Lumber Liquidators Holdings (NYSE:LL) finally responded to allegations made by a short-seller-funded group, and covered nationally by 60 Minutes, the CBS news show, that its Chinese-made laminate flooring is illegal in California, and potentially dangerous. The company gave an hour-long conference call and 50-page presentation, which can be found here. Here are the highlights:
- Stands firm on its position that all its products are safe and legal.
- Provides significant detail about CARB compliance and testing.
- Announces that it will provide in-home air quality testing for concerned customers, and will address it free of charge if any prove to have dangerous emissions from Lumber Liquidators flooring.
- Provided a financial update of the impact, including a "worst-case" scenario.
Frankly -- as you'll see below -- at this point, either Lumber Liquidators fully addressed this issue, or they are flat-out lying. There's just no room for any middle ground now. Let's take a deep dive into their response. If you're looking for more about the allegations against the company, go here for my in-depth coverage.
The "core" issue
The allegations, in short, claim that Lumber Liquidators is sourcing and selling laminate flooring from China, and claiming that it meets California Air Resources Board, or CARB, Phase 2 compliance -- but that it actually doesn't meet this standard. As part of its investigation, 60 Minutes purchased 31 Chinese-made laminates from several California and non-California Lumber Liquidators stores, and paid for third-party testing of formaldehyde emissions.
The testing method used by the labs was so-called "deconstructive testing," for which CARB has an SOP for this method, and calls it an approved method. However, since the beginning of the story, Lumber Liquidators has been steadfast in its position that this testing procedure isn't proper or accurate in measuring the formaldehyde emissions of its product.
For the first time in the 11 days since the 60 Minutes story aired, the company gave a very detailed explanation of its position, including discussions that the company has had with CARB about this. CEO Rob Lynch had this to say on the call (emphasis mine):
As we start to discuss the topic of deconstructive testing (the test that 60 Minutes used), I want to read from an Federal Wood Industries Coalition release from yesterday. "Some laminated flooring recently has been the subject of "deconstructive testing", the mechanical removal of the outer laminates and finishes by planers or sanders to expose the substrate. This type of testing is not required by CARB to demonstrate compliance. CARB has used this approach as a "rough" screening method, but the procedure is not part of the regulation nor has it been adopted by ASTM or other consensus standards bodies. The deconstructive method is "rough" because the process can fundamentally change the emission properties of the panel substrate. It should only be used by professionals who understand its use and limitations."
When CARB finalized its regulation, it told the stakeholders that it was going to try to figure out a way to determine whether finished goods sold in California were CARB compliant. Their first attempt to do that was through their Standard Operating Procedure, or "SOP," in October 2013. The SOP described how to prepare a finished good by deconstruction, or ripping it apart, for formaldehyde emission testing. But one important thing to understand about this document is that it does not discuss how to interpret the results ... We have been engaged with CARB over many months, provided them with additional information and, like others in the industry, have expressed our concerns on the validity and applicability of the deconstructive testing method. CARB has indicated to us that no one in the industry is expected to conduct deconstructive testing for compliance purposes and we know of no further action that has been taken by CARB with respect to our products or the suppliers and manufacturers that provided these products to us.
So either the company is in compliance, or is lying about what CARB is telling it and the industry.
More about deconstructive testing
The deconstructive testing method has been approved by CARB for "screening" and having an SOP in place; but it hasn't been adopted by ASTM International, a worldwide body for developing common standards, due to the range of variability in testing results. A joint industry statement points out that CARB has acknowledged this, and this is the primary reason why it only uses deconstructive testing as a screening tool, and not for enforcement.
Furthermore -- and this gets to the heart of the matter, Lumber Liquidators' position has always been that deconstructive testing is invalid because the manufacturing process fundamentally alters the core:
Furthermore, deconstructive testing also tests the product in a manner in which it would never be present in someone's home. More from Lynch (emphasis mine):
...the process of removing these outer layers – including the glues and resins that hold the product together -- is problematic because it alters the core's integrity and structure. As you remove the surface of the fiberboard it becomes less dense. So, deconstruction exposes the less dense areas of the core, which promotes formaldehyde release because the higher density areas, which act as barriers, have been stripped away. Another problem is that it is impossible to remove the glues and resins, some of which include formaldehyde. This formaldehyde, which was not part of the original regulated core, can be absorbed by the original core and then be released as a part of the deconstructed core. The testing method also has not been validated by independent accreditation bodies. And, as I mentioned in discussing the SOP, there is no established standard for evaluating the results...
...So what does all this mean? We believe CARB, as it should, is regularly looking at the entire industry, up and down the supply chain, to ensure compliance. We know they are using deconstructive testing as part of this process, but they have indicated that they do not expect the industry to use this testing method.
In short, not only is deconstructive testing not consistent or approved by international standards organizations, but CARB has said that it's not an official enforcement procedure. Furthermore, it's also not included in the proposed EPA regulation, according to Lynch.
Financial impact: Is the company overly exposed?
If the company is to be believed, then the only impact would be on its reputation, and the lost sales that would result. Before the 60 Minutes story was aired on March 1, the company's sales in the first two months of 2015 were up 18.7% from the year before, with comparable-store sales up almost 10% from last year's weather-affected results.
