LUMBER LIQUIDATORS HLDGS INC LL S
June 21, 2013 - 8:28am EST by
wanna974
2013 2014
Price: 82.50 EPS $0.00 $0.00
Shares Out. (in M): 25 P/E 0.0x 0.0x
Market Cap (in $M): 2 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 2 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Activist Short
  • Retail
  • Housing
  • Regulatory Downside Risks
  • Fraud
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Description

This Product Reeks!

Lumber Liquidators (NYSE:LL) product found to contain illegal levels of formaldehyde – a known carcinogen.  

Lumber Liquidators (NYSE:LL) is one of the largest specialty retailers of hardwood flooring in the United States, operating 293 stores in 46 states.   The company reported net revenue of $813 million gross revenues, garnering a 10.7% market share of the market, and $47 million in net income for the year 2012.  At $82 a share, this stock is the definition of a high flier:  trading at over 50x fiscal year 2012 earnings, amazing for a building material retailer.  The rationale for this huge multiple is twofold:

1)     Huge gross and net margins, despite selling a commodity product

2)     An aggressive growth plan to double the number of retail outlets

Lumber Liquidators’ stock has been on a tear, rallying 300% over the last year, primarily on dramatic expansion of its gross and net margins.  Management has often made reference to the significance of its acquisition of Sequoia Floorings Inc. in Shanghai as a primary reason for the tremendous improvement in margins.  Sourcing product in China is certainly hardly unknown to competitors, and skeptics have wondered how an $8 million acquisition could have such a dramatic effect on gross margin and bottom line, and more importantly, enable Lumber Liquidators to undercut fierce price competitors such as Home Depot and Lowe’s.    

That piqued our curiosity, but we found nothing improper about the acquisition of Sequoia itself.  We then directed our investigation towards the quality of flooring sold by Lumber Liquidators that is imported from China. And that is where we found the problem we report today.

The Stinking Truth

We recently conducted independent lab testing – engaging Berkeley Analytical, an IAS accredited testing laboratory -- on a sample of Lumber Liquidators house brand flooring (“Mayflower” brand), and the results that came back weren’t pretty:  Over 3.5x the maximum legal level for formaldehyde.  (This product was purchased retail from a Southern California retail store.) 

Fully understanding the importance of this finding, we submitted samples from the same package to a 2nd laboratory, this one the “gold standard” lab for the National Wood Flooring Association, NTA   .  This 2nd lab confirms the product is in violation of the legal limit for formaldehyde.

The reality is formaldehyde is a known carcinogen, and it is now illegal to sell product that exceeds safety standards.  California has had regulations on formaldehyde emissions for years, enforced through its Air Resources Board (CARB), but Federal regulations with the same standards have recently been implemented by the EPA.

What particularly caught our attention was that not all Lumber Liquidator’s products failed formaldehyde testing.  Lumber Liquidators sells several “house brands”, and the materials in the brand that failed are imported from China.  More about this connection in the next section. 

For investors who are unfamiliar with formaldehyde, it is listed as a known human carcinogen in June of 2011 by the National Toxicology Program. In addition, formaldehyde has also been held accountable as a cause of childhood asthma and female reproductive issues.

Enforcement against non-compliance is serious business, and serious fines are attached; fines  can be levied each day for willful violations.  A good general overview of the relevant CARB regulations can be found here., courtesy of Greenberg Traurig, a huge international law firm with substantial expertise in regulatory compliance matters. 

Highlights include detailed lab report showing LL's product emits formaldehyde at 3.4x the legal limit. All the relevant reports and documents can be found in this Seeking Alpha article 

Lumber Liquidators officially states that all of its products are CARB compliant. In fact, labeling on the boxes of its flooring products clearly states the product is California 93120 phase 2 compliant for Formaldehyde in plywood. Also, Lumber Liquidators’ representative stated the following on the Q&A section of its own website:

“Q: Does this product use urea formaldehyde and does it have low or no VOC?

-- Asked on 12/2/2012 by Aimee from Houston, TX

A: The adhesive that is used in bonding our Bamboo, Cork, Engineered, and Laminate flooring products contain very low amounts of Urea Formaldehyde. We feel that our products are very safe and most meet California CARB Phase I or California Phase II regulations, which is listed on the boxes. We also list MSDS sheets for most of these products on the Lumber Liquidators website “Flooring 101”.

-- Answered on 12/10/2012 by cc-2”

The China Factor

Formaldehyde Contamination in Hardwood Flooring:  a Huge Issue in China

There is specific background for concerns about formaldehyde in flooring products from China.  In particular, A&W, Anxin Weiguang Flooring, was a leading hardwood flooring company in China until February of 2012 when a consumer advocate broke the news on the internet that A&W branded engineered hardwood flooring products did not meet regulatory formaldehyde emission standards.

A&W is a major Chinese flooring company, counting Carlyle as one of its investors. Media nicknamed the issue “toxic flooring gate” and it drew an incredible amount of attention from consumers. Among the allegations, the advocate detailed A&W branded engineered hardwood flooring products used in certain condominiums developments significantly exceed the regulatory limits and such flooring products were sourced directly from A&W. The issue turned into a major controversy forcing China Vanke, the largest residential real estate developer in China, to re-test all the flooring products sourced from A&W. After comprehensive testing of the flooring products in question, Vanke identified at least one of its developments where the formaldehyde emission level of the flooring products was noncompliant. The incident caused significant public concerns and subsequently, A&W experienced a drastic sales slump and almost went bankrupt as a result of the incident. In addition to supplying products to real estate developers in China, companies such as A&W also export flooring products to the United States. 
http://www.wantchinatimes.com/news-subclass-cnt.aspx?id=20120226000087&cid=1502

http://www.china.org.cn/business/2012-02/21/content_24689966.htm

http://www.chinadaily.com.cn/bizchina/2012-02/22/con

Company Reputation

U.S. Consumer complaints about exposure to formaldehyde in Lumber Liquidators products

It’s not like there’s never been awareness about formaldehyde in Lumber Liquidators flooring. 

http://usaconsumercomplaints.com/shops-trade/209907-sell-defect-products.html

http://www.complaintsboard.com/complaints/bella-wood-c383939.html

http://floormasters.com/flooring-pros/viewtopic.php?f=1&t=10074

But in fairness, while these complaints should have been sufficient to put the company on notice, they are sporadic and across time.  

