Whitney Tilson: Why I’m Again Short Lumber Liquidators

Why I’m Again Short Lumber Liquidators (again) by Whitney Tilson

Summary

After being very publicly short Lumber Liquidators’ stock for 26 months, during which it fell by nearly 90%, I exited the position in December. At the time, I had no expectation of shorting the stock again, yet in the past week I reestablished a meaningful (~4%) short position in the stock.

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Yesterday, I gave a 48-slide presentation explaining the reasons why. I believe the odds of very bad outcomes for Lumber Liquidators and its stock have risen materially based on new information in six areas.

Most importantly, my best source tells me that the recent cancer scare associated with the toxic, formaldehyde-laden Chinese-made laminate flooring that Lumber Liquidators sold for years is having a devastating impact on the business.

The company was already in a precarious situation, so I question whether it can withstand this new blow. I now believe that there is at least a 50% chance that Lumber Liquidators eventually goes bankrupt.

The most likely scenario for the stock, I believe, is that it drops to ~$8 after Q1 earnings late next month, when I expect the company to acknowledge that its business has weakened further; then, I think the stock will continue to fall over the course of the year as the business remains crippled, and approaches zero within a year.

If you have information that either confirms or is contrary to mine, I’d love to hear from you at [email protected]

Summary

In a 48-slide presentation at an investment conference yesterday, I revealed why I’m once again short the stock of Lumber Liquidators (NYSE:LL). While it may seem odd to reestablish this position at a lower (i.e., less attractive) price than when I covered, I changed my mind because I have new information that leads me to believe that the odds of very bad outcomes for Lumber Liquidators and its stock have risen materially based on new information in six areas:

1) Widespread media coverage of the CDC’s error and increased cancer risk appears to be having a severe impact on the business

2) The cancer risk is likely significantly greater than even the CDC’s revised estimate, which could result in further damaging publicity and increased liabilities

3) A “Prop 65” trial has just begun that LL is likely to lose, resulting in further adverse publicity

4) Likelihood of even larger legal and regulatory liabilities

5) Operating performance of the business in Q4 was much worse than I expected – and I think meaningful improvement is unlikely for quite some time (if ever)

6) Lack of confidence in company leadership

Below I summarize the highlights. For those interested in the details, here is further information:

  • The slides I presented yesterday are here (followed by the three previous public presentations I made on this company in 2013, 2014 and 2015)
  • A video of my 20-minute presentation is here
  • Afterward, I did a 10-minute interview with CNBC, which is posted here (part 1) and here (part 2); a transcript is here
  • All 20 articles (including this one) that I’ve published on Lumber Liquidators are here

Background

From late 2013 through last December, Lumber Liquidators was one of my most successful investments in my 17-plus year investing career. During this 26-month period, when it was my largest short position, the stock crashed from $115 at the time I first went public with my short thesis at the Robin Hood Investors Conference in November 2013 to around $14 when I covered.

I’m proud of the role I played in bringing to light the company’s misdeeds, namely sourcing and selling illegally harvested hardwood and toxic formaldehyde-drenched laminate flooring. What happened to Lumber Liquidators (being the subject of a devastating 60 Minutes story, followed by well over 100 lawsuits and a half dozen investigations by various regulators – and, of course, the collapse of its share price) has, I believe, not only led the company, but the entire industry, to adopt more stringent compliance measures. I’m especially proud of this recent story: A Hedge Fund Manager Helped Save Siberian Tigers. Here’s an excerpt:

But the best thing about this case is that it will slow the rate of deforestation in the critical habitat of the Russian Far East. So next time you see a wild Siberian tiger in a photo or on television, spare a kind thought – unlikely as it may sound – for a hedge fund manager. Tilson has moved on to other stocks. But I’m betting that this case will keep both him and Zhou on the lookout for bad environmental practices as one more clue to stocks worth shorting.

Why I Covered

I published an article in December explaining why I was exiting my short position. Here’s the summary:

  • In the past week, I’ve received information that leads me to believe that senior management of Lumber Liquidators wasn’t aware that the company was selling Chinese-made laminate that had high levels of formaldehyde.
  • If this information is correct, then the company was sloppy and naïve, but not evil.
  • If there are no “smoking gun” documents/emails, then the doomsday scenario for the company (and the stock) is less likely, so I covered my short position today.

