Guilty or not, Lumber Liquidators just can’t win

The latest ‘battleground’ stock de jour is Lumber Liquidators (NYSE: LL), a hardwood flooring retailer based in Virginia. Shorts had historically targeted the company for its seemingly too-good-to-be-true margin profile (much higher than competitors), large inventory build, and questionable supply sources in China; nevertheless the company belied the skeptics, for a time, rising from $20 to $120 between 2011-13 on the back of heady growth numbers and the promise of more. Alas, the wheels started to come off mid last year when growth slowed dramatically, remarking the stock from $80 to $55 in a day. But recent events have been more interesting still: in late Feb, LL reported weak 4Q numbers and guided down, but also warned the company would be the subject of a negative 60 Minutes investigative report in the coming weeks. The stock promptly cratered again, breaching $50 and headed lower before the 60 Minutes report.

About a week later, the report aired, and – for the shorts, at least – it did not disappoint (you can see the entire thing on Youtube here: https://www.youtube.com/watch?v=vUadsOJT24c). In a beyond-scathing attack, the program claimed LL floorboards contained up to 7x the California legal limit for formaldehyde, that Chinese workers falsified laminate flooring composition labels, and that – by extension – thousands of families’ health was at risk. A renowned short-seller, Whitney Tilson, claimed to add to his bet against the company; even senators called for a full investigation of the quality of LL’s floorboards. Of course the company was quick to cry foul, and has published rebuttal presentations and held conference calls. Meanwhile, the stock has tumbled to $35 – ostensibly attractive at just 6x EV/EBITDA.

This scenario piqued my interest for a few reasons, but mostly because in evaluating investments, I try to identify ‘heads I win, tails you lose’ type scenarios: that is, I am trying to find a trade where if I’m right, I do well; but even if I’m a fair bit wrong, I still come out OK. To me, LL may well fit the bill in this regard. Let me explain.

In my mind, there are basically just two outcomes to this story. Either LL’s floorboard really are massively above the legal limits for formaldehyde, or they are not. In each scenario, we can readily speculate what the stock may be worth. Let’s take the ‘guilty’ side first; it is relatively straightforward. Assuming 60 Minutes’ claims are for the most part true, LL would likely have to to replace, gratis, all the relevant floorboard, and would also be exposed to a massive legal liability. It is difficult to speculate on the exact liability but as of Dec 31, 2014, the company has just $20mm cash and a $50mm line of credit (ie, $70mm of total liquidity). Even if we assume just 100,000 affected homes and a class action settlement of $700 each, and assume zero reinstallment costs – these numbers are laughably small, as LL has historically had millions of customers and serves 600,000 per year – this would be enough to exhaust the company’s liquidity. Suffice to say, in the ‘guilty’ scenario, LL stock is likely a zero.

But what happens if LL is found to be in the clear? To my mind, the outcomes for LL would still be dire, since consumer-facing ‘high cost of failure’ businesses cannot afford to have their reputations destroyed – especially when it comes to safety. Consider the example of Malaysian Airlines: after the two horrific accidents last year, the company has seen traffic evaporate to the extent that the airline is being restructured by the Malaysian government. You could actually make a case that flying Malaysia now is likely much safer than any other airline – given the heightened focus on safety, etc – and yet they can’t sell tickets even at fractions of the cost charged by competitors. I understand consumers’ risk aversion – I wouldn’t fly Malaysian either, as it is simply not worth the risk.

While less extreme, I suppose, