What To Make Of Lumber Liquidators -- Should We Believe Anderson Cooper and Whitney Tilson?

By Markets Fool.com


60 Minutes'Anderson Cooper with Lumber Liquidators founder Tom Sullivan. Source: 60 Minutes.

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Back in late 2013, flooring retailer Lumber Liquidators was the classic American success story. Founder and Chairman Tom Sullivan had taken the business from one location and turned it into the country's largest retailer of wood and wood laminate flooring in about 20 years. Investors who bought shares after the IPO in late 2007 saw 10-fold returns by November of that year:

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Since then the company has faced a Department of Justice investigation into illegal wood sourcing activity, a weak housing market that has seriously affected sales, and now a report from 60 Minutes, in which Anderson Cooper accuses the company of selling laminate flooring that is not only illegal in California but could put people's health at risk.

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Denny Larson & Richard Drury are suing Lumber Liquidators. Short-sellers are funding their efforts. Source:60 Minutesbroadcast.

The story came to60 Minutesby way of hedge fund manager Whitney Tilson, a well-known investor with a short position in Lumber Liquidators stock. Furthermore, as was disclosed in the story, short-sellers are funding at least one lawsuit against the company.

Since the peak in 2013, Lumber Liquidators stock has been hammered by almost 70% as of this writing, and many recent investors are paying a heavy price in losses. The question on many investors' minds today: Who's right? Is the company sourcing and selling an illegal product -- and, maybe more important, a potentially dangerous one?

This is a worthy and important question, but there's one that's just as important: How much is the company exposed right now? Furthermore, what's theactualrisk that this creates for the company? Let's take a deeper dive into the allegations and, more specifically, into just how big a part of Lumber Liquidators' business is driven by the products alleged to be illegal and potentially harmful to consumers.

Already skeletons in the closet
These latest allegations against Lumber Liquidators aren't the only public-relations and potential legal problems the company has to deal with. The company's annual report filed with the SEC in February disclosed the following (emphasis mine):

On September 26, 2013, sealed search warrants were executed at the Company's corporate offices in Toano and Richmond, Virginia, by the Department of Homeland Security's Immigration and Customs Enforcement and the U.S. Fish and Wildlife Service. The search warrants requested information, primarily documentation, related to the importation of certain of the Company's wood flooring products. Since then, the Company has been cooperating with the federal authorities, including the Department of Justice ("DOJ"), in their investigation. In recent communications, the DOJ indicated that it is contemplating seeking criminal charges under the Lacey Act. The Company expects to continue to communicate with the DOJ regarding its intentions and possible courses of action in this matter. At this time, the Company does not have enough information to estimate a reasonably possible loss or range of loss that may result from actions by the DOJ as a result of its investigation.

The company made major changes to its documentation requirements from suppliers soon after the investigation began.

Sourcing challenges hurting margins?
Stricter documentation requirements on suppliers affected the company's ability to source product, and it felt the impact in nearly every quarter in 2014. It became a regular refrain from management to blame lost sales oninventory issues, forcing the company to discount substitute products to retain business, which hurt margins and reduced profits.

The company's gross margin percent has declined almost every quarter since peaking in 2013:

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LL Gross Profit Margin (Quarterly) data by YCharts.

However, the margin question isn't that straightforward. This is because the company also invested heavily in store expansion and a massive East Coast distribution center in 2014, and some of these investments have probably affected gross margins at least in the short term. Furthermore, the housing market -- specifically existing-home sales -- has lagged, hurting sales at many specialty retailers that cater to specific high-ticket home-improvement products. Put simply: it's hard to segment out the impact of sourcing from that of a weak sales environment on the company's margins.

Either way, that doesn't really pertain to the allegations at hand.

Formaldehyde and CARB Phase 2


Source:60 Minutesbroadcast.

Formaldehyde is common in a number of industrial applications, including the glue used for backing in many inexpensive laminate floors. Since formaldehyde is a known carcinogen at high levels of exposure and can cause eye and respiratory irritation and health problems at lower levels, the California Air Resources Board, or CARB -- and, more recently, the federal government -- set limits for what is considered safe exposure to emissions laminate flooring that contains the chemical.

