Shares of Lumber Liquidators (LL +0.00%) sold off sharply Friday afternoon after hedge fund manager Whitney Tilson revealed a short position in the fast-growing hardwood flooring retailer. As an analyst who has followed both Lumber Liquidators and Tilson closely for years, I was surprised to learn that Tilson was betting against a company that I believed to possess sustainable competitive advantages, a strong balance sheet, and a stellar management team. Was I missing a critical red flag?
Fortunately, after reviewing Tilson's short thesis, I'm no longer concerned that my assessment of Lumber Liquidators is flawed. In fact, I think Tilson is wrong about the company.
I'll address the key points of Tilson's short thesis in a moment. But first, I think it's instructive to review Tilson's history in shorting stocks, as well as the lessons he claims to have learned.
A short recap of Tilson's shorting history
Tilson's hedge fund badly lagged the S&P 500 in 2010 due to significant losses in his short book, including a very public, very poorly timed bet against Netflix. After Tilson finally capitulated and closed his Netflix short in early 2011, he reassessed the role of shorting in his portfolio in a letter to his investors. Here are some excerpts, with emphasis added in bold:
Over time we've been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where we have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme. Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them entirely unless we have a high degree of conviction about a specific, near-term catalyst.
We're embarrassed to admit -- we pushed to the back of our minds two facts that have always been true: 1) shorting is a terrible business ... and 2) we're much better long investors than short investors. Said another way, long investing is a massively better business than shorting, plus our experience, skill set and temperament is much better suited to it. We will not forget this again.
He forgot it again
At last week's Robin Hood Investors Conference, Tilson presented his short case for Lumber Liquidators. Based on his PowerPoint slides, the main crux of Tilson's short thesis seems to be that substantially all of Lumber Liquidators' recent gross margin improvement can be attributed to sourcing low-cost product from China. Tilson believes that "a meaningful percentage" of Lumber Liquidators' Asian-sourced wood "is from Chinese mills that are trafficking in illegal wood," and "a meaningful portion of [Lumber Liquidators'] margin expansion could be due to buying illegal wood." Finally, Tilson claimed that resolving this issue "is likely to disrupt [Lumber Liquidators'] supply chain and materially impact margins."
Let's take a look at Tilson's claims to see whether Lumber Liquidators shareholders should be concerned.
Tilson says: Lumber Liquidators' "high [operating] margins make no sense in light of the commodity product and ferocious competitive environment."
It's true that Lumber Liquidators sells similar products as its peers. But Lumber Liquidators provides a distinct customer experience in terms of service, selection, and price. Lumber Liquidators offers a wider selection of flooring options than Home Depot and Lowe's, in a nicer atmosphere, with a more knowledgeable sales staff, and lower prices. When you consider that Lumber Liquidators stores are a fraction of the size of its big-box competitors' and operate with a much leaner staff, it's no surprise that the company boasts higher margins. This is the equivalent of claiming that Starbucks and Safeway should have similar margin profiles because both companies sell coffee.
Tilson says: "Reduced product cost accounts for nearly all of [Lumber Liquidators'] gross margin expansion."
This statement is accurate, but I believe Tilson misunderstands the source of those reduced product costs. As you can see in the chart below, Lumber Liquidators' margins have been on a steady upswing over the last two years.
|
2Q11 |
2Q12 |
2Q13 | |
|---|---|---|---|
|
Gross Margin |
34% |
37.3% |
41.3% |
Source: S&P CapitalIQ.
Tilson attributed Lumber Liquidators' margin improvement to an increase in the percentage of product sourced from China. In a sense, he is correct -- buying additional inventory from lower-cost Asian locations has certainly contributed to the company's gross margin expansion. But Tilson conveniently overlooks another factor that led to significant margin expansion at Lumber Liquidators: CEO Rob Lynch.
Upon joining the company in early 2011, Lynch implemented a series of margin-improving strategic initiatives, including regular product line reviews, additional direct mill sourcing, and transportation cost reductions. These initiatives have likely added hundreds of basis points to Lumber Liquidators' margins, and Tilson didn't mention any of them.
Furthermore, Tilson assumes that Lumber Liquidators' gross margin expansion was only due to lower costs. But that's not the case -- Lumber Liquidators has also benefited from a sales mix shift toward higher-margin products. A new marketing campaign, a revamped store prototype, and better trade locations are attracting a more casual consumer. Thanks to assistance from the better-trained sales staff (another Lynch initiative), these customers tend to purchase higher-margin products, including moldings and accessories.
So while some of Lumber Liquidators' gross margin improvement is due to increased sourcing from China, a large portion is due to the separate initiatives.
Tilson says: "A meaningful percentage" of Lumber Liquidators' Asian-sourced wood "is from Chinese mills that are trafficking in illegal wood," a "meaningful portion of [Lumber Liquidators'] margin expansion could be due to buying illegal wood," and resolving this issue "is likely to disrupt [Lumber Liquidators'] supply chain and materially impact margins."
This is the crux of Tilson's short thesis -- the specific, near-term, high-conviction catalyst he requires to short a stock. Surprisingly, Tilson provided no data to support these statements. While it's true that federal authorities are investigating Lumber Liquidators' importation of certain wood flooring products, the company has not released details about the scope of the investigation. It's not clear how many mills will be affected (if any), and what percentage of Lumber Liquidators' product supply they represent.
It is certainly possible that Lumber Liquidators will pay a fine related to the importation of illegal wood. The company may need to incur additional compliance costs going forward, and it is also possible that its supply chain will be temporarily disrupted. But I am aware of no data that supports Tilson's claims. If he has evidence, he certainly didn't include it in his presentation.
A dangerous short
I was concerned when I learned that Tilson was short Lumber Liquidators, but I found his case against the company to be surprisingly weak. It's certainly possible that Lumber Liquidators' margins will be affected by the Chinese sourcing issue. But there isn't sufficient information available to determine how significant the impact might be. Tilson provided no factual basis for his claim that the impact will be material, and I believe he has overestimated the benefit that Lumber Liquidators derives from its China-sourced products.
Lumber Liquidators is neither a fad nor a fraud. The balance sheet is strong and the business has plenty of room left to run. And while I don't consider the stock a screaming buy at current prices, I certainly don't believe the valuation is extreme. In other words, this is the exact type of stock that Tilson tells us is very dangerous to short.
