Did Lumber Liquidators Know It Was Selling Toxic Laminate? by Whitney Tilson, Seeking Alpha
- This question defines the bull-bear debate on Lumber Liquidators.
- I think senior managers knew, for six primary reasons: industry scuttlebutt; Ray Cotton; Lumber Liquidators’ behavior; knowledge of the industry, the product, and China; knowledge of the Chinese mills; and a lie-detection analysis.
- If they knew and this information becomes public, then it would be devastating to the company (and the stock).
In many ways, the question of whether senior managers of Lumber Liquidators knew that they were buying toxic, formaldehyde-drenched, non-CARB-compliant laminate from their Chinese suppliers defines the bull-bear debate on this stock. If this proves to be the case, it would be devastating to the company in the courtroom, amongst regulators, and in the court of public opinion – so much so, in fact, that I believe the fate of the company (and the stock) will be largely determined by this issue.
The bulls, to the extent that they acknowledge any formaldehyde problem at all, tend to think that Lumber Liquidators’ Chinese suppliers deceived the company, claiming to be producing CARB-compliant laminate but in reality not doing so to inflate their profits, so at worst the senior managers of Lumber Liquidators are guilty of being sloppy, naïve and/or overly trusting.
Conversely, the bears (myself included) think they deliberately sourced toxic laminate – knowingly threatening the health and safety of their installers and customers, especially children – to save ~10% on their sourcing costs, and are now engineering a massive cover-up to hide their evil behavior.
ValueWalk's Raul Panganiban interviews Kirk Du Plessis, Founder and CEO of Option Alpha, and discuss Option Alpha and his general approach to investing. Q1 2021 hedge fund letters, conferences and more The following is a computer generated transcript and may contain some errors. Interview with Option Alpha's Kirk Du Plessis
Let me be very clear: I cannot prove my hypothesis. To date, no damning emails, documents or whistle-blowers have emerged, nor have any Chinese suppliers ratted them out. But I’m not surprised by this – these things take time, and it’s only been 38 days since the 60 Minutes story aired.
I’m confident that the truth will eventually be discovered by the many regulators, lawyers, reporters and short sellers who are carefully scrutinizing the company. When the truth does emerge, I think it’s 90% likely that we will learn that at least some senior managers at Lumber Liquidators knew exactly what was going on.
Why am I so sure? There are six primary reasons:
1) Industry scuttlebutt. I have spoken with numerous people in the industry and have yet to hear a single person tell me anything along the lines of “I was shocked by the 60 Minutes story because it’s not at all consistent with the company I know.” In fact, no one I’ve spoken with was the slightest bit surprised by it.
Without exception, they tell me that Lumber Liquidators is a notorious bad actor: cutting corners at every opportunity, selling very low-quality products, treating customers, installers and employees badly, and, most damningly, not being serious about compliance.
2) Ray Cotton. No company serious about compliance would hire (and twice promote) someone like Ray Cotton to be Senior Vice President, Chief Compliance and Sustainability Officer. As I document in the last section of this article, Lumber Liquidators’ Campaign Of Distraction And Deception, he’s totally unqualified for the job and is not a serious person (to see what I mean, take a look at his personal home page and Twitter feed before he took them down – see links below). In fact, he’s exactly the person I think a company would hire if it was knowingly sourcing tainted product and didn’t want the head of compliance to know about it. Here’s an excerpt about him from my article:
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…
3) Lumber Liquidators’ behavior. Since the 60 Minutes story broke, the company has, in my opinion, acted exactly as I’d expect a guilty company, not an honest and reputable one, to act. Imagine if this story was about Home Depot. Immediately after it aired, Home Depot would:
a) Stop selling the product in question (even if it doubted the validity of the testing 60 Minutes did, why take any chances with customers’ health and the company’s reputation, not to mention future liabilities?);
b) Offer a full refund to any customers who wanted to return unopened product;
c) Set up a Special Committee of the board, made up of independent directors, to conduct a full investigation; and
d) Hire an independent firm to do a wide range of testing, not just of Chinese-made laminate, but all of the company’s products.
This isn’t rocket science – it’s Crisis Management 101. Yet Lumber Liquidators hasn’t done a single one of these things. The only possible explanation, in my mind, is that they have a lot to hide – and they know it – in which case, the deny-and-attack strategy they’ve adopted, which I analyzed in my article, Explaining Lumber Liquidators’ Reckless Strategy And Rebutting Its Claims About Deconstructive Testing, makes perfect sense.
4) The industry, the product and China. The idea that Lumber Liquidators was duped by nefarious Chinese mills is preposterous. As I wrote in my first article, Why Lumber Liquidators’ Wood Testing Doesn’t Comply With CARB:
Laminated wood is a low-end, global commodity product in which 1% or 2% differences in pricing are meaningful. For a savvy player like LL, which has been buying in China for roughly two decades, they would instantly know that if they were buying 10% below the standard price for a particular piece of laminated wood that something was wrong: perhaps it was stolen, used illegal or incorrect wood, was of exceptionally low quality, or was filled with toxic chemicals.
Maybe this example will resonate. Let’s say you’re in Shanghai and looking to buy the DVD of the latest Hollywood movie – let’s say, Academy Award winner Birdman, which is still in theaters, so it’s of course not yet out on DVD. Ah, but lo and behold, as you walk down the street, you see that a street vendor has a copy and sells it to you for $2. Moments later, the police apprehend you and accuse you of buying illegal/forged merchandise. You would of course claim that you had no idea – but OF COURSE you knew, based on where you were (China) and the price you paid.