I continue to believe that Lumber Liquidators’ senior management was unaware of the toxic laminate and thus no longer believes this company is evil, plus the stock is now a bit lower. In addition, the company had $6.7 million of net cash and $67.2 million available on its line of credit at the end of Q4, and, under normal circumstances, this is a nicely profitable business.

Nevertheless, I believe the stock is a great short today because I now believe that there is at least a 50% chance that Lumber Liquidators eventually goes bankrupt for the following reasons:

  1. I think operating losses and cash burn will remain severely negative (in the range of Q4’s -$20-$30 million per quarter) for the foreseeable future – and could even get worse
  2. It will likely be very difficult and expensive to settle the regulatory issues (Consumer Product Safety Commission, CA Air Resources Board, etc.) as well as class action (multi-district litigation), securities fraud, and Prop 65 cases, especially in light of the CDC recently tripling its exposure and cancer risk estimate, as well as the fact that more than one million Americans may have been exposed to Lumber Liquidators’ Chinese- made laminate since 2010
  3. Lumber Liquidators’ liability insurers have all denied coverage for the formaldehyde claims under the pollution exclusion in the insurance policies, forcing the company to pay its enormous legal fees out of pocket

More Than One Million Americans May Have Been Exposed to Lumber Liquidators’ Chinese-Made Laminate Between 2010 and May 7, 2015

It’s hard to know when Lumber Liquidators’ Chinese-made laminate first became toxic (maybe it always was?), but forced to guess, let’s go with 2010. If so, I estimate that Lumber Liquidators sold this product to ~400,000 households, thereby exposing over one million Americans, as this table shows:

Assumptions/estimates:

  • LL finally suspended sales of Chinese-made laminate on May 7, 2015
  • For 2012 and 2013, laminate sales and percent from China are estimates
  • Average Ticket (Laminate) is an estimate based on 80% of the total ticket (laminate is cheaper than engineered and solid hardwoods)
  • People exposed is customers x 2.54 residents per household (US Census)
  • January – May 7, 2015 assumes that sales continued at 2014 levels in January and February and then fell by half after the 60 Minutes story aired on March 1, 2015

In other words, this isn’t a small problem – it’s a huge one.

Severe Impact of Recent Publicity About a Cancer Scare

I now believe that Lumber Liquidators’ sales will not recover in the first half of the year, possibly longer, due to a recent well-publicized cancer scare that, according to my sources, has had a hugely deleterious impact on Lumber Liquidators – possibly even exceeding what happened in the aftermath of the initial 60 Minutes story a year ago.

As we’ve seen over the past year, adverse publicity linking a Lumber Liquidators’ product to formaldehyde has severely damaged the business – but, let’s be honest, while exposure to this chemical sounds sort of scary, most people don’t know much about it. And to the extent they do, the primary symptoms – irritation of the eyes, nose and throat – don’t sound like cause for alarm. But everyone knows about – and is rightly terrified of – cancer. Thus, a Lumber Liquidators’ product (even one it no longer sells) becoming very publicly associated with increased cancer risk could be a mortal blow to the company.

Here’s how it happened:

Last month the Centers for Disease Control and Prevention (CDC) released the results of the Consumer Product Safety Commission’s tests of Lumber Liquidators’ Chinese-made laminate flooring, and it was mostly good news for the company. Though it found elevated levels of formaldehyde, in its conclusions the CDC seemed to be trying to downplay the risks and calm homeowners. While acknowledging that “The amount of formaldehyde released could cause health symptoms in some people,” the media focused on this line: “The added cancer risk from exposure to formaldehyde released from the floorboards is small.”

Importantly (and, I believe, wrongly – see below), the CDC assured homeowners that if their flooring is more than two years old, the formaldehyde had likely “off-gassed” down to a normal level: “Several studies have shown that formaldehyde levels return to normal levels about 2 years after formaldehyde-emitting products are installed in a home.”

