaldehyde is somewhat “sealed” into the laminated wood by the outer layer doesn’t mean LL’s customers aren’t being poisoned – it just means that the formaldehyde leaks out slowly over a long time, along the edges, as the floor wears, etc.

 

9) Finally, here are some spot-on insights from friend who manufactured and imported luggage from China for many decades:

 

Sent: Monday, March 02, 2015 2:43 AM
To: Whitney Tilson
Subject: You on TV

 

Whitney,

 

I watched the 60 minutes piece. Congrats.

 

Having done business in China for literally decades, what I found most amazing in the piece is the LL CEO’s statement that they trust their manufacturers. If that is true, then the company is guilty of incredible naivete or incompetence.

 

I have negotiated with factories in China. What happens is that the American buyers drive a hard bargain…..and with multiple factories, as LL has, the factories know that they are in competition with one another. A negotiation always comes down to pennies. It is pretty common for the Chinese factory to do what they have to do to keep the business…..ie, agree to the best price they can get from the buyer, but agree nevertheless. And then, once they have the business, they try to figure out how to make money on it.

 

But a reasonably savvy buyer knows that, and has approved samples against which actual production is compared. If the actual production does not match the approved sample, then the production is rejected. We did that with just about every production run. If LL didn’t do that, then they deserve whatever flak they catch….not because they are deceitful necessarily, but just because they are incompetent.

 

Of course, if they knew about it, and were complicit either by looking the other way or somehow condoning it, then that is a different story. Either way, however, the company is guilty. And the State of California goes after the seller, not the supplier. So a company like Home Depot, for example, will have a standard clause in their contracts whereby the vendor indemnifies Home Depot against any action that may arise from a product that they sell, made by the vendor.

 

But a vertically integrated operation like LL, where they are both the retailer and the supplier, has no place to hide if the California DOJ comes a’callin’.

 

Even with our best inspections, our best efforts to compare product against the approved samples, from time  to time, there would be quality problems. We had our standard purchase agreement which we executed with each factory that supplied us, which allowed us to deduct from future payments to them, whatever quality charge-backs we received from our customers. That is unbelievably punative. Here’s why:

 

Suppose a product was sold to us FOB China for $10. By the time it landed in the US, freight and duty etc included, it cost us $13.20. We would then sell it to the retailer for $20 (which would net us about $18 after advertising deductions etc.) And they would sell it for $40. If the consumer returned the product, the store refunded the consumer the $40 she paid. And charged that $40 back to us. We in turn charged the factory $40 for one defective product they had originally sold to us for $10.

 

The point is that, knowing they stood to risk a 4:1 expense if the quality was poor, was the best quality control tool we had. The factories ultimately found it was much less expensive to give us the correct quality and make a smaller profit, than to cut corners and risk a 4:1 expense. In other words, they way you get quality control out of China is to make it in their economic interest to do what you want them to do.

 

Now I didn’t learn this in business school. It is common sense. If LL doesn’t have common sense, then they deserve to lose. As simple as that.

 

Anyway, I enjoyed watching you on TV.

 

Best regards,

 

10) Here’s the email I sent last night:

 

I hope you had a chance to watch the 60 Minutes story tonight (if not, the transcript (also below) and video are already posted at: www.cbsnews.com/news/lumber-liquidators-linked-to-health-and-safety-violations).

 

It was UNBELIEVABLE! I am in awe of the investigative journalism 60 Minutes did, which validated my decision to bring the story to them. They uncovered many things I didn’t know and I am now even more convinced that this stock is a zero, for reasons I outline below.

 

PS–Here’s a collection of the eight best quotes from an article in Benzinga:

The investigative report has aired, and it’s not pretty.

As Anderson Cooper explained on the broadcast, Lumber Liquidators’ Chinese-made laminate flooring contains dangerous levels of formaldehyde.

Total exposure may be as large as 100,000+ U.S. homes, according to the program.

