Whitney Tilson discusses the latest version of the securities class action lawsuit against Lumber Liquidators and talks about Paul Midler’s book Poorly Made In China in an email to investors.

Also see the tweet below

Securities Class Action Lawsuit Against Lumber Liquidators

Attached is the latest version of the securities class action lawsuit against Lumber Liquidators. I’ve now come to the conclusion that this, not regulatory action nor lawsuits about deceptive advertising or adverse health effects, is what could bankrupt the company. Here’s why: the company’s market cap has declined by nearly $3 BILLION! If the plaintiffs can show that Lumber Liquidators’s management and/or board inflated the stock based on false information (like telling investors margins doubled due to managerial brilliance rather than what we now know was the bulk of it: CHEATING!), then the company, as I understand it, becomes liable for damages equal to all investors’ losses, calculated as the difference between the price they paid for the stock vs. the “normalized” price of the stock (i.e., what it would have been absent the fraud). Damages equal to even a tiny fraction of what investors have lost would bankrupt Lumber Liquidators.

There’s some devastating stuff in here, especially testimony from six “Confidential Witnesses” (outlined on page 19). Here are some highlights:

  • CW1 stated that Defendant Lynch traveled to China several times a year and that Defendant [Chief Merchandising Officer William] Schlegel and his direct report, John Jakob (VP of Supply Chain / Manufacturing Operations) (“Jakob”), traveled to China frequently to oversee operations, find new Chinese suppliers, and report back to Lynch. According to CW1, Schlegel was “the go-to guy for everything that was going on for [the Company] over in China.” CW1 stated that the Company also had a point person located in China at Sequoia who operated as the “eyes and ears” on the ground. [Numerous other CWs confirmed this.]
  • At the time they were published through Seeking Alpha, CW6 was aware of Tilson’s comments regarding Lumber Liquidators and its formaldehyde issue. According to CW6, Lumber Liquidator’s response was to attempt to disparage Tilson instead of dealing with the issue Tilson called out. Moreover, CW6 stated that nothing changed within the Company when Tilson’s allegations came out. He believed that Defendant Schlegel had first-hand knowledge of the issues because of their trips to China, which CW6 said occurred “twice, if not three times a year.”
  • With regard to laminates and formaldehyde content, CW6 said that “there may have been some wrong doing on our part.” CW6 believed that “vertical integration of the supply chain” was a problem at the Company. According to CW6, Lumber Liquidators treated all their suppliers like they were the “cheapest suppliers around” and that vendors would be cut based on a price differential of three cents a foot. CW6 said that vendors were selected by price rather than quality and that was how negotiations were driven. CW6 stated that Lumber Liquidators “had the due diligence to know better what we were buying” but bought anyway. CW6 stated, “if you’re going to keep buying the cheapest car on the market, when your car breaks down how can you act surprised?”
  • 102. According to CW5, a member of EIA who was involved in EIA’s undercover investigation of illegal logging in the RFE, Xingjia was well known to Russian logging enforcement agencies as one of the worst illegal loggers in the region. “If you are Lumber Liquidators, all you would do is, first of all, Google the name of the company, and then go to forest enforcement offices if you have any interest in avoiding illegal wood,” CW5 said. “You ask [the enforcement office]: ‘Is my main supplier involved in this?’” CW5 said the answer would have been, “Yes.”
  • During a second visit to Dalian Xingjia in early 2012, Mr. Yu stated that around half of the oak used in flooring for Lumber Liquidators came from Russia. According to CW5, Mr. Yu openly admitted that Xingjia “misdeclared” the source of wood for its products. Mr. Yu told CW5 that his company declared Russian wood as Chinese wood for tax purposes as well as to avoid scrutiny from enforcement agencies because any wood that is declared as Russian in origin receives intense scrutiny due to the high likelihood that it was harvested illegally.
  • 108. When CW5 asked Mr. Yu if Lumber Liquidators was aware of this illegal harvesting activity, Mr. Yu said, “Yes, of course they know that.”
  • 110. Mr. Sun told EIA investigators that he and his managers provided a tour similar to the one provided to EIA investigators to a high-level team of U.S. executives from Lumber Liquidators during a visit in early 2012, which included Lumber Liquidators’ U.S. “head of sourcing” operations – Defendant Schlegel – as well as two representatives from the Company’s Shanghai office. According to Mr. Sun, this tour included a trip to Xingjia’s operations in Khabarovsk, visiting sawmills and meeting with local officials in the RFE [Russian Far East].
  • 111. Mr. Yu, who accompanied these officials on their visit, reported that Lumber Liquidators officials were not troubled at all by what they saw. To the contrary, Lumber Liquidators has expanded its relationship with Xingjia.

These confidential witnesses confirm everything I’ve been saying: that Lumber Liquidators’s senior managers knew that they were sourcing illegally harvested and toxic flooring in China – and didn’t care because it was cheaper.

Poorly Made In China

Speaking of sourcing in China, I just finished reading (actually, listening to) the book, Poorly Made in China: An Insider’s Account of the China Production Game, by Paul Midler, an American with a Wharton MBA who moved to Guangzhou, learned the language and over ~20 years helped foreign (mostly American) companies source in China. I found it to be very insightful about how difficult it is to source in China because the suppliers will screw you in a myriad of ways. Here’s the summary:

An insider reveals what can—and does—go wrong when companies shift production to China. In this entertaining behind-the-scenes account, Paul Midler tells us all that is wrong with our effort to shift manufacturing to China. Now updated and expanded, Poorly Made in China reveals industry secrets, including the dangerous practice of quality fade—the deliberate and secret habit of Chinese manufacturers to widen profit margins through the reduction of quality inputs. U.S. importers don’t stand a chance, Midler explains, against savvy Chinese suppliers who feel they have little to lose by placing consumer safety at risk for the sake of greater profit. This is a lively and impassioned personal account, a collection of true stories, told by an American who has worked in the country for close to two decades. Poorly Made in China touches on a number of issues that affect us all.

One might read this book and think that maybe LL didn’t know what it was buying – that it, like so many other companies, was duped/deceived by nefarious Chinese mills – but I don’t think so for nine reasons that I outlined on pages 34-38 of my presentation last week (posted at www.tilsonfunds.com/LL.pdf).

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