The latest from Whitney Tilson on LL – excerpted from an email which he sent to investors.
I really would like to move on and get a good night’s sleep one of these days, but when Lumber Liquidators is, I believe, selling 100+ million square feet of laminate flooring every year to American families that has levels of formaldehyde (a known carcinogen) 6-7 times above the limit set by the California Air Resources Board, the benchmark the company itself says it adheres to – and then, when confronted with this, rather than acknowledging a problem and pledging to fix it going forward and do right by customers who already installed the flooring, instead completely denies everything and launches a campaign of distraction and deception (and smearing critics like me) – well, I for one won’t be silent.
I’ve put a lot of hours into the article below (rooted in ~18 months of research), which I just posted on Seeking Alpha, showing clearly exactly how I think the company is misleading its customers, installers, investors, regulators and the media.
While some of this is a bit complex, it’s so blatant and obvious to me what the company is doing that I’m cautiously optimistic that the truth will out. Time will tell…
Whitney Tilson: Lumber Liquidators’ Campaign Of Distraction And Deception
Disclosure: The author is short LL. (More…)
- For most customers and investors, it really boils down to a simple question of credibility: whom are you going to believe?
- One might not agree with my analysis or conclusions, but know that my beliefs are genuinely held.
- My short position simply reflects my best assessment of the many possible outcomes and the probabilities I assign to each.
In what appears to be a desperate attempt to distract customers, employees, investors, regulators and the media from the charge that it may have been poisoning its customers with dangerous levels of formaldehyde (which, if proven, I believe could eventually lead to the company filing for bankruptcy), Lumber Liquidators (NYSE:LL) is pulling out all the stops. On a new web page the company created, it declares unequivocally that “all of our products are 100% safe” and smears its critics (like me) as “a small group of short-selling investors who are working together for the sole purpose of making money by lowering our stock price.” Management will no doubt repeat these points on its conference call scheduled for Thursday morning.
I believe that both of Lumber Liquidators’ assertions are false for reasons I will detail in a moment. But before doing so, allow me to share some thoughts about credibility, because in many ways that’s what this battle is about. Most people don’t have the time, money or expertise to test the company’s products themselves, weigh the competing arguments about testing methodologies, evaluate how dangerous formaldehyde is, how many Lumber Liquidators customers and installers were exposed to how much of it, what harm might it have caused them, etc.
So for most customers and investors, it really boils down to a simple question of credibility: whom are you going to believe? 60 Minutes, one of the most long-standing and respected news programs in the world, whose lawyers no doubt went through every word of the segment with a fine-toothed comb before it aired, or a company with every reason to lie, a terrible reputation (see here, here, here, here and here), and Chinese sourcing questions hanging over it that are so credible that Federal agents raided its headquarters in September 2013, which (as the company recently disclosed in its 10-K) could result in criminal charges?
The question sort of answers itself, doesn’t it?
An Improper Test Method?
Lumber Liquidators claims that “60 Minutes used an improper test method in its reporting that is not included in California’s regulations and does not measure a product according to how it is actually used by consumers.” To support this statement and demonstrate how safe the company’s laminate is, the new web page has two impressive-looking charts. The first shows the results from tests of the fiberboard cores before they are processed to produce laminate flooring and concludes that “test results over the last three years fall well below the accepted California standard for fiberboard (MDF) cores.” The second tests the “products that have fiberboard cores in their finished state (i.e., laminate flooring), which is how our products are sold and used in our customers’ homes.” The company goes on to state that, “These tests also fall well below the California standard for fiberboard (MDF) cores.”
Before I dive into the weeds on this issue (which is in reality quite simple, though the company is furiously trying to muddy the waters), just apply common sense and ask yourself this simple question: if 60 Minutes’ testing (all of which is posted here) was improper, why did the same testing methodology and labs that found that 30 out of 31 samples of Lumber Liquidators’ Chinese-made laminate had formaldehyde levels averaging 6-7 times the CARB 2 (California Air Resources Board) limit also show formaldehyde levels below the CARB 2 limit for every sample of laminate flooring from Home Depot, Lowe’s and even Lumber Liquidators’ own flooring sourced from U.S. mills?
