Lumber liquidators (NYSE:LL) is one of the biggest sellers of hardwood flooring in the US. Company has enjoyed stellar growth and its share price has skyrocketed from about $25 in July 2011 to $114.68 at the time of writing. On the surface current valuation seems to be well justified by company's financials and growth but once you dig a bit deeper you can unravel a different story.
It is easy to build a bull case for the stock. Lumber Liquidators has been enjoying a unique niche sandwiched between big DIY stores and smaller privately owned shops. Company has been demonstrating superb revenue and earnings growth. They have been enjoying industry's best gross margin peaking at 42% in Q3 2013 (calculated using Q3 10-Q from). Their net margin is below peers but is still impressive at 8.02% in Q3 (source: Reuters).
Lumber Liquidators has zero debt, $84.2m of cash and cash equivalents and $237m of inventory. The latter has been rising more or less in line with revenue.
Company keeps costs to a minimum. In its 2012 10-K statement, they write a lot about the fact they are sourcing their wood directly from producers and are usually their biggest client, which implies they enjoy a substantial bargaining power. Indeed, Lumber Liquidators can price their products substantially below their competition, we will take a close look at this point further down.
Company is trading at 45 times P/E (source: Bloomberg). It seems you can even justify this high multiple with impressive 70% QoQ earnings growth and 3-year average EPS growth of 33%.
Lumber Liquidators does not have any long-term lease commitments, and their shops are usually rented on a 5-year lease plan. After that they would check to see if there is a cheaper deal and would be eager to move if they find one.
No matter how you slice the numbers in their 10-Ks and 10-Qs the company looks solid. But once you dig a litter deeper worrying signs start to emerge.
Low customer satisfaction is extremely evident even to an untrained eye of casual browser yet alone any serious research analyst. I did not need to do a massive research undertaking on this topic because the evidence is already so abundant. Check out recent posts section on the official Facebook page. Now with any business you tend to get some unhappy customers but almost every 3rd commentary is a complaint or negative feedback, I encourage you to see for yourself.
Another simple check, Google "lumber liquidators reviews", and just glance through top hits. The amount of unhappy customers is astounding.
Now Lumber Liquidators is a discounter and high customer satisfaction may not be their top priority (which is contrary to what they claim in their 10-Ks) but I can not see how such business model can be sustainable. Eventually customers will avoid the brand and pay a premium for better service and quality.
Lumber Liquidators owner Tom Sullivan who also happens to be the chairman has been selling his shares. Easy to see from the regulatory filing on NASDAQ. Senior management has also been selling shares and exercising options.
Tom is also the guy who owns corporate HQ and 28 out of 300 shops directly. What he does then is leases them to Lumber Liquidators. The company openly says that they see a tangible risk of those leases rising and actually report that in their 2012 10-K. What kind of an owner does that? One that is afraid to lose control of his company and is looking to get some extra income at the expense of other shareholders.
Not that long ago company has been involved in a rather controversial story regarding high formaldehyde contents in their floors. A toxic carcinogenic chemical used in wood production. You can read more on the topic from various sources including Seeking Alpha.
Finally, there are two real components to how Lumber Liquidators manages to keep their costs and prices significantly below competition. Firstly they sell low quality hardwood. They process mis-mills i.e. the stuff that other hardwood producer discard. There are plenty of complaints because of that about floor panels being misaligned, cosmetic damage etc. Well you probably would not expect much from a discounter anyway, which brings us to their second method and main rationale for a short position.
There is a high chance that Lumber Liquidators has been using illegally cut wood from emerging markets, particularly the more expensive higher margin types. There are several factors pointing at that.
On Sept 27, Lumber liquidators offices were raided by federal authorities in connection with illegal wood imports investigation. The share price collapsed from about $113 to $98 on that day but has since recovered to $105.5.
There is a video from the Environmental Investigation Agency (EIA) on this matter.
To summarize, the clip tells a story of how Russian trees are illegally chopped down, shipped to China, re-marked and processed at a Chinese factory and then shipped in Lumber Liquidators packaging (they actually show those in the video). The shipment then arrives in the US with fake paperwork saying all wood has been legally sourced. This is a direct violation of the Lacey Act, which is designed to prevent selling illegally sourced wood in the US.
If you read the guidance section on the law available freely from the EIA webpage, you will see that even if the wood is sourced elsewhere and comes from a third party supplier importer Lumber Liquidator is still liable. Companies need to demonstrate that they have done sufficient due diligence and they cannot rely solely on paper work to make sure the wood they are buying is legal. If they fail to put sufficient controls in place, there is a fine, inventory confiscation and a prison sentence. Even if a company proves it has sufficient controls, illegal wood can still be confiscated.
Lumber Liquidators response to the whole situation has been rather muted: "The Company takes its sourcing and compliance very seriously, and is cooperating with authorities to provide them with requested information… The Company has more than 60 professionals around the world who perform and monitor those processes. Quality is a key component of Lumber Liquidators' value proposition…" I wonder if those were the same 60 professionals who kept an eye of formaldehyde levels earlier. Company has not made any comments on the investigation progress during the recent Q3 conference call either.
Full version of the official response can be found here :
In my opinion, the contra factual wood is a perfect explanation as to how Lumber Liquidators has been able to price its products below the market and keep its costs to a minimum.
The investigation was stalled due to government shutdown but has most likely resumed by now. In the mean time the senior management keeps selling. If Lumber Liquidators will be found guilty of Lacey Act violation, they would damage their reputation, face a fine, and would lose the illegal inventory. They will not be able to source cheap illegal wood anymore, which will depress the financials further.
Given that current share price is very close to most analysts' price forecasts you can benefit from a favorable asymmetric risk profile by going short Lumber Liquidators with investigation outcome being the key catalyst.
Disclosure: I am short LL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have not personally gathered any evidence on Lumber Liquidators illegal practices and am simply relying on publicly available information.