The announcement this morning that Robert Lynch is resigning as Lumber Liquidators' (NYSE:LL) President, CEO and board member was not only a surprise to the company, but to me as well. In fact, in light of the company's circle-the-wagons, deny-and-attack approach since the 60 Minutes story aired on March 1st, I'm shocked by this announcement because it undermines all of the company's denials since the 60 Minutes story aired.
If Lumber Liquidators was a good company with no formaldehyde problem - or was the innocent victim of nefarious Chinese suppliers - Lynch never would have resigned.
The fact that he did - and did so "unexpectedly" - is powerful evidence that the three main things I've been saying all along are undoubtedly true:
1) Lumber Liquidators, until only two weeks ago when it finally suspended sales of its Chinese-made laminate flooring, was for years selling American families hundreds of millions of square feet of this product, which contained high levels of formaldehyde, a dangerous chemical and known carcinogen, and thus endangered the health and safety of its customers, especially children.
2) Lumber Liquidators' senior executives knowingly did this in order to save ~10% on sourcing costs. Why would they do something so immoral and potentially destructive? The oldest reason in the universe: greed. Laminate is one of the company's most profitable product lines and non-CARB-compliant laminate is ~10% cheaper, so the company saved a lot of money on sourcing costs (not a few pennies, as founder, Chairman and new CEO Tom Sullivan claims), which I think was a major contributor to a quick doubling of margins, which in turn helped send the stock price up eight times from $15 to $119 in less than two years. Sullivan and Lynch recognized a golden opportunity when they saw it, dumping $37 million worth of stock at prices more than triple today's level in early- to mid- 2013; and
3) Lumber Liquidators is a notorious bad actor: cutting corners at every opportunity, selling very low-quality products, treating customers, vendors, installers and employees badly, and, most damningly, not being serious about compliance.
(A pdf of the 16 articles I've written on Lumber Liquidators since the 60 Minutes story aired - with a table of contents - is posted here.)
There are a number of other possible implications of Lynch's sudden departure:
1) It likely means that Lumber Liquidators is under immense pressure from regulators, who will, I expect, take decisive action to rein in and punish this rogue company.
2) I think Lumber Liquidators' board members are finally waking up to what really happened, are rightly panicked about the implications, both for the company and their own personal liability, and are seizing control of the situation. Thus, Lynch was likely under immense pressure from the board, saw the writing on the wall, and decided to jump before being pushed. As I wrote in my article two weeks ago, The Market Is Misunderstanding Lumber Liquidators' Announcement, in response to the company's decision to halt sales of its Chinese-made laminate: "One source tells me that the decision to halt sales was made by the board, over management's objections, which, if true, means that perhaps they kept the board in the dark about their nefarious actions."
3) Reflective of the change in who's running the show is the company's new "Commitment to Quality & Safety" web page, replacing the one it posted shortly after the 60 Minutes story aired.
The old one made the laughable claim that "all of our products are 100% safe," had videos featuring both Sullivan and Ray Cotton, Lumber Liquidators' Senior Vice President, Chief Compliance and Sustainability Officer, impressive-looking charts that purported to show that its laminate had safe levels of formaldehyde (which I rebutted in this article), and laid the blame for its problems at the feet of short sellers like me:
These attacks are driven by a small group of short-selling investors who are working together for the sole purpose of making money by lowering our stock price. They are using any means to try and scare our customers with inaccurate allegations. Their motives and methods are wrong and we will fight these false attacks on all fronts.
The new web site makes no claim that Lumber Liquidators' laminate is safe or compliant, has a slick, new, feel-good video with no company employees in it, and doesn't mention short sellers. Instead, it has pretty pictures and this generic, carefully-crafted statement that says nothing (with a cute new logo):
Offering value means more than saving our customers money, that's why Lumber Liquidators is committed to providing high quality, durable, safe products.
For more than 20 years, Lumber Liquidators has delivered on that promise by making beautiful, high quality hardwood flooring affordable for everyone.
Your life is lived on our floors, and we take that to heart. We go the extra mile for your safety and satisfaction. That's why we use quality and compliance processes designed to ensure we meet applicable regulations and our stringent quality standards.
4) I doubt that Lumber Liquidators was ever a corporate exemplar, but I'm not sure that it was always a notorious bad actor. I've heard from numerous people that when Lynch became CEO at the beginning of 2012, the company's sourcing and compliance procedures as well as how it treated vendors and installers got much worse - all part of an effort to increase margins, profitability and, of course, the stock price in the short term, long-term consequences be damned. If Lynch was, in fact, a major source of the rot in the company, then his departure is good news for Lumber Liquidators and everyone who interacts with it, most importantly customers. If the few remaining bulls on this stock are looking for a silver lining to today's news, this is it.