Again, the question answers itself.
If you’re interested in the details of exactly why Lumber Liquidators’ claim that 60 Minutes (and others’) testing is “improper” is wrong – it’s their testing that’s questionable and/or improper – I suggest reading my article, Why Lumber Liquidators’ Wood Testing Doesn’t Comply With CARB, and this one: GeoInvesting Concurs With Tilson And 60 Minutes: Our Take On Testing Methods Used For Lumber Liquidators Study.
Then why, you might ask, do the two charts on Lumber Liquidators’ new web page show that its products are, in fact, CARB 2-compliant? The answer is different for each chart.
Let’s first examine the one on the left, reproduced here:
This chart shows the results of tests of the medium-density fiberboard (MDF), which is the core of laminate flooring.
Before discussing the test results, all me to give a little background on MDF. According to Wikipedia, it is:
“an engineered wood product made by breaking down hardwood or softwood residuals into wood fibers, often in a defibrator, combining it with wax and a resin binder, and forming panels by applying high temperature and pressure…
…Formaldehyde resins are commonly used to bind together the fibers in MDF, and testing has consistently revealed that MDF products emit free formaldehyde and other volatile organic compounds that pose health risks at concentrations considered unsafe, for at least several months after manufacture.”
In light of the formaldehyde risk, it’s critical to test the MDF to make sure levels are below acceptable limits, which, as shown in the chart above, CARB has set at 0.11 and 0.13 ppm for MDF Core and Thin-MDF Core, respectively.
My quarrel with this chart isn’t the testing methodology, but rather I don’t believe the results shown. Why? Because based on my conversations with a number of experts, I don’t think it’s possible for formaldehyde levels of the finished product that 60 Minutes, Drury and I all independently tested to be as high as they were – 6-7 times CARB 2 limits – if the MDF cores had low levels of formaldehyde. Thus, I can only conclude that the test results must be bogus.
If so, I can only speculate how the tests have been rigged. One way would be for the Chinese laminate mill to buy a small amount of safe MDF to give to the labs, while actually producing the laminate with tainted, cheaper MDF. Another way, as told to me by an industry insider with first-hand knowledge of many mills that Lumber Liquidators buys from, is to use corrupt and/or conflicted inspectors:
“What even LL does not know is their own QC (quality control) inspector is paid a commission by the factories. This inspector knows there’s no way to make CARB2 compliant product at the prices LL demands, especially after he takes his cut of the price.”
I have no way to verify this statement, but: a) I believe the person is credible; and b) It’s consistent with what I know about China – namely, that creating phony documents is very common.
Here’s the other chart that Lumber Liquidators shows on its new web page:
This chart shows the results of tests done in the United States of finished laminate flooring. I have identified two problems with it:
1) CARB doesn’t require testing of finished laminate at all (only the initial MDF), but if it’s done, it specifies clearly how to do it – and Lumber Liquidators is doing it wrong, as I discussed in my article last week, Why Lumber Liquidators’ Wood Testing Doesn’t Comply With CARB:
I, 60 Minutes and others 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:
- 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
- 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.
Since I published this article, Lumber Liquidators has posted the following statement:
60 Minutes used a “deconstructive test,” which would be like testing the emissions of a car by removing the catalytic converter and muffler.
This is a spurious analogy. A correct one would be if the emissions standard for cars was set by regulators based on a test in which the catalytic converter and muffler were removed, and then a company rigged the test by not removing them – and then (falsely) reported that its cars met the standard.
For more color on this, I spoke with Kip Howlett, the President of HPVA, which operates HPVA Laboratories, a CARB-certified lab that I hired to test samples of Lumber Liquidators’ laminate. When I asked him about the charts the company posted on its web site, he first pointed out that the number of tests the company has done over the past 18 months “is laughable – so few samples for such a huge volume of products.”