The CDC calculated that “the cancer risk from the off-gassing floorboards is 2 [to 9] additional cases of cancer per 100,000 people exposed” [20-90 per million] and reassured homeowners: “To put those numbers in perspective, the American Cancer Society (www.cancer.org) estimates that for people living in the United States, one in two men and one in three women will develop cancer from all causes.”

In its recommendations, the CDC suggested that homeowners should see a doctor if they have symptoms related to indoor air quality and take steps to reduce the concentration of formaldehyde in the air (increase ventilation, lower temperature and humidity, cease smoking indoors, etc.).

But the CDC pooh-poohed the idea of widespread air testing (“Generally residents do not need to consider testing the air in their homes, especially if the flooring was installed more than two years ago.”) or replacing any flooring:

Residents should consider the following before removing this type of laminate flooring from their homes:

  • If the flooring was installed more than 2 years ago, the levels of formaldehyde have most likely returned to what is normally found in homes – so there is probably no reason to remove it.

  • Removing laminate flooring may release more formaldehyde into the home. Some new flooring may also release formaldehyde.

  • Consult a certified professional (such as a CIH or REHS/RS) before taking any action to remove the flooring.

The media coverage of the report was minimal and, in general, quite favorable: the cancer risk is de minimis and most homeowners don’t have to test the air much less replace the flooring. Not surprisingly, the stock rose ~20% in the next few days.

But it turns out that the CDC made a major computational error: its analysts calculated the formaldehyde concentration in the test room based on a ceiling height of eight meters instead of eight feet!

60 Minutes learned of the CDC’s mistake and on Sunday, February 21st, Anderson Cooper gave the following update (which you can watch here):

After our story aired last March, the Consumer Product Safety Commission, working with the Centers for Disease Control, launched a study of that laminate flooring. This month, the government published its findings. They showed the flooring gave off enough formaldehyde to irritate the eyes, nose and throat, and could trigger breathing problems. It also increased cancer risk by a small amount.

After the report was published, 60 Minutes was alerted to the possibility that government scientists made a major mathematical mistake in their report. We sent the report to scientists at several universities and discovered the government forget to convert feet to meters in some calculations.

That error means that all the predicted formaldehyde levels from Lumber Liquidators’ flooring are 3.3 times higher than government scientists calculated, which can amount to more than 18 times higher levels of formaldehyde than those in a normal home and triple the cancer risk to a level that’s considered unacceptable by national and international health agencies.

(Here are screenshots of the scary, rising-bar graphics in the background as Cooper read the last paragraph:)

Whitney Tilson Lumber Liquidators

The Centers for Disease Control has admitted its mistake and issued a correction.

The Consumer Product Safety Commission is continuing its investigation and told us it’s working to provide more specific answers to homeowners about the safety concerns.

The key words here are “triple the cancer risk to a level that’s considered unacceptable by national and international health agencies” and, on the chart, “Additional cancer risk.”

The CDC issued a press release admitting its error and tripling its formaldehyde exposure and cancer risk estimates:

CDC/ATSDR was notified February 13 of an error in its report released February 10, 2016, about the possible health effects from exposure to formaldehyde emitted from select laminate flooring samples. Health risks of people who have the laminate flooring are being revised to reflect greater exposure to formaldehyde, which could cause eye, nose, and throat irritation for anyone. The estimated risk of cancer associated with exposure to the flooring increased.

The CDC/ATSDR indoor air model used an incorrect value for ceiling height. As a result, the health risks were calculated using airborne concentration estimates about 3 times lower than they should have been… After correcting the measurement in the model, CDC/ATSDR is revising the possible health effects… The estimated risk of cancer is 6-30 cases per 100,000 people [60-300 per million].

In the days after the 60 Minutes’ story and the CDC’s correction, there was a media frenzy, including stories on every major evening news program, and unlike the first round of (limited) publicity, the focus was on the increased cancer risk. Not surprisingly, the next day the stock dropped 20% to around $11.