We note a particular ascerbic comment in a recent writeup mentioning concerns about Lumber Liquidators’ reputation with flooring professionals and consumers.  This came from Grant’s investment newsletter, which contained several insightfully skeptical critiques of the bull case thesis:  

"The man from the Garden State asked to remain anonymous.   So did a retailer from Maryland. "I'm the general manager of this company, and I've been in the industry for 26 years now," our informant said. "The reputation of Lumber Liquidators is that they are the dumpster of the industry." 

The author of a Yelp review of the Lumber Liquidators' store on E 1st St. in Manhattan, dated Dec.10, 2012, was only one-half anonymous. "The  ood that they sell you is of poor quality, even if it's Bellawood hardwood," wrote Sarah F. "The planks are not the same width across their length, and they are not durable at all. I've had my floor for less than six months and it looks awful already." The Web site Reseller Ratings posts 63 customer reviews of Lumber Liquidators. On a 10-point scale, LL scores 3.61 for pricing and services, 0.63 for shipping and packaging and 0.56 for customer service.  

So did a retailer from Maryland. "I'm the general manager of this company, and I've been in the industry for 26 years now," our informant said. "The reputation of Lumber Liquidators is that they are the dumpster of the industry."

Insider Sales

We would be remiss if it didn’t mention Lumber Liquidators truckload size insider sales, including an eye-popping $30 million in May 2013 alone!  Look out if evidence ever emerges of management’s prior knowledge of contaminated product being knowingly distributed and sold.

Conclusion

It is impossible for an investigator such as us to fully assess the impacts of Lumber Liquidators vulnerabilities to its business from this finding.  How many brands and SKU’s show formaldehyde contamination.  How long has such product been distributed in the U.S.?  (We note that all US product is distributed from a single point of supply, so we think it highly unlikely that our finding is isolated.)  However, it does create serious doubts which every investor had better evaluate, such as:

  • To what extent have Lumber Liquidator’s extraordinarily high profit margins been dependent on substandard or improperly tested product?   Will Lumber Liquidators be able to maintain margins while clamping down on distributing contaminated product?
  • How much contaminated product is in inventory nationally?   What will be the costs of liquidating it?  (Note that all of Lumber Liquidators product in the US is distributed from its single Virginia Warehouse facility.)
  • How much contaminated product has been installed in consumers’ property, for which the company might be liable for remediation, including removal and replacement, including reinstallation ?
  • What regulatory liabilities, including fines, does the company now have exposure to? 
  • What civil litigation, including a potential class action suit, is the company now exposed to?
  • Will a shareholder suit uncover willful misconduct or negligence in corporate officers?
  • What reputation damage will the company incur?
  • What are the consequences of these bad outcomes on the company’s growth plans?

We want to be completely candid about what this report is and what it isn't.  It isn't our job to be the company's quality control department.  We found one seriously non-compliant batch of product in a total of three samples of the Chinese imports, and verified the result at a two independent labs with top credentials.  What does it mean?  Could this be a near-meaningless oversight or could it be "the turd in the punchbowl"?

It might not be dissimilar to the China Vanke situation, where only a small minority of the installed wood products were contaminated, yet the consequences were widespread.  

The company sold appx 200,000,000 square feet of product last year.  If 10% is contaminated, that would be over 20,000,000 square feet of product producing toxic outgas into US homes and businesses, maybe 250,000 rooms.   If even 10% of that amount, say one sample in a hundred, is contaminated, that's still 2 million square feet of contaminated product, maybe 20,000 rooms worth.  We have no idea.

The company's response to this report will tell the investing public a lot more about Lumber Liquidators than this blog post.  If the company launches a major, highly transparent campaign to acknowledge the problem, do the right thing, retest and recall all contaminated product, redouble its efforts to insure the safety and quality of its products, and stand behind all contaminated product sold to the public, that will tell you something.  If they attack the messenger, it will tell you something else.  We stand ready to supply the company with the remaining product we tested and copies of the lab results.  

We want to be completely candid about what this report is and what it isn't.  It isn't our job to be the company's quality control department.  We found one seriously non-compliant batch of product in a total of three samples of the Chinese imports, and verified the result at a two independent labs with top credentials.  What does it mean?  Could this be a near-meaningless oversight or could it be "the turd in the punchbowl"?

It might not be dissimilar to the China Vanke situation, where only a small minority of the installed wood products were contaminated, yet the consequences were widespread.  

The company sold appx 200,000,000 square feet of product last year.  If 10% is contaminated, that would be over 20,000,000 square feet of product producing toxic outgas into US homes and businesses, maybe 250,000 rooms.   If even 10% of that amount, say one sample in a hundred, is contaminated, that's still 2 million square feet of contaminated product, maybe 20,000 rooms worth.  We have no idea.

 



I hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Potential margin compression due to the need to introduce quality control measures
Inability to source cheap Chinese products
Added consumer scrutiny and potential abandonment should consumer awareness grow
Valuation collapse
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