For those that missed the broadcast, here are some key highlights:

  1. Cooper: “Lumber Liquidators is a U.S. company, but much of its laminate flooring is made in China, and as we discovered during our investigation, may fail to meet health and safety standards because it contains high levels of formaldehyde, a known cancer causing chemical.”
  2. Denny Larson, Global Community Monitor: “[I want the company to remove] every single board. At their cost and replace it with clean flooring…they’re guilty of selling people product that could make them sick.”
  3. Richard Drury, attorney: “There are probably tens of thousands of households in California that have installed Lumber Liquidators Chinese laminates that may exceed formaldehyde standards…nationwide it’s probably hundreds of thousands.”
  4. Drury: “The average level in Lumber Liquidators products that we found was over 6 to 7 times above the state standard for formaldehyde. Some that were close to 20 times above the level that’s allowed to be sold…It was so high, in fact, that one of our test labs thought their machine was broken.”
  5. Dr. Philip Landrigan: “Long-term exposure at that level would be risky because it would increase the risk for chronic respiratory irritation…it’s not going to produce symptoms in everyone, but children will be most likely to show symptoms”
  6. Whitney Tilson, hedge fund manager: “I’ve seen hundreds of companies do stuff to get their stock price up. This might be the worst.”
  7. Tilson: “[Lumber Liquidators is doing this because of] greed. Plain and simple. It’s cheaper, and it reduces the cost by about 10 percent.”
  8. Cooper: “CARB 2 means it’s compliant with California law, but listen to what a general manager [at a Changzhou mill] told us…all three mills said they falsely label these products as CARB 2 compliant. That’s cheating.”

PPS—Here is LL’s official response:

Lumber Liquidators Statement on @60minutes report $LL

“Lumber Liquidators is a leader in safety, as evidenced by our track record of providing our wide range of products to two million satisfied customers across America.

We comply with applicable regulations regarding our products, including California standards for formaldehyde emissions for composite wood products – the most stringent rules in the country — and take our commitment to safety even further by employing compliance personnel around the world and utilizing the latest in cutting-edge technology to provide our customers with top quality and high value flooring.

These attacks are driven by a small group of short-selling investors who are working together for the sole purpose of making money by lowering our stock price. They are using any means to try and scare our customers with inaccurate allegations. Their motives and methods are wrong and we will fight these false attacks on all fronts.

As recently as late 2014, testing by independent third parties confirmed that 100 percent of the randomly selected cores used in the laminates from the three factories that 60 Minutes investigated came back as fully safe and compliant with California standards. While we were unable to witness 60 Minutes’ testing methods and have still yet to see a test using validated methods that has come back as anything but completely safe, out of an abundance of caution, we are now reviewing our processes at these three mills.

We stand by every single plank of wood and laminate we sell all around the country and will continue to deliver the best product at the best price to our growing base of valued customers.”

My thoughts:

 

1) I love the old “conspiracy-of-short-sellers” trope. In fact, sometimes short sellers DO communicate with each other, share information and analysis, etc. There’s nothing wrong with this – investors talk to one another every day. But in this case, I’ve never had any communication whatsoever with the lawyer and environmentalist that appeared in this segment, nor with the short sellers who are apparently backing them. I’m almost embarrassed to admit that 60 Minutes found them, as I was only vaguely aware of their existence.

 

In fact, this is a case study of how hedge funds, however self-interested their motivations may be, can be a force for good, by doing the difficult and expensive work it can take to uncover companies doing nefarious things (such as poisoning their own customers) – and then bringing this to the attention of regulators, prosecutors and the media.

 

2) As for who has motivation to do nefarious things to manipulate the stock price, let’s look at the players. For me, this is around a 3% short position. So, if I’m right that the stock is a zero, I make three percentage points of return — so, for example, instead of having a 12% year, I’d have a 15% year. It would be nice to have an extra 3% of course, but it’s not going to make or break me – and certainly not cause me to make false accusations against a good company.

 

In contrast, the senior executives at LL have massive incentives to get their share price up. Guess what the top two executives (Founder and Chairman Tom Sullivan and CEO Robert Lynch) did after the stock skyrocketed from ~$13 to as high as ~$119? Of course they dumped a ton of stock and pocketed a small fortune. Specifically, Sullivan, in May and August 2013, sold 300,000 shares (~1/3 of his total holdings) at an average price of $89, pocketing $26.7 million.

 

Meanwhile, Lynch, in May and July 2013, sold 154,500 shares at an average price of $68.61, for a total of $10.6 million (contrast this with his total cash comp in 2012 of $1.2 million). (He appears to have sold every share he could at that time, as his remaining holdings hadn’t vested yet.)