Keep in mind that this is anecdotal, but my best source (an industry veteran whose information and anecdotes are derived not from anyone at Lumber Liquidators itself, but from installers and others who have had interactions with the company), whose information is consistently accurate, tells me that this wave of publicity has had a hugely deleterious impact on Lumber Liquidators, possibly even exceeding what happened in the aftermath of the initial 60 Minutes story a year ago. The impact is in three primary areas:

  1. Sales are down because customers are avoiding Lumber Liquidators.
  2. Customers with Lumber Liquidators’ flooring are returning it (if not yet installed) or demanding that it be removed.
  3. Lumber Liquidators’ employees are demoralized and looking to leave.

Here are some anecdotes that he shared with me:

From Stores

  • A store manager on the east coast said that sales in January and February were the two worst months in the history of the store – and then things got worse! He said the week after the 60 Minutes update and resulting cancer scare was the “worst experience of his life.” In the first two days of March the store actually had negative revenue due to returns.
  • At another store, the incoming phone calls were so intense and frequent that the store manager unplugged it and threw it in the warehouse.
  • On Tuesday, February 23rd (two days after the 60 Minutes update aired), one store had a long line of people returning product – a total of $10,000-$11,000 just that morning.
  • Last week, the store manager of a competitor, whose store is directly across the street from a Lumber Liquidators’ store, looked over a half dozen times during the day and on at least two occasions saw trucks pulling in with product but leaving with nothing (i.e., returns). At least one customer came into the competitor’s store that day saying he had cancelled his order with Lumber Liquidators and just wanted something “non-toxic!” The competitor says this is now a regular occurrence.

From Customers

  • My source has heard multiple stories of Lumber Liquidators’ customers who are so desperate to get this “crap” out of their homes to protect the health of themselves and their families that they’re paying for removal themselves, even though they doubt that they’ll get a refund or any reasonable remedy from Lumber Liquidators. They just don’t want a carcinogenic floor.
  • A customer showed up absolutely livid because she felt that the Lumber Liquidators’ store manager had deceived her when he told her in January that the laminate floor she had purchased had been discontinued. She later learned that it had been pulled because it was toxic. The manager recounted this story to an installer and confessed, “You know what, she’s right. I lied to her. I feel so bad. I can’t keep doing this.
  • A customer showed up with documentation showing that he had bought a floor from Lumber Liquidators in 2011-12, and last year his dog died from some strange cancer. Now he says he “knows what happened!”

If these anecdotes are at all representative of what’s happening across Lumber Liquidators’ entire store base (which I think is likely the case), then the company is in big, big trouble.

Five More Pieces of New Information

In the rest of my presentation, I detailed the five additional pieces of new information that, along with the cancer scare discussed above, led me to reestablish my short position in Lumber Liquidators. Here’s a summary of each:

The cancer risk is likely significantly greater than even the CDC’s revised estimate, which could result in further damaging publicity and increased liabilities

I believe that the CDC’s report, even after adjusting it to increase formaldehyde levels by 3.3x, significantly understates the actual amount of formaldehyde that homeowners are exposed to, for two reasons:

  1. The CDC did two types of tests, small chamber and large chamber, and appeared to weight them equally. However, I believe that the large chamber test, which showed ~6x higher formaldehyde levels, is far more realistic and therefore that these results should be used to calculate risks of adverse health effects.
  2. The CDC assured homeowners that if their flooring is more than two years old, the formaldehyde had likely off-gassed down to a normal level. However, I believe this statement is incorrect; my analysis of the research regarding how quickly formaldehyde off-gasses leads me to believe that elevated (and dangerous) levels of formaldehyde persist for far longer than two years – and thus the cancer risk is 12-26 times greater than the CDC’s revised estimate.

A “Prop 65” trial has just begun that LL is likely to lose, resulting in further adverse publicity

Proposition 65 is a California law requires businesses to notify Californians about significant amounts of chemicals in the products they purchase, in their homes or workplaces, or that are released into the environment. Formaldehyde is one of ~800 chemicals covered by the law.

Global Community Monitor, a California-based environmental organization, and Sunshine Park LLC, an entity formed by one or more anonymous hedge funds, have filed a Prop 65 lawsuit against Lumber Liquidators (I have had no contact with GCM nor the hedge fund(s) and don’t know who they are). I have posted the opposing trial briefs here and here.

