Why I Got Out Of Growing, Undervalued Armstrong Flooring

| About: Armstrong Flooring, (AFI)
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I initially invested in Armstrong Flooring because it was a growth stock at a value price.

But a lawsuit alleging excess formaldehyde levels in their flooring threatens the share price, short and/or long term.

Discretion is the better part of valor. I’m out of Armstrong Flooring.

Armstrong Flooring, Inc. (NYSE:AFI) was spun out earlier this year from Armstrong Worldwide Industries (NYSE:AWI). I was attracted to it because it seemed like an undervalued but growing company. For the bull case, I encourage you to look at an article by Stock Spinoff Investing Guy.

In a way, none of that has changed. When I first bought AFI, I calculated fair value at $24+, or about 20% higher from present prices. Under most circumstances, I would continue to hold that opinion. Furthermore, I expect a positive operational report on the upcoming earnings call, August 12.

But there is a fly in the ointment, and I recently sold my shares.

Just one little thing …

In May, a Florida couple filed a class action lawsuit against Armstrong Worldwide and Lowe's (NYSE:LOW). They had bought some Armstrong-branded laminate flooring at their local Lowe's and installed it in their home in 2014. Then they had it tested in 2016, and discovered that it contained levels of formaldehyde that "far exceeded" the levels allowed by the California Air Resources Board, although the flooring was labeled as CARB-compliant.

(For those of you not familiar with flooring construction, laminate flooring and engineered flooring are made with "cores" of factory-made material. Usually these cores are made in China. It is cheaper to create the core material by using large amounts of formaldehyde. However, concentrations of formaldehyde are bad for your health. Until recently, California was the only state with regulations about the level of formaldehyde in flooring. The EPA is working on federal regulations now.)

In July, lawyers for Armstrong Flooring (who inherited the case after the spinoff) and Lowe's asked to have the suit dismissed. Their objections are technical, as would be expected for this phase of the case. Neither party is disputing (yet?) the alleged formaldehyde levels in the flooring.

So far, this case is flying under the radar, and one imagines that Armstrong would like to keep it that way. I have seen no news articles about it in either mainstream or industry press.

My concern is not really about the merits of the case. It is entirely possible, in my mind, that this couple is alleging defects that may not exist at all, or in any systematic way in Armstrong flooring. It is also possible that Armstrong uses a Chinese supplier who was trying to cut a few corners, and Armstrong knew nothing about it. On the other hand maybe there is real production problem here. Who knows.

My concern, rather, is what these kinds of allegations do to (1) the share price, in the short term, and (2) the reputation of the business, in the long term. The most famous example, of course, is Lumber Liquidators (NYSE:LL), which in February 2015 was the object of a 60 Minutes special on the dangerous levels of formaldehyde in some of their flooring. LL dropped 60% in a matter of days and, after a long series of lawsuits only now being resolved, has never recovered.

In May 2015, SA author Xuhua Zhou wrote an article that alleged something similar about Tecsun flooring sold at Lowe's. Lowe's pulled the product immediately. The report had a sharp but brief downward effect on the stock. Then again, Lowe's sells a lot of things besides Tecsun flooring and they handled the controversy well.

In November 2015, Whitney Tilson (who had broken the Lumber Liquidators story) alleged something similar about Ark Floors. Ark is privately held, but Tilson bet against Wayfair (NYSE:W), which sold Ark Floors product online. Wayfair dropped 17% when the report came out.

Most recently, Floor & Decor has been sued for selling flooring overdosed on formaldehyde. Floor & Decor is also privately held, so no market impact can be discerned just yet.

Back to Armstrong Flooring

As I said, I expect positive operational results from Armstrong Flooring on its upcoming call. I also expect them to mention this lawsuit, as it is certainly material for shareholders. What will that do to the stock, either in the short term, if traders sell on bad news, or in the long term, if customers shun Armstrong Flooring?

I don't know. But I didn't want to stick around to find out!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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 closed my position in AFI on Wednesday, August 3.