Whitney Tilson on Lumber Liquidators (LL)

Summary

  • While everyone is exposed to small amounts of formaldehyde in the air, the amount emitted by Lumber Liquidators’ Chinese-made laminate, according to tests 60 Minutes and others have done, is far above typical indoor air levels.
  • Thus, Lumber Liquidators is vulnerable to lawsuits by customers suffering adverse health effects associated with exposure to excess levels of formaldehyde.
  • There is currently no national law setting a limit for formaldehyde in indoor air, but I think regulators are almost certain to set a standard in the 7-33 ppb range (probably much closer to the low end).
  • The three Lumber Liquidators samples 60 Minutes had tested came in far higher, at 57, 93 and 268 ppb.
  • Assuming the regulators’ tests show similar results, it’s unclear what actions they might take, but I suspect they’ll be very onerous for Lumber Liquidators – and its stock.

In any investment I make, I do my best to seek out people, facts and analyses that challenge my investment thesis – and I make an extra effort for my largest positions and those about which I’ve been very public, as I’m especially vulnerable in these situations to what’s called “confirmation bias.”

Lumber Liquidators (NYSE:LL), my largest short position, is a good example. To try to offset confirmation bias, I regularly engage in healthy debates with numerous people regarding this company, consider every analyst report, whether bullish or bearish, read articles on this site and elsewhere, and participated in a bull-debate debate over a lunch organized by PiperJaffray last Friday.

The bull case can be summarized as follows: this whole Lumber Liquidators-is-knowingly-breaking-the-law-and-poisoning-its-customers thing is “fantastical,” nothing meaningful will happen to the company vis-à-vis regulators, customers or legal liability, earnings will rebound strongly, exceeding $3/share within a couple of years, and the stock will once again be awarded a premium growth multiple by investors, and therefore trade up to at least $75.

With the NBA regular season ending today, allow me to use a basketball analogy: the bulls think this is a touch foul while I think it’s a flagrant 2 foul, for the reasons I’ve outlined in the 12 articles I’ve published over the past six weeks. If the bulls are right, this stock is going up; if I am, this company (and stock) will be under enormous pressure for years to come.

In this article, I’d like to address two arguments I’ve heard the bulls make, both related to formaldehyde.

The Many Sources of Formaldehyde

The first is that, even if it can be shown that someone exposed to Lumber Liquidators’ Chinese-made laminate is suffering adverse health effects caused by formaldehyde, who’s to say that the formaldehyde came from the company’s flooring? After all, according to the Environmental Protection Agency (EPA), “Everyone is exposed to small amounts of formaldehyde in the air” because formaldehyde is found in:

  • Resins used in the manufacture of composite wood products (i.e., hardwood plywood, particleboard and medium-density fiberboard)
  • Building materials and insulation
  • Household products such as glues, permanent press fabrics, paints and coatings, lacquers and finishes, and paper products
  • Preservatives used in some medicines, cosmetics and other consumer products such as dish washing liquids and fabric softeners
  • Fertilizers and pesticides

It is a byproduct of combustion and certain other natural processes, and so is also found in:

  • Emissions from un-vented, fuel burning appliances, like gas stoves or kerosene space heaters.
  • Cigarette smoke.

The primary way you can be exposed to formaldehyde is by breathing air containing off-gassed formaldehyde. Everyone is exposed to small amounts of formaldehyde in the air that has off-gassed from products, including composite wood products.

To address this argument, I asked Dr. Philip Landrigan, who is one of the world’s leading experts on exposure to toxic chemicals and was interviewed in the 60 Minutes story, the following question:

Given all of these sources of formaldehyde, why should anyone be worried about a little bit more from Lumber Liquidators’ laminate?

He replied:

It all depends on how much someone is exposed to. Substances considered toxic are harmless in small doses and, conversely, an ordinarily harmless substance can be deadly if over-consumed.

Exactly. For all the talk about the many sources of formaldehyde in a home, various studies have shown that the average American is actually exposed to very low and declining levels of formaldehyde in their home. For example, regarding one of the main sources, pressed-wood products, the Consumer Product Safety Commission notes that:

Formaldehyde emissions from pressed-wood products have been reduced 80-90% from levels in the 1980s and earlier due to mandatory formaldehyde emission standards in California and national voluntary formaldehyde emission standards…

And here’s an excerpt from a report by the Centers for Disease Control and Prevention, Formaldehyde Exposure in Homes, that cites four studies from 1985, 1999, 2000 and 2005 showing sharply declining formaldehyde levels in the average home over time:

An early U.S. study conducted in 1985 investigated formaldehyde levels in different types of housing. That study demonstrated that formaldehyde levels in 38 conventional U.S. homes averaged 40 parts per billion (ppb) with highs of 140 ppb. Nineteen apartments and 11 condominiums were also studied and had formaldehyde levels averaging 80 ppb and 90 ppb, respectively, with highs of 290 ppb (Stock & Mendez, 1985). A more recent study of new homes found the geometric mean formaldehyde level was 34 ppb in manufactured homes and 36 ppb in site-built homes (Hodgson et al., 2000). This study also suggested that formaldehyde concentrations in conventional homes have decreased greatly since the 1980s due to decreased use of plywood paneling and reduced emissions from the composite wood products used.

In another study conducted by the US Environmental Protection Agency (EPA), the National Human Exposure Assessment Survey found 189 Arizona homes had a median formaldehyde level of 17 ppb with a high of 332 ppb. (Gordon et al., 1999) The most recent study of 184 single family homes in different several cities (RIOPA, 2005) found a mean concentration of formaldehyde in outdoor ambient air of 3 ppb and in housing of 17 ppb. That same study found a mean level of formaldehyde for mobile homes or trailers ranging from 15.5 to 24.7 ppb.

In short, the most recent study found the “mean concentration of formaldehyde…in housing of 17 ppb..(and) a mean level of formaldehyde for mobile homes or trailers ranging from 15.5 to 24.7 ppb.” (Note that this study is a decade old, so levels are likely even lower today.)

This trend of declining formaldehyde levels in the average home is a testament to the effectiveness of strong environment regulation and is great news for American families.

But it’s not great news for Lumber Liquidators because the formaldehyde emitted by its Chinese-made laminate flooring is many times higher: 57, 93 and 268 ppb, according to the three emissions tests 60 Minutes commissioned (posted here).

Thus, assuming additional testing is consistent with these results, I think most reasonable people (including, most importantly, regulators, judges and juries) would conclude that when someone exposed to Lumber Liquidators’ Chinese-made laminate suffers symptoms consistent with breathing in excess levels of formaldehyde, the flooring is to blame.

What Indoor Air Limits Regulators Are Likely to Set

Another, related, argument bulls make is that even if the three emissions tests

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