I presented my analysis of one of my most recent short positions, Lumber Liquidators, yesterday at the Robin Hood Investors Conference (my slides are posted at www.tilsonfunds.com/LL.pdf). Though the stock dropped 12% yesterday, I think it has much further to fall (after a 7x run-up in less than two years), as it still trades at 40x trailing earnings and 22x trailing EBITDA – but I’d love to hear from the VIC community in case I’m missing something. I’ve had too many painful experiences being short companies putting up great numbers – and LL sure is: last quarter, revenues, SSS, and EPS grew 25%, 17%, and 58%, respectively.
Wanna974 did a nice write-up in June (when the stock was at $82.50) focused on high levels of formaldehyde in one batch of wood (of three) he had tested. But nothing seems to have come of this. (How expensive would it be to buy 100 random wood samples and test them?)
The focus of my presentation is my conviction that a meaningful contributor to the company’s unprecedented margin expansion in the last two years is due to sourcing large quantities of illegally harvested and imported hardwoods. The best evidence for this is a 64-page report and an 11-minute video released last month by the Environmental Investigation Agency, which are posted at: http://eia-global.org/campaigns/forests-campaign/liquidating-the-forests.
I found EIA’s work to be meticulously researched and documented. It's an extremely impressive piece of investigative work – and is 100% consistent with everything we know about Russia and China: the Wild West of capitalism, widespread corruption, little rule of law or concern for environmental issues, etc.
Federal authorities obviously think the EIA report is credible, as agents from the Department of Homeland Security's Immigration and Customs Enforcement and the U.S. Fish and Wildlife Service on September 26th they raided LL’s headquarters, executing sealed search warrants "which relate to the importation of certain of the Company's wood flooring products." It’s amazing to me (and speaks volumes about investors’ lack of concern for risk in today’s market) that the stock fell only slightly and then quickly recovered after the raid.
I think this raid is really important – not because I think the authorities are going to do anything meaningful (I expect a slap on the wrist a year or two from now), but rather because it puts LL under intense scrutiny and will force the company to ensure that its supply chain is pristine.
Lumber Liquidators says that its largest supplier only accounts for 4% of its hardwood purchases, meaning that even if the EIA report, which only focused on one Chinese supplier, is correct, it’s no big deal – LL will just stop buying from that supplier.
I disagree. If the EIA report is correct (and I think it is), I think this problem is pervasive in China and thus likely affects a meaningful percentage of the 51% of LL's wood that is sourced in Asia. Thus, cleaning up its supply chain is likely to be highly disruptive and cause LL’s margins to revert back toward historical levels, which is most definitely not priced into this high-flying stock.
My two-year price target is $53 (and I think I’m being generous) based on the following back-of-the-envelope math:
- Sales grow 16% annually in the next two years, as analysts expect (resulting in revenue of $1.35 billion)
- Operating margins give back half of the 830 basis point increase in the last nine quarters and go to 9% (still far above LL’s long-term average)
- The market responds to this by assigning the stock a 20x P/E multiple
- Result: $1.35B x 9% - 39% tax rate / 28M shares = $2.65 EPS x 20 = $53
I welcome any comments, insights, or information.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.