Whitney Tilson explains why has he significantly increased his lumber liquidators short position in the last two days in an email sent to investors.
After not trading the stock at all since early October last year – I didn’t want there to be any questions about my trading in advance of the 60 Minutes story (you think nearly five months is conservative enough? ;-) – I added materially to my short position on Wednesday and yesterday, such that it is now a 3.8% position, which is a very large for a short for me.
Whitney Tilson explains increasing Lumber Liquidators short position
Allow me to explain why:
I’m not even trying to hazard a guess at what Lumber Liquidators’s liabilities might be (though I think it’s likely that they’ll be far more than enough to swamp the company, making the stock a zero) because I don’t have to have an opinion on this to have this be my largest short today. My rationale is as follows:
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On the revenue side, this story has been picked up by a ton of local news outlets across the country, so millions of Lumber Liquidators’s past, present and future customers are aware of the formaldehyde issue – and they are freaking out based on numerous anecdotal stories I’m hearing: installers saying most of their jobs have been cancelled, contractors swearing to customers that they’ll never use Lumber Liquidators’s products ever again, etc. This leads me to believe that Lumber Liquidators’s sales ($1.047 billion last year) will take a major, lasting hit, no matter what spin the company puts out there. How big of a hit and for how long? Who knows. But it will be very material I think.
On the expense/margin side, the company faces major issues:
a) Legal and compliance costs going through the roof immediately;
b) Government penalties/sanctions associated with Lacey Act violations (i.e., buying hardwoods that were illegally harvested in Siberia) (by the way, the formaldehyde scandal makes it much more likely that the government will act forcefully in this area, now that they know the company is a bad actor in other areas); and
c) Likely massive (though unquantifiable) contingent liabilities.
But even ignoring all of this, at the very least Lumber Liquidators now has to of course start sourcing its products legally, which I think are likely to bring margins back to historical levels (if not below them). This chart shows Lumber Liquidators’s operating margin going back 11 years (all the data CapitalIQ had):
This chart captures what was a key factor in my initial short thesis: since when does a commodity business, competing against giants like Home Depot and Lowe’s, with an operating margin consistently between 4-8%, suddenly (in less than two years) more than double margins? That’s so unusual and inexplicable that I figured they had to be cheating (and was I ever right!).
Thus, I think it’s very likely that Lumber Liquidators’s margins, which were already starting to return to historical levels in 2014, will quickly fall to the 4-8% range they’d always been in (and I’m being very generous in excluding a possibly massive hit to sales and skyrocketing expenses due to the formaldehyde scandal).
So where might that take the stock, even before the contingent liabilities start to hit? Well, as of last week (pre-crisis), 2015 earnings estimates were $2.74, very close to peak earnings of $2.77 in 2013. I’d be shocked if Lumber Liquidators earned $2 this year – and, if so, a 10 multiple would be a stretch in light of declining earnings, a tidal wave of lawsuits (even if most get thrown out or settled for an affordable amount), etc. So that would be a $20 stock, down 40% from today’s level around $33.
Applying a more realistic scenario, I think the company might earn only $1.50 (and I truly think I’m being generous here) and trade at 6x this amount, leaving the stock at $9, down 73% from here. (I haven’t quite picked that number out of thin air, as Herbalife, another tainted company I’m short, is currently trading at 6.6x peak earnings of $4.91 in 2013.)
In summary, I don’t have to have an opinion today on whether Lumber Liquidators’s stock is a zero. All I have to believe is that it likely has huge downside from here – and that there’s only a small chance of meaningful positive news flow that could run it up against me. (I’m very cognizant of what happened to HLF after it tumbled after the first major wave of negative publicity – that run-up was very painful for a lot of shorts, including me. But I just don’t see a Carl Icahn/Dan Loeb/Bill Stiritz getting involved here, nor the company reporting great numbers for the next few quarters and/or buying back a lot of stock. The only real danger I see is a short-term short squeeze – there is now a huge short interest – perhaps triggered by some investors believing (foolishly) the positive things the company will surely say next Thursday on its scheduled conference call – but I don’t worry too much about short-term volatility.)
In summary, when Lumber Liquidators’s stock gets down to the high end of my range ($20), I can re-evaluate based on the information I have then about what to do. Until then, however, it’s an easy decision to load up on my short position.