Ignore Lumber Liquidators Holdings Inc.'s Bounce

By Rich DupreyFool.com

A new face in the executive suite helped pump up Lumber Liquidators stock, but the flooring company will need more than that to fullyrecover. Image: Lumber Liquidators.

The 10% bounce in Lumber Liquidators stock one day last week had more to do with the announcement that the flooring specialist hired a new CEOthan its dismal third-quarter earnings report.Still, it was a welcome reprieve for investors who've seen their shares lose more than three-quarters of their value over lingering concerns about the safety and quality of its flooring.

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Unfortunately, I still see an investment in Lumber Liquidators as being as toxic as its flooring is alleged to be. Until the sawdust settles over whether the allegations are true, appointing a new face to the front office won't have much impact on the course the company ultimately takes.

Allegations of improprietyLumber Liquidators has been buffeted by serious charges following a 60 Minutes news program alleging its China-source flooring contains dangerously high levels of formaldehyde. It further appeared to show the flooring specialist's suppliers openly admitting they package and ship products that are knowingly mislabeled as being compliant with air-quality regulations when they are not.

The flooring company's bungled response to the allegations, and the successive abrupt resignations by Lumber Liquidators' CFO, CEO, and chief compliance officer, did nothing to help the situation. Nor did the other crisis the company was dealing with at the time -- mainly, allegations of improperly importing wood from protected forests. However, Lumber Liquidators settled those claims, agreeing to plead guilty to violating the Lacey Act (a conservation law regarding the protection of plants, fish, and wildlife), and it agreed to pay $10 million in fines, community service payments, and forfeited proceeds.

Lumber Liquidators put out one brush fire by settling charges that it improperly imported protected wood into the U.S., but that could be the least of its troubles. Image: Lumber Liquidators.

The stock jumped some 30% in the days following that announcement, but the weight of the challenges the flooring company still faces caused its stock to sink once again. As its third-quarter earnings report showed, there are significant challenges ahead for Lumber Liquidators, hurdles that perhaps even an experienced executive like its new CEO John Presley will find difficult to get over.

Losing its lusterThe flooring company said revenues tumbled more than 11%, to $236 million, from the year-ago period, and an even steeper decline than that experienced in the second and first quarters, when sales fell 5.8% and 5.6%, respectively. It suggests that, even though the information about its woes has been out there for some time, consumer concerns are growing, not lessening, and it's losing customers, maybe for good.

Home Depot could be one of the beneficiaries of Lumber Liquidators' problems. It realized about 7% of its revenues from flooring sales, and was the recipient of accolades from researchers at The Ecology Center for voluntarily removing the presence of a harmful chemical called orthophthalates from its flooring. Lowe's , on the other hand, which gets about 6% of its annual sales from flooring, still had about half its product containing the chemical according to the researchers, while all of the inventory at both Ace Hardware and Lumber Liquidators was found by the researchers to contain orthophthalates. They did say, though, that Lumber Liquidators had committed to working with its suppliers to remove the chemical.

Of course, that was before its current crisis exploded, and there have been plenty of other fires to put out in the meantime. What it means, though, is that the flooring specialist is still hemorrhaging customers, and has little means of keeping them coming back other than by fire-sale prices.

Gross margins suffered a massive plunge from 39.2% in the third quarter of 2014 to 30.1% this year. Its expenses have also soared during the past year as it has seen a substantial jump in legal costs, but also because it had to take impairments on its assets. More telling is that it paid out nearly as much in "retention incentives," or $2.7 million -- which amounts to essentially bribing its employees to stay -- as it did writing down non-core investments, or $3 million.

The result was that a $15.7 million profit last year was turned into an $8.5 million loss this go-round.

A liquidation sale on its stockLumber Liquidators is hurting, and though I don't think it's taken a fatal hit, it's clearly damaged, so I wouldn't be betting on a recovery anytime soon. Yet its stock could still bounce higher, even dramatically so. Some 10.7 million shares, or 55% of the outstanding stock, are sold short. Noted hedge-fund operator Whitney Tilson, who brought the allegations of the formaldehyde issue to 60 Minutes attention, has previously said he would look for any increase in the share price to short more of Lumber Liquidators stock.

Bounces like the one the flooring specialist just experienced can lead to squeezes as short-sellers rush to cover their positions, but that could serve as an incentive for investors like Tilson to only short more. Until all the investigations and charges against Lumber Liquidators are cleared, and then in its favor, which is a distinct possibility, this stock is much too risky to play.

The article Ignore Lumber Liquidators Holdings Inc.'s Bounce originally appeared on Fool.com.

Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Lumber Liquidators. The Motley Fool recommends Home Depot. 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.

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