When I asked about Lumber Liquidators’ assertion that his lab, by removing the outer layer of the laminate, was doing the test improperly, he replied:
CARB has an SOP (Standard Operating Procedure) where you take the surface layer off to test the formaldehyde level in the core. So when you have five labs follow the SOP and remove the surface layer – and all show levels of formaldehyde higher than the CARB 2 standard, you have a problem. And when it’s 1,000% higher, you have a big problem!
When you have five labs all doing it the same way and getting the same results, it isn’t about the test method. The company either didn’t understand the SOP, or did understand it and did a work-around. They’re either stupid or they’re lying – which is it?
Another problem they have is that if you stamp the box CARB compliant, you had damn well better be CARB compliant.
It’s telling that the American-made laminate was all compliant, but every sample from China wasn’t. The Chinese producers are completely and totally unfairly competing with American and Canadian companies who abide by the law and produce safe laminate.
I can’t say it any better than this.
2) Lumber Liquidators claims that its tests “measure a product according to how it is actually used by consumers.” Again, this is highly misleading and deceptive because its tests only measure the formaldehyde that’s present in the test chamber, not what people are actually exposed to in a home, school or workplace.
To determine the latter, one must follow rigorous protocols established by the California Department of Public Health ((CDPH), including making assumptions that are widely accepted and scientifically based regarding various factors such as how much formaldehyde is seeping through the veneer of the laminate, the ventilation in the home, school or workplace, etc. Such testing is expensive, but obviously necessary – yet Lumber Liquidators didn’t do it. Why? Maybe they’re just cheapskates – but I would also bet it’s because this more rigorous methodology would have shown troubling levels of formaldehyde in a true real-world setting.
Dr. Philip Landrigan: It’s not a safe level, it’s a level that the US EPA calls polluted indoor conditions.
Anderson Cooper: Would you want that in your home?
Dr. Philip Landrigan: No.
Dr. Philip Landrigan of N.Y.’s Mt. Sinai Hospital, specializes in environmental pediatrics and exposure to toxic chemicals. He’s talking about the results of another kind of test Drury and Larson conducted measuring the concentration of formaldehyde emissions coming off the laminates into the air of a typical home.
Dr. Philip Landrigan: I would say long-term exposure at that level would be risky because it would increase the risk for chronic respiratory irritation, change in a person’s lung function, increased risk of asthma. It’s not going to produce symptoms in everyone but children will be the people most likely to show symptoms at that sort of level.
In light of these frightening risks, especially to children, it’s little wonder why Lumber Liquidators didn’t do the proper tests to determine its customers’ actual exposure to formaldehyde.
A Short-and-Distort Campaign?
Lastly, Lumber Liquidators writes:
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.
It’s almost not worth responding to the usual trope about we’re-the-victim-of-a-conspiracy-of-nefarious-self-serving-short-sellers, but a few points are in order.
I’ve spent my entire life building a good reputation. Of course I have an interest in making money – that’s my job – but the idea that I would destroy my reputation by inventing a story to smear an innocent company to benefit a ~3-4% position in my portfolio is beyond absurd. One might not agree with my analysis or conclusions, but know that my beliefs are genuinely held.
I believe that Lumber Liquidators’ stock remains significantly overvalued, even though it has fallen ~70% from when I first shorted it above $100 (and, shortly thereafter, shared my analysis with the public). In fact, I think there’s a not-immaterial chance that the company eventually collapses into bankruptcy amidst a wave of lawsuits and the stock goes to zero. And even if it doesn’t, I think it has meaningful downside from here, as I explained in my article last week, Why I Significantly Increased My Lumber Liquidators Short Position In The Last Two Days. My short position simply reflects my best assessment of the many possible outcomes and the probabilities I assign to each.
Regarding the conspiracy-of-short-sellers charge, I’m certainly not aware of one. While I’ve of course discussed my research and analysis with numerous people over time, I reached my conclusions and have acted independently. What I suspect is really going on is that Lumber Liquidators’ misdeeds are so broad, deep and long-standing that, over time, numerous people were able to figure out at least pieces of what the company was doing.