Since the 60 Minutes story aired, Lumber Liquidators has consistently done the wrong thing at every turn. If it wants to break this dismal streak and start behaving like an honest and reputable company, it needs to take a number of steps:
1) Offer a full refund to any customers who want to return Chinese-made laminate that's already been delivered but not yet been installed.
2) Cease the bogus formaldehyde testing program that it's currently offering customers (see my article, Lumber Liquidators' Offer to Do Indoor Air Quality Testing Appears to Be a Sham), and instead offer to send a trained specialist with sophisticated equipment to do a proper test.
3) Rather than waiting for inbound calls and complaints, Lumber Liquidators should send a letter to every customer who has purchased its Chinese-made laminate flooring in the past, say, five years, informing them that the product may be emitting dangerous levels of formaldehyde and offering a proper test.
4) For any customers with a reading above 0.016 parts per million (16 ppb), the standard set by both FEMA and NIOSH (I'm being generous - 7 ppb is the limit set by the California Office of Environmental Health Hazard Assessment; for more on this, see my article, More On Lumber Liquidators And Formaldehyde), offer to pay all costs for them, if they wish, to temporarily move out of their home until the flooring can be removed and replaced with safe flooring, at Lumber Liquidators' cost (even if the customer chooses carpeting or wood flooring bought from another company). Also, for these customers, offer to pay all medical bills for anyone in the home suffering symptoms consistent with formaldehyde exposure; and
5) Fire Ray Cotton, who, as I showed in this article, is not a serious person and, not surprisingly, has failed miserably in his job as head of compliance at Lumber Liquidators.
As I disclosed in previous articles (here and here), I've added to my Lumber Liquidators short position twice since the 60 Minutes story aired because further evidence emerged that my short thesis was correct, the company continued to pursue a reckless and truly insane deny-and-attack strategy, and the stock remained significantly overvalued.
Today, the story is now more mixed. While I'm even more certain that my investment thesis is correct, the company has finally done what it should have done long ago: suspended sales of its Chinese-made laminate and engineered the departure of Rob Lynch. And, of course, the stock is much lower, hitting a 3+ year low this morning.
Thus, I'm not inclined to add to my short position at this price, especially since, even after today's decline, it's still my largest at ~3%.
But I'm not inclined to cover and take some profits either, for two reasons:
1) I see nothing but bad news emerging for the company over the short-, intermediate- and long-term horizons. In particular, I think regulators (most likely the California Air Resources Board and the Consumer Product Safety Commission) will announce that their tests of Lumber Liquidators' Chinese-made laminate are consistent with the test results commissioned by 60 Minutes, myself and others; that, consequently, they will take strong action against the company (perhaps requiring some of the steps that I outline above); and that the legal liabilities will be enormous, especially once hard evidence emerges that the company was knowingly poisoning its own customers; and
2) I still think the stock is significantly overvalued. In my article on April 3rd, Comments on Lumber Liquidators' First Quarter Business Update (when the stock was above $33), I wrote:
If we take the midpoint of the historical operating margin, 7%, and assume $1 billion in sales, that means Lumber Liquidators would have $70 million of operating income. Applying a 39% tax rate and dividing by 27.2 million shares results in earnings per share (EPS) of $1.57 - which is almost exactly current consensus analysts' estimates for 2015 of $1.60.
The difference between us, however, is that I think $1.57 is normalized earnings power in a best-case scenario, excluding many costs that I believe are likely to be substantial and long-lasting, whereas analysts think 2015 will be an unusual trough year and that the company's EPS will soar 41% to $2.26 in 2016. I would bet my last dollar that Lumber Liquidators doesn't earn $2.26 in 2016.
Rather, I think it would be extremely generous and optimistic to estimate that the company's earnings grow 10% in 2016, which would result in EPS of $1.76. If I'm right, what multiple might the stock trade at? It could trade as low as 6x if regulators take strong action and various lawsuits gain traction (which I think is highly likely), and as high as 15x if not, which results in a stock price range of $10.56-$28.16. Either way, it's a substantial discount to the current price of $33.20, which is why this remains my largest short position.
Since then, analysts have been scrambling to lower their estimates, which now stand at $0.46 for this year and $1.58 for next year. Thus, the stock, at $21.50 today, trades at 46.7x this year's estimates and 13.6x next year's estimates. These multiples are much too high for a business of mediocre quality (at best) that is facing enormous uncertainty and contingent liabilities that, in a worst-case scenario, could bankrupt it. Think about it: would anyone care if Lumber Liquidators ceased to exist?
I highly doubt that Lumber Liquidators will earn $1.58 next year, but even if it did, I think a 10x multiple would be generous, so that translates into a stock price of $15.80 - 26% below today's levels. Thus, while I'm not adding to my short position, I'm very comfortable keeping it as my largest short.
PS - I don't read the message boards for the articles I publish, but I do want to hear thoughtful comments and questions so I invite my readers to communicate directly with me via Seeking Alpha messaging. I will post my answers on the message board.
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Disclosure: The author is short LL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.