Lumber Liquidators shares plummeted after 60 Minutes aired a report stating that the company’s floors failed safety tests in California. This morning the company’s shares were halted for a time pending the release of news.

By the time the stock was halted, shares of Lumber Liquidators had plunged by nearly 25% to $38.91 per share in premarket trading. One issue that’s now up for debate on Wall Street is whether investigators used the right method to test the company’s flooring. Morgan Stanley suggests that they did not, while Wedbush suggests that they did.

Lumber Liquidators damaged by 60 Minutes report

On Sunday, CBS aired a 60 Minutes report that stated its reporters had tested the flooring sold by 60 Minutes and found that it had levels of formaldehyde that were too high. According to the report, only one of the 31 laminate floorings they tested was compliant with California’s rules about content of the chemical. In fact, the report indicated that some of the floors were more than 13 times the limit in California. Lumber Liquidators has said it complies with the rules, however.

Hedge fund manager Whitney Tilson is shorting the flooring retail chain and has been for months. He told 60 Minutes that someone had tipped him off to the high formaldehyde content of the company’s flooring.

Lumber Liquidators pre-warned of the report

Last week Lumber Liquidators management warned investors that a bad news report was about to be aired, which sent shares into a nosedive then as well. CEO Robert Lynch said on the company’s earnings call that they will “vigorously challenge any false allegations or incorrect presentations.”

Further, he warned that the Dept. of Justice may file criminal charges against the flooring chain related to the “illegal harvest of tropical hardwoods,” reports CNBC with Reuters.

Morgan Stanley downgrades Lumber Liquidators

In a report dated March 2, Morgan Stanley analysts Simeon Gutman and Joshua Siber said they have downgraded Lumber Liquidators to Equal-weight based on the uncertainty that now surrounds the company. They also eliminated their price target, which was previously $85 per share.

The Morgan Stanley analysts said they thought the quality issues in the company’s supply chain were mostly in the past. They noted that the allegations about the quality of the flooring are two or three years old and that it appeared as if management had taken actions to correct the problem.

They added that many of the allegations in the weekend news report were not new because they still deal with formaldehyde content. However, they also said Lumber Liquidators “significantly beefed up its compliance” in the wake of the allegations from two or three years ago. The result was a disruption in the company’s supply last year.

“Altogether, with LL’s greater vigilance, something would really have to be awry if there were still product quality issues,” the Morgan Stanley team stated.

What 60 Minutes didn’t say

The analysts also pointed out that the news report did not reveal the method that was used to test the flooring. They said California Air Resource Board (CARB) regulations require testing of the core platform or particle board to be tested. Further, they said this should happen at the mill before it is finished or sealed.

They think the show tested the product using what’s called the “deconstructive method,” which requires that the finished product be taken apart. Additionally, they point out that this brings the complication of disassembling a finished product, which contains other things like binders and glue that aren’t in the product when it leaves the mill. As a result, they suggest that the testers could have gotten false positives.

Conflicting reports?

In his report also dated today, however, Wedbush analyst Seth Basham seemed to suggest that 60 Minutes did indeed use the proper testing method. The reason Basham’s report is tilted in this direction is because investigators apparently interviewed some workers at three of the Chinese mills that produce Lumber Liquidators’ flooring.

The workers reportedly said on camera that the company’s floors were not compatible with California’s Phase 2 regulations. Further, they said they could produce flooring up to those standards but that it would cost 10% to 15% more, which would mean Lumber Liquidators may not want to pay extra for the flooring.

The Wedbush analyst further states that some of the company’s gross margins are “well over 50%,” while the company’s average margin is 40%. He reiterated his Neutral rating and $55 per share price target on Lumber Liquidators, pending an explanation from management.

Tilson gains on his short position

Further, the news report explained that investors who are selling shares of Lumber Liquidators short have a vested interest in the outcome of this news flow. The interview with Tilson and the fact that he brought this issue to the media clearly show how short-sellers are benefiting from the plummeting share price.

Basham compared this story with that of Herbalife, which has been under attack from short seller Bill Ackman for years. He points out that the nutritional supplements company has seen its U.S. sales grow drop off significantly and then decline last year according to volume points.

However, he adds that a Nightline expose on Herbalife last April didn’t have much of an immediate impact on the company’s stock.

At the time of publication LL had just released the following rebuttal:

In light of Sunday night’s 60 Minutes episode featuring Lumber Liquidators (NYSE: LL), the Company is providing the following statement:

“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 set by the California Air Resources Board (“CARB”), which is currently the only regulator of composite core emissions. Although the CARB regulations only apply in California, we adhere to these standards everywhere we do business. Every manufacturer of fiberboard cores used in our products is certified in accordance with CARB regulations. We have documentation to support each step of our production process, including vendor agreements, vendor invoices, CARB certificates, and test results, to serve as further proof that our processes, practices and products are compliant across the board. Independent third-party test results are available on our safety website at www.lumberliquidators.com/safety.

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 by consumers. Our laminate floors are completely safe to use as intended. In our attempt to be fair and transparent, we provided significant testing results to 60 Minutes, including the results of the random testing performed on products from each of our laminate suppliers. We also went to great lengths to document issues between the validated test method and that used by 60 Minutes. Our Chairman addressed the differences and our position on the test methodology but 60 Minutes chose not to include it.

After becoming aware of the nature and content of the 60 Minutes story, we immediately reached out to the Chinese suppliers included in the story. The suppliers have confirmed that all products provided to Lumber Liquidators have been and are CARB compliant. The suppliers could not verify the identity of the individuals appearing in the videos. One of the suppliers featured questioned whether the product shown was actually from its factory. We randomly test each of our six laminate suppliers in China using unannounced audits and all products tested are compliant and safe. Again, the results of the third-party testing are on our website.

As 60 Minutes noted, these attacks are driven by a small group of short-selling investors who are working together for the purpose of making money by lowering our stock price. Their motives and methods are wrong and we will fight these false attacks on all fronts.

All of our resources are focused on ensuring our customer understands the truth, our products are 100% safe and our testing is thorough. Also, we are focused on maintaining the customers’ trust and addressing any concerns over our long purchase cycle.

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.”