The heart of the 60 Minutesstory was that three of the company's Chinese suppliers were falsely labeling hardwood laminate they make for Lumber Liquidators as CARB phase 2 compliant. Cooper interviewed Denny Larson, executive director of a nonprofit that's filed a lawsuit against the company based on claims that it has violated California law, as well as environmental attorney Richard Drury, who stated in the interview that "it's probably in the hundreds of thousands" of households in the U.S. that have laminates from the company that could exceed safe levels of formaldehyde emissions.

60 Minutesclaimed that it bought 31 cases of Chinese laminate from Lumber Liquidators stores in several states and had them tested at certified testing facilities, and it said 30 far exceeded regulated and safe limits:


Source: 60 Minutes broadcast.

Some samples exceeded the standards by a wide margin.

Testing methods called into question
When asked about this, Lumber Liquidators' Sullivan called into question the testing methods 60 Minutes used. While I'm not an expert in this area, there is probably some validity to his point. Testing methods can differ greatly, and the company's first obligation is to the regulatory standard. However, the company claims that it takes testing to an even further standard, but that -- and this is where there's a major difference of opinion -- its testing is focused on potential emissions in a real-world environment. From the company's website, updated after the60 Minutespiece aired:

60 Minutes used an improper test method in its reporting that is not included in California's regulations and does not measure a product according to how it is actually used by consumers. 60 Minutes used a "deconstructive test," which would be like testing the emissions of a car by removing the catalytic converter and muffler. In contrast, we perform California Air Resource Board (CARB) testing on the fiberboard core and A SECOND ROUND OF TESTING on the finished product.

The company has made a serious and concerted effort to communicate its testing process and focus on making sure its products are safe, and has a section on its website devoted to providing significant detail on this to the public. As things stand today, it's hard to imagine that the company -- especially since claims that it was selling products that didn't meet CARB-compliant standards have been around since 2013 -- would continue selling and sourcing product that CARB could easily acquire at any store and test.

On Thursday, 60 Minutesreleased the full reports from its analyses, but frankly we still have a major disconnect between what Lumber Liquidators claims is the proper testing protocol, and the testing protocol that was performed. Here's the short version:

There are two kinds of tests that can be done: Finished product testing, and composite wood panel testing, each with different standard operating procedures, or SOPs, which can be found here. It seems to me -- based on everything that's been presented by both parties -- that Lumber Liquidators' position is that the composite wood panel testing SOP is the proper one, as it sources its products from mills that are certified by CARB to produce Phase 2 compliant products. In other words, Lumber Liquidators has direct access to the panels that contain formaldehyde, they're made in a mill that's certified to make them to Phase 2 standard, meaning they can be tested in that state before the finished product is made.

60 Minutes'position -- as well as that of those selling its shares short and suing the company -- is that the products fail the finished product test, which requires the finished product be deconstructed, by removing the laminate and sanding the surface of the underlying material. As the test results provided by60 Minutesshow, this leads to much higher-than-legal levels of emissions. Lumber Liquidators' stance is that this isn't the proper test for its product, and it's also not testing a product in anything like the condition it would be used in.

I'm guessing CARB will be the judge on this issue.

Potential impact: the knowable and the unknowable
As things stand, the issue is one of credibility. Do you trust a company that may have illegally sourced product in the past? Or do you trust a group that's being backed by people with a financial incentive to drive down the company's stock price?

What can we measure? To some extent, we can get some idea about the company's exposure and the potential impact on sales going forward.

To start, the allegations against Lumber Liquidators are largely based on products sourced at three Chinese mills that provide the company with laminate flooring. For some context, the company says it sources its products from more than 130 mills globally, and that laminate from China comes from six manufacturers. So if we go by the60 Minutesaccusations, three of the six mills in China were found to be knowingly mis-labeling laminate flooring as CARB compliant.

Emissions testing by 60 Minutes. Source: 60 Minutes broadcast.

We also know -- from the company's annual report -- that "laminate, bamboo, cork, and vinyl plank" flooring have accounted for 38%, 38%, and 36% of sales over the past three years. If we assume that laminate was around half of that total, which is probably on the high side, that would be just under 20% of total revenue.So we know that at least three other Chinese mills provide the company laminate flooring, and60 Minutesmade no mention of these companies.

Furthermore, if we assume that 90% of laminate comes from China, and that half of that amount comes from the three mills60 Minutesidentified, then we're talking about roughly 9% of the company's sales that potentially come from these three mills. Chances are that's on the high side, and it could be by a pretty wide margin. These three mills probably provide closer to 5% of sales, if that much.