In the nine days following the broadcast, sales were down 7.5% versus the same period last year, with comps down almost 13%. This was driven by a 10% decline in customers invoiced, which quite frankly is surely related to the story. Furthermore, laminate sales had been 21% of the sales mix through February, but were only 16.4% in the nine days after. Similarly, the sales mix of Chinese-made laminate fell from 14% to 8.5% before and after the airing.
However, it's hard to say what the impact will be going forward. While some customers will be satisfied with the company's response, there will surely be some who remain skeptical. With that in mind, management provided a "worst-case" scenario for investors.
In short, if the company kept its advertising, operating, and capital expenses in line with prior projections, it would take sales falling 27% from last year, and gross margin falling to 37%, for the company to need to tap its line of credit for capital, or use its assets as collateral for more debt.
It looks like the company would have to be lying about essentially everything, and for CARB and the Department of Justice to come after the company with fines and lawsuits for anything close to this to happen.
As the image to the left shows, it would take sales falling by more than the company's entire laminate flooring sales last year for revenues to fall that far. Frankly, it's just hard for anything close to that happening.
Peeling back another layer, Chinese laminate only made up about 10% of last year's sales:
Whitney Tilson's response
The short attack against the company has been largely led by hedge-fund manager Whitney Tilson, who brought the story to 60 Minutes. Tilson responded before Lumber Liquidators' call today, attacking the company's decision to not take questions.
He also responded after the fact, stating that he was still shorting the company's stock, and continuing to accuse the company of, "...a vain attempt to mislead customers, investors and regulators."
Frankly, my position is that Tilson is simply mistaken in his attempt to "prove" the company guilty, largely based on his analysis of the company's profit margin expansion in recent years, and his belief that the company couldn't have pulled this off with legitimate business practices. To start, he claims that, "The accusation against Lumber Liquidators is simple: that in order to save approximately 10% on its sourcing costs the company has over an extended period purchased in China."
Considering that last year's sales of Chinese laminate were 10% of total sales, the company would have had to get almost all of this material almost free to save 10% off its sourcing costs. It's a biased and inaccurate position.
Second, Tilson refers to statements made by Dr. Philip Landrigan -- a well-known expert on exposure to toxins -- as evidence to support his claims. He said this:
I would say long-term exposure at that level would be risky because it would increase the risk for chronic respiratory irritation, change in a person's lung function, increased risk of asthma. It's not going to produce symptoms in everyone but children will be the people most likely to show symptoms at that sort of level.
For anyone who didn't see the 60 Minutes broadcast, Dr. Landrigan was responding to the results of the tests, not the veracity of the testing methods. Lumber Liquidators has provided significant evidence to support its assertion -- that core testing is the method that applies to its products, and CARB uses deconstructive testing for screening but not regulation -- and also provided information to demonstrate that CARB agrees with this assertion. Dr. Landrigan may be an expert on the health risks of exposure, but he's not an expert on the testing methods of wood laminates, and it's unfortunate that his reputation is being used to validate something that he didn't address.
Furthermore, Lumber Liquidators' offer to provide third-party air-quality testing to customers makes it clear the company stands behind its products as being safe.
Tilson didn't bring that up in his rebuttal.
Frankly, his response was largely rhetoric, with links to plenty of "bad consumer reviews" websites. However, just a few moments of poking around at those sites will lead you to just as many (or more) terrible reviews of companies like Lowe's and The Home Depot. Frankly, it appears that Tilson is now defending his reputation, evidence be damned.
Frankly, it's really hard to imagine that the company is lying at this point. There were just too many very direct statements about CARB's position on testing -- and serious support from industry associations that would be distancing themselves from the company if it were making false statements about CARB's position -- for that to be anything close to likely.
However, that doesn't mean that this is over. Far from it. Lumber Liquidators remains involved in a series of lawsuits, and these need to play out further. Not only that, but there will be some hangover from the 60 Minutes story for weeks, and maybe months.
Most importantly, maybe, is the current market the company is operating in. So far, housing sales -- especially existing home sales -- remain well below historical levels. Until this changes, the company will operate in a challenging environment. Nonetheless. management is moving forward with plans to expand its store base and relocate or remodel some stores this year, though it did expand the range on the low-end based on the potential lingering affects of this story.
Time to buy?
Despite the risks above from continuing litigation, the overhang of the impact on the company's reputation, and the general malaise in home sales, I think it's time to buy. As Warren Buffett said:
You want to be greedy when others are fearful. You want to be fearful when others are greedy. It's that simple.
I think that's the case here, now that we have enough information to validate that the "blood in the streets" was panic induced.
Here's the bottom line as I see it: The bear case brought forward by short-sellers misses the mark, and 60 Minutes should have consulted with CARB about the testing methods and how it enforces regulations around Phase 2 for laminate flooring. As things stand today, its story influenced a lot of people, but omitted a lot of important context.
A lot of shareholders who sold were harmed by their decision to sell so early in the story. I'm planning to take advantage of this opportunity to buy.