Rather than having a conflict of interest, I believe I have a confluence of interest: in speaking out, I am both doing my job and also serving the public interest by warning others about the possible dangers posed by certain Lumber Liquidators’ products.
I find it quite ironic that the company is accusing me of distorting the truth for my own financial gain when it is, in fact, the senior executives of the company who have far greater incentives to do so than I. This is one of two dozen positions in my fund (only six of which are shorts), so it’s not going to make or break me one way or another. In contrast, the outcome of this battle means everything to founder and Chairman Tom Sullivan and CEO Robert Lynch, both reputationally and financially. Sullivan currently owns 608,998 shares – still worth a pretty penny – and both were heavy sellers in mid-2013, after the stock had soared, pocketing $26.7 million and $10.6 million, respectively.
This $37 million jackpot helps answer the question I’m often asked: “Why would the senior management of Lumber Liquidators knowingly (or at least willfully ignorantly) sell toxic products when, if discovered, it could destroy their reputations – and the company?” This question could, in fact, be asked of all sorts of bad behavior and the answer is generally the same: the short-term rewards are wonderful/profitable and immediate, and the long-term costs, even if much greater, are deferred and uncertain (after all, nobody ever expects to be caught).
A Serious Compliance Program?
Finally, let’s take a look at Ray Cotton, Lumber Liquidators’ Senior Vice President, Chief Compliance and Sustainability Officer, because it speaks volumes about how unseriously the company takes its compliance program.
Lumber Liquidators hired Cotton in November 2013 and subsequently promoted him twice (the last time in September 2014) to his current position. He’s in charge of backing up Lumber Liquidators’ claim that its “products are 100% safe.” Consistent with that role, he is featured prominently in the video on the company’s new web page (he appears at 0:12, 1:41 and 3:04 and gets more air time than anyone except founder and chairman Tom Sullivan).
His LinkedIn profile reveals a college degree from an online, for-profit school followed by plenty of job hopping (10 jobs at seven employers from October 2000 to the present), yet little relevant experience related to his most important areas of responsibility at Lumber Liquidators: quality control, sourcing, managing suppliers in China, overseeing the testing program, etc. Rather, every prior job was related to either “security” or “loss prevention.”
Worse yet, Cotton doesn’t appear to be a serious person, as evidenced by his personal home page, which borders on comical and bizarre (he took it down a day or two ago, but not before I took screenshots of every page – click here), and the fact that less than two weeks ago, on February 24-26, he attended the Oscars and posted to his Twitter account (#raycotton) a dozen photos of himself standing behind the stars on the red carpet (again, he’s since removed them, but I have posted my screenshots here).
Why should anyone care if he took a few days off to attend the Oscars? Because at the very moment that he was posting some of these pictures (check the time stamps) – the morning of Wednesday, February 25th – the company was reporting: a) terrible earnings; b) that the Department of Justice might be bringing criminal charges against it for violations of the Lacey Act (for buying and importing hardwoods illegally harvested in Siberia); and c) that 60 Minutes was running a negative story a few days later – all of which crushed the stock 26% that day.
To repeat: on this crucial day, Lumber Liquidators’ Senior Vice President, Chief Compliance and Sustainability Officer was yukking it up at the Oscars. Talk about fiddling while Rome burns…
Lumber Liquidators claims to have a serious sourcing, testing and compliance program, but it is very, very hard to reconcile this claim with hiring (and twice promoting) someone like Ray Cotton to oversee it. Read into this what you will, but my experience is that actions speak louder than words.
Mark my words: Cotton will not survive this scandal – but firing him will be like closing the barn door after the horse has bolted: far too little, far too late for Lumber Liquidators.
I think management knows that they and their company are in very deep trouble, which is why they, not their critics, are engaged in a campaign of distraction and deception to further their own self-interest. Don’t be fooled!