New Company Documents Reveal ‘A Problem’ With Engineered Hardwood At Lumber Liquidators

Lumber Liquidators

As ValueWalk first reported earlier this morning – see the full piece below.

New Company Documents Reveal ‘A Problem’ With Engineered Hardwood At Lumber Liquidators by Max Vision, Seeking Alpha

Summary

  • LL’s sourcing problems most likely extend beyond the laminate category.
  • Internal company documents reveal that LL is currently in the process of a cover-up.
  • Although this is another shoe to drop for LL, I predict many more over the upcoming months.

One saving grace for the Lumber Liquidators bulls has been the idea that the problem was contained to the laminate product category.

However, new evidence has come to my attention that certain engineered hardwood SKUs from China are being suspended from sale availability at the store level and on the website pending further cover-up attempts.

These cover-up attempts will be detailed below. It is my belief based on conversations with industry sources in China, coupled with the internal documents from LL, that LL has uncovered noncompliance at certain factories that were inspected by TPC #14, which is SGS Hong Kong Limited, (see here). Although LL has pulled all laminates from China, engineered hardwood makes up another large category of Chinese-sourced products. In an effort to mitigate the disastrous consequences of having to pull all products manufactured at facilities approved by TPC #14, LL has chosen to hide the source of its products. In addition to saving itself from pulling these products by “relabeling” them, LL is seeking to mitigate its regulatory and legal risk as regulators and class action attorneys will look to broaden their product scrutiny.

Lumber Liquidators’s products manufactured at TPC #14 approved facilities are most likely unsafe. If these products were safe, then there would be no need to alter the labels to hide the source. If unsafe, as I believe; then the logical, legal and moral choice would be to pull the products and issue a recall for products sold from these facilities. However, that is not the path that LL is choosing.

Lumber Liquidators’s previous behavior with respect to compliance-related problems has been marked by surreptitious and devious actions. As previously reported on Seeking Alpha almost two years ago, Xuhua Zhou first uncovered an excessive amount of formaldehyde in LL’s engineered hardwood products (see here). Attention has shifted to the laminates category due to the 60 Minutes piece, however, given the new evidence, I believe the non-compliant sourcing extends beyond the laminates.

Later, as Whitney Tilson, the hedge fund manager at KASE Capital whose firm is a well-known short of LL, brought more attention to LL’s non-compliance and eventually led 60 Minutes to conduct a highly public and damaging investigation into LL’s non-compliant laminate, LL’s response took over two months (as opposed to Lowe’s, which took four hours) and the resignation of two high level executives, CFO Dan Terrell and recently CEO Rob Lynch. If this were any other company, I’d normally not be so suspicious, but based on the evidence below I am firmly convinced newly appointed CEO and Founder, Tom Sullivan, has no intention of altering the moral compass of the confused and floundering retailer.

In a recent directive to stores, LL has instructed its store-level employees to “relabel” all products manufactured at facilities approved by TPC #14 to hide the facility source for these products.

Lumber Liquidators¬† provided a memo to store-level employees, detailing over 6 pages and 14 specific steps of how this “relabeling” process is to occur. To be clear, the products covered in this memo are engineered hardwoods, not laminates. Currently, these specific products have been placed on “Administrative Hold,” meaning that the stores cannot sell these products. This is occurring at both the store-level and on the website so this is not a geographically isolated issue. Additionally, it is very clear from the instructions that the intent of the “relabeling” is to remove any evidence the product is from a TPC #14 approved facility – through the use of both a “sharpie” and an “Avery 5160” white address label (both specifically described in the memo).

The consequences of this information being disseminated will be the following:

First, LL will be forced to pull these items from their inventory and possibly suffer from an additional inventory write-off if this “Administrative Hold” becomes permanent. Based on dates of availability for the SKUs mentioned in the memo, several engineered products will not be available until Q3 or Q4 of this year, which will further drag down LL’s sales as engineered hardwood is LL’s current substitute for its lack of laminate inventory. Engineered hardwood and laminates are “designed primarily to be installed in areas where traditional hardwood is not conducive, such as slab construction, basements and areas where moisture may be a factor.” Without adequate supply of these two product categories, I predict sales at stores in these areas, such as the South and South West regions where engineered hardwoods and laminates account for a substantial portion of Lumber Liquidators’s sales could fall as much as 50%.

Second, regulators, not to mention class-action attorneys, will expand their search to engineered hardwood products. Furthermore, regulators will see this “relabeling” as evidence of bad faith and raise the level of scrutiny even further.

Third, another round of negative PR will broaden the level of mistrust between LL and the general public. Now that the damage goes beyond one small category of Chinese products, it may be tough to contain or isolate the negative brand awareness that is already relatively high.

Fourth, I predict employee turnover will increase beyond what is already occurring. Telling your employees for the past 3 months that your products are safe, and then asking them in a detailed memo to relabel all of those same products will only engender mistrust. Any employees with a shot at landing another position will leave at their first chance.

Fifth, LL’s insurance providers have already balked at defending LL in the wake of massive class action lawsuits. After this revelation that LL is attempting to hide the source of some its engineered hardwood products, I think this will provide clear evidence for the insurers to further resist defending LL, given LL’s clear bad faith behavior.

I started researching this company and situation because I thought 60 Minutes and its band of merry short-selling brothers had overplayed their hand. What I have found has been clear evidence to the contrary – in fact, the discoveries of underhanded and shady business practices continue to mount. I have never suspected that there might be a snowball’s chance in hell that LL would file for bankruptcy as a result of these sourcing problems. However, as so often occurs, when you find one cockroach in a room, there are many more where that came from. Today’s revelation is a big cockroach, but I expect to continue to find others in the weeks and months to come. The bankruptcy possibility no longer seems so far-fetched.

Below you will find a detailed memo laying out to store-level employees how to hide the manufacturing and third-party certifier information from various engineered products (i.e. not laminates).

Employees have been instructed in the fourteenth and final step to do the following:

Email the photographs to your Regional Manager for review/confirmation. Your Regional Manager must reply with approval that the relabeling effort is complete for your location. Once all locations have completed the relabeling process we can release the product from Administrative Hold. Do not ship the product until you are notified that the relabeling effort has been completed by all locations and that the product has been released from the Hold. (emphasis in original)

In terms of potential stock recommendation, I think there are a variety of strategies. Buying in-the-money puts that extend out to July or August (after LL’s next earnings) would be a good idea as continued revelations of bad behavior will continue to become public.

Additionally, based on my research, the Q2 earnings are going to be even more horrific than anyone currently projects. Traffic is down, margins are down, and the stock will also be down following the earnings. If the timing of the puts presents a problem for your trading style, shorting the stock would also be an option. However, one thing I would not recommend is holding this stock hoping for a quick rebound. That’s no longer in the cards.

Lumber Liquidators

Lumber Liquidators

Lumber Liquidators

Lumber Liquidators

Lumber Liquidators



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