 

So, in summary, I stand to make for my investors less than $3 million if I’m right and the stock goes to zero, whereas just the top two guys at LL have already cashed out to the tune of $37.3 million!

 

3) As for LL challenging the test results, I can’t figure out if they are evil liars, trying to cover up the fact that they’re knowingly poisoning their own customers to save a few bucks on sourcing costs, or whether they’re just incompetent – but it’s one or the other. Based on my research and analysis, I believe that LL’s testing regimen is largely a sham because it’s disconnected from rigorous, credible tests that others (regulators, Home Depot, Lowe’s, etc.) use and rely on. Evidence for this are the results from five independent sets of tests, including one I commissioned, which show that LL is buying and selling to its customers highly toxic laminated wood (virtually all of it from China).

 

4) Once it becomes clear that LL is, in fact, doing this, they will undoubtedly go on an apology tour, saying how sorry they are and positioning themselves as the victims who were defrauded by unscrupulous Chinese mills. This is complete nonsense. Laminated wood is a low-end, global commodity product in which 1% or 2% differences in pricing are meaningful. For a savvy player like LL, which has been buying in China for roughly two decades, they would instantly know that if they were buying 10% below the standard price for a particular piece of laminated wood that something was wrong: perhaps it was stolen, used illegal or incorrect wood, was of exceptionally low quality, or was filled with toxic chemicals.

 

Maybe this example will resonate. Let’s say you’re in Shanghai and looking to buy the DVD of the latest Hollywood movie – let’s say, Academy Award winner Birdman, which is still in theaters, so it’s of course not yet out on DVD. Ah, but lo and behold, as you walk down the street, you see that a street vendor has a copy and sells it to you for $2. Moments later, the police apprehend you and accuse you of buying illegal /forged merchandise. You would of course claim that you had no idea – but OF COURSE you knew, based on where you were (China) and the price you paid.

 

Similarly, LL had to have known there was something seriously wrong with the laminated wood it was buying, given the absurdly low price and the fact that it was coming from China, which is the wild west when it comes to environmental standards and rule of law. Even if the Chinese mills said they were CARB 2 compliant and even if they were supposedly inspected, this cannot be relied on. Heck, this is a country that sold us defective wallboard that soon because filled with toxic mold, and which pumped pigs full of clenbuterol (see:www.rsc.org/chemistryworld/News/2011/April/19041102.asp). In short, many Chinese companies, especially those in highly competitive, commoditized industries, scoff at most regulations, especially if the product is being shipped to the US. Many friends have told me that China is for the Chinese; if they can screw Americans, they will – and they did with LL, which might take down company.

 

But LL’s pleas that they are the victim here ring hollow once you realize that the two biggest buyers of wood flooring in the US, Home Depot and Lowe’s, also buy laminated wood in China, yet don’t have a formaldehyde problem (to the best of my knowledge). The reason is simple: they have serious, rigorous compliance programs and understand that you can’t hit the low bid in China and expect to get high-quality, compliant product. So they pay more and get good flooring – but earn lower margins, something LL wasn’t willing to do in its pell mell pursuit (regardless of the consequences) of a higher and higher stock price so insiders could cash out.

 

It worked for a couple of years – but now I believe the company is going to have to pay a price that I believe will bankrupt it, for a number of reasons:

 

  1. What customer is going to want to buy any product from LL?
  2. Every customer is going to demand that LL pay to have their floor tested – and not just laminated flooring.
  3. If any formaldehyde is detected (even below CARB2 standards), customers will demand that LL pay to remove and replace their floor.
  4. If anyone in a household with LL flooring (again, not limited only to laminate) suffers any illness associated with formaldehyde (chronic respiratory irritation, change in a person’s lung function, increased risk of asthma; myeloid leukemia and nasopharyngeal cancer at high levels and respiratory issues as well as eye, nose and throat irritation at even low levels), they will surely demand that LL not only pay their medical bills, but also compensate them for pain and suffering, job loss, etc.

 

I believe the combination of a dramatic decline in sales plus the massive contingent liabilities will quickly overwhelm the company’s ability to stay in business. While it has no debt, it only has $20M in cash and earned a mere $63M in net income in 2014 (operating cash flow was $57M, but cap ex was $71M, resulting in free cash flow of -$14M).

Whitney-Tilson Lumber Liquidators
Lumber Liquidators LL

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