Lumber Liquidators rallied on Tuesday after short-seller Whitney Tilson announced that he had closed out his position on the flooring retailer. The rally was short-lived, however, as Goldman Sachs analyst Matthew Fassler and his team downgraded Lumber Liquidators stock from Neutral to Sell. They maintained their price target of $13 per share, however.

Lumber Liquidators

The retailer’s shares plunged in premarket trading this morning, falling by more than 6% to as low as $17.51 per share.

Lumber Liquidators to recover reputation

The Goldman Sachs team said there were already signs that Lumber Liquidators’ fundamentals were eroding even before the serious damage was done to its reputation. The damage came from allegations raised by 60 Minutes regarding the sourcing of some of its flooring from China. The TV show alleged that the formaldehyde levels were higher than what was allowed by regulations, sparking a battle between the retailer and short-sellers with Lumber Liquidators management claiming that the wrong testing method was used.

The Goldman team expects the retailer’s reputation problems to “recover gradually,” but they believe that, “to a degree,” this recovery was already more than priced into the stock. They emphasized that their valuation has been based on Lumber Liquidators’ fundamentals rather than about fallout from the investigations into some of its flooring products.

Goldman estimates below consensus

The analysts believe that the path to recovery – particularly in terms of leading to earnings being able to support the current stock price – is going to be quite long. As a result, their estimates are lower than consensus for the next two quarters and for the next two full years. They remain “guarded” because of Lumber Liquidators’ low margins, combined with the reputational damage, which is made worse by the retailer’s heavy reliance on marketing, and growing competition from more specialty retailers and Home Depot and Lowe’s.

Further, Lumber Liquidators continues to grow its number of stores, and its fundamentals remain challenged in the near term.

Why Tilson covered his Lumber Liquidators short

Tilson outlined why he dumped out of his short position on Lumber Liquidators earlier this week. It was allegations raised by him and another lesser-known short-seller that sparked the 60 Minutes investigation. He said he received information that the retailer’s management didn’t even know that the laminate flooring made in China had formaldehyde levels that were higher than what was allowable by regulations.

He admitted that if management didn’t know, then their company “was sloppy and naïve, but not evil.” He added that his “doomsday scenario” becomes less likely if there are no documents or emails indicating that they knew what was going on. Tilson said he has also heard that management only continued selling the Chinese-made laminate after the 60 Minutes show aired because they firmly believed that the flooring they were selling was safe.