Similarly, LL had to have known there was something seriously wrong with the laminated wood it was buying, given the absurdly low price and the fact that it was coming from China, which is the wild west when it comes to environmental standards and rule of law. Even if the Chinese mills said they were CARB 2 compliant and even if they were supposedly inspected, this cannot be relied on. Heck, this is a country that sold us defective wallboard that soon because filled with toxic mold, and which pumped pigs full of clenbuterol (see here). In short, many Chinese companies, especially those in highly competitive, commoditized industries, scoff at most regulations, especially if the product is being shipped to the US. Many friends have told me that China is for the Chinese; if they can screw Americans, they will – and they did with LL, which might take down company.
But LL’s pleas that they are the victim here ring hollow once you realize that the two biggest buyers of wood flooring in the US, Home Depot and Lowe’s, also buy laminated wood in China, yet don’t have a formaldehyde problem (to the best of my knowledge). The reason is simple: they have serious, rigorous compliance programs and understand that you can’t hit the low bid in China and expect to get high-quality, compliant product. So they pay more and get good flooring – but earn lower margins, something LL wasn’t willing to do in its pell mell pursuit (regardless of the consequences) of a higher and higher stock price so insiders could cash out.
5) The Chinese mills. As further evidence that Lumber Liquidators knew exactly what it was buying, my sources with direct, on-the-ground experience in China tell me that the Chinese mills openly sell non-CARB-compliant laminate – just ask them for a price quote. This isn’t surprising, as they sell to customers all over the world and many countries don’t have formaldehyde standards.
It’s simple: the Chinese mills will produce whatever the customer orders and package it however the customer wishes, even if it says the laminate is CARB-compliant when it’s not. Heck, they’ll even provide phony documentation to that effect! This is all part of the customer service package many Chinese mills are happy to provide – especially to a very big customer like Lumber Liquidators.
I wrote about this in my article, Lumber Liquidators Is Evil:
In fact, someone who reached out to me after the 60 Minutes story aired, who’s very credible and knowledgeable about the industry, shared with me an email he received from one of his suppliers (which happens to be one of the mills shown on the 60 Minutes segment), in which the Vice President of the mill offers to sell him laminate and gives two prices: one for safe laminate with formaldehyde levels below the limit set by CARB and one for toxic laminate that doesn’t comply (for a lower price of course). Here is the key part of the email:
I think it will be good manner to solve this problem of the carb2
boards. When u be here we can talk about it, ok?
Now customers need the carb2 need to add 0.5usd/Sqm.
Here’s what really boggles my mind: this email was sent seven days after the 60 Minutes story exposed that the mill was selling non-CARB 2-compliant laminate – they’re not ashamed of it; rather, they’re perfectly open about it.
It’s also powerful evidence that, while Lumber Liquidators can show lots of paperwork from the Chinese mills and testing facilities attesting to CARB 2 compliance, the company in fact knew exactly what it was buying in China – and, in turn, selling its customers.
6) A lie-detection analysis. The ex-CIA guys at Qverity, authors of Spy the Lie, did a careful analysis of what Lumber Liquidator’ founder and Chairman, Tom Sullivan, did and didn’t say when he was interviewed by Anderson Cooper in the 60 Minutes story, and they have posted a damning report that concludes:
QVerity’s behavioral analysis of the interview concluded that Sullivan was likely aware that his company was selling flooring that was non-compliant with these regulations, and that he appeared to be withholding information, the disclosure of which could result in serious negative consequences for himself and his company.
We have drawn that conclusion on the basis of the high volume and the specific types of deceptive behaviors exhibited by Sullivan during the course of the interview.
I think it’s highly likely that the senior managers of Lumber Liquidators knew that they were buying toxic, formaldehyde-drenched, non-CARB compliant laminate from their Chinese suppliers, knowingly putting untold numbers of American families at risk – and now that they’re been caught red-handed, are desperately trying to cover it up.
Why would they do something so immoral and potentially destructive? The oldest reason in the universe: greed. Laminate is one of the company’s most profitable product lines and non-CARB-compliant laminate is ~10% cheaper, so the company saved a lot of money on sourcing costs (not a few pennies, as Sullivan claims), which I think was a major contributor to a quick doubling of margins, which in turn helped send the stock price up eight times from $15 to $119 in less than two years. Sullivan and Lynch recognized a golden opportunity when they saw it, dumping $37 million worth of stock at prices more than double today’s level in early- to mid- 2013.
If they knew – and this information becomes public – the result could be not only an implosion of the company but also big financial penalties and even criminal charges against the company and its executives. Consequently, seen through management’s lens, their current strategy actually might be logical in a twisted sort of way: deny everything, take advantage of the uncertainty about the testing methods and the harm formaldehyde causes to muddy the waters as much as possible, bully critics and regulators, and hope the storm passes.
I think this strategy is very unlikely to work, however, so this remains my largest short position.
PS – I no longer read the message boards for the articles I publish because the attacks from anonymous trolls cause me too much agita. I do, however, want to hear thoughtful comments and questions so I invite my readers to communicate with me via Seeking Alpha messaging and I will post my answers on the message board.