GSM is asking for the following damages: a recall of the toxic flooring, reimbursement of attorney’s fee, and a penalty of $2,500/day per violation (subject to a one-year statute of limitations). I estimate that Lumber Liquidators sold Chinese-made laminate to ~80,000 customers nationwide per year. If California was 12% of the total, that’s 9,600 customers. At $2,500 each, that’s $24 million/day or $8.8 billion over one year!

Alexander Robertson of Robertson & Associates, a lawyer who is very familiar with this case, told me that he expects Lumber Liquidators will lose this trial and, even before the damages phase starts, the headlines will be that a judge has determined that the company’s laminates were toxic. This additional adverse publicity will likely further impact sales to new customers and cause even more panic among prior Lumber Liquidators’ customers, who will demand refunds and replacement flooring.

Likelihood of even larger legal and regulatory liabilities

Lumber Liquidators settled Lacey Act violations (related to illegally harvested hardwoods) with the Department of Justice last October for $13.2 million. But the company has yet to reach settlements with any of the regulators or lawyers related to formaldehyde – and the CDC recently tripling the exposure level and cancer risk by 3.3x will make undoubtedly make settlements that much more difficult and expensive to achieve.

The amounts at stake here could make the cost of the Lacey Act settlement look like chump change – and if the CDC revises the risk upward again, as I believe it should, then all bets are off.

Operating performance of the business in Q4 was much worse than I expected – and I think meaningful improvement is unlikely for quite some time (if ever)

Lumber Liquidators’ operations are performing even more poorly than I thought they would when I covered this position a couple of months ago – and I can see no signs of a turnaround.

Same-store sales worsened in Q4 to -17.2%, gross margin remained depressed, and overhead (SG&A) costs remained elevated, resulting in an operating loss of more than $30 million. And, unlike Q1-Q3 2015, when inventory reductions led to $15 million of positive free cash flow despite $51.4 million of operating losses, in Q4 free cash flow was -$28 million. Now that inventory has been right-sized, I expect operating income and free cash flow to track each other fairly closely going forward.

Turning to the balance sheet, as of the end of Q4 (12/31/15), the company had $67.2 million available on its line of credit and $6.7 million in net cash, but both are declining rapidly: net cash fell sharply from $33.8 million at the end of Q3 to $6.7 million at the end of Q4 – and is likely negative now. (On the Q4 conference call on 2/29/16, CFO Greg Whirley said: “During the first quarter of 2016, we borrowed an additional $10 million against our asset-based revolving credit facility to fund additional inventory purchases in advance of the higher volume spring flooring season.”)

Thus, the onus is now on the company to turn things around because if sales and margins remain depressed, it could soon be in big trouble. I don’t lightly throw out the possibility of Lumber Liquidators going bankrupt, but simple math tells me this is not only possible but likely within a year if the company keeps posting quarterly losses in the $30 million range.

Lack of confidence in company leadership

Pretty much the entire board and the current CEO, John Presley, presided over Lumber Liquidators when, over an extended period, it purchased and imported illegally harvested hardwoods and toxic laminate, thereby bringing the company to its knees – yet these are the people who are supposed to fix the mess they’re responsible for???

If they had confidence in their ability to turn things around, why aren’t they buying stock? There hasn’t been one insider purchase in the past year.

John Presley, who’s been on Lumber Liquidators’ board since 2006 and was chairman of the audit committee in recent years, has no retail experience – his entire career has been in banking – and, according to two of my sources, he’s not getting the job done:

  • Multiple store managers say that their sales plan (on which each manager’s bonus is based) has been increased to 2014 levels, so few stores have any chance of hitting their goal. In one region, with over 20 stores, only a few hit plan in February
  • This has further demoralized store managers, who are increasingly seeking employment elsewhere
  • LL’s supply chain, price articulation strategy, product selection and quality are all areas of severe neglect and concern
  • Both merchandising and operations are in need of an upgrade

My conclusion is that the board needs to find a new CEO – and shareholders need to replace most of the board – before it’s too late.

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.

Disclosure: Funds I manage are short the stock of Lumber Liquidators. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.