The biggest risk -- if the company is found to have sold illegal product -- would be a combination of fines, lawsuits, and replacing product or refunding customers. If we go by the statements made by Messrs. Drury and Larson, it could be upwards of 10,000 California customers. At $2.00 per square foot, and an average of 1,000 square feet per installation, that's about $20 million to replace existing flooring. That wouldn't include any potential damages a court might award.

It also wouldn't include potential fines from the state for selling improperly certified -- or worse, intentionally falsified -- flooring.

Where do you stand?
This has been a hard one for me to wrap my head around. I'm a shareholder in the company, but I have a tiny position, with less than 10 shares I bought as a starter. Frankly, I don't really have a big enough dog in this fight to let it create too much bias. With that said, I'm a generally optimistic person, and I rarely agree with the philosophy of short-selling. However, that doesn't mean short-sellers are wrong in this case, and 60 Minutesproduced what looks like damning test results, if its testing protocol turns out to be properly applied, according to CARB.

Whitney Tilson has a well publicized short position and brought the story to 60 Minutes. Source: 60 Minutes broadcast.

But I'm just not convinced that the 60 Minutes piece really uncovered anything. Frankly, there are still too many questions around what wasn't disclosed or discussed in the story, to really draw any absolute conclusions. Case in point: The show tested 31 boxes of product, but we don't know how manydifferentproducts were tested, or whether the Chinese product came from just the three factories highlighted in the story, or from others as well.

In other words,60 Minutespainted a very broad stroke but left a lot of important detail out -- even after releasing all of the results of the analyses performed on the 31 boxes of flooring on March 4. As a matter of fact, the release of these test results leaves reason to wonder if they're actually CARB compliant tests, since they were so-called "small chamber" tests, which can be inaccurate.

I realize they only had about 15 minutes of airtime to cover the story, but I still find concern that Anderson Cooper and the producers chose to produce a story that left so many things uncertain -- especially considering that their perspective was heavily influenced by people with a financial incentive to see Lumber Liquidators harmed.

I could very well be wrong, and time will prove that out. However, I think the reality is, even if the company wasselling some products that fail to meet CARB (and soon EPA) standards, my analysis indicates that it's probably a very small amount of product. Furthermore, we're talking about the company's cheapest products with very slim margins. That would mean limited financial harm, and probably not a major blow to the bottom line to lose sales in this category.

Can the company weather the storm?
For investors who are holding their shares or even buying more, can the company pull through? That's the most important question.

Frankly, this is one of the risks that has worried me about the company's balance sheet. As of the end of 2014, the company had around $20 million in cash on hand, and a $50 million revolving line of credit. The company carries no long-term debt, which is good, butI've been concerned that the lack of a more substantial cash position could leave it exposed to a "black swan" event -- i.e., something that was unforeseen that created a serious financial challenge. Over the past three years the company has spent $135 million on share buybacks. Frankly, it would be much better off if it had retained even half that cash for an unforeseen event.

With that said, its capital position isn't terrible. If the company experiences any significant impact on sales, it could put its expansion plans on hold, which would result in a temporary boost to cash on hand. This wouldn't be a good long-term move, but it could turn out to be necessary if any of the allegations turn out to be true, and/or there is a significant impact on the company's sales.

Looking ahead
Lumber Liquidators just announced that it will hold a conference call on March 12 at 10 a.m. ET to address the allegations. I don't know what we'll learn, but it's likely that the company is having a third party lab conduct the more accurate "large chamber" tests which can take a week to complete, as well as core testing on panels, and not the deconstructive test on finished products.

I think the reality is, even after March 12 comes and goes it will still boil down to trust. It could burn me, but the evidence I see leads me to make the call that Lumber Liquidators will survive this event. I'm not saying the stock will go up in the next few days, weeks, or even this year, but I think the company will survive this event. However, even as this plays out, the company must continue operating in a less than ideal housing market.

I'm not selling my shares, and until the story plays out a little more, I don't expect I'll buy. We could look back in a few years and see this as having been a great chance to buy shares. On the other hand, we could look back and see a cautionary tale of a company playing fast and loose with the law. Only time will tell which it is.

The article What To Make Of Lumber Liquidators -- Should We Believe Anderson Cooper and Whitney Tilson? originally appeared on Fool.com.

Jason Hall owns shares of Lumber Liquidators. The Motley Fool recommends Lumber Liquidators. The Motley Fool owns shares of Lumber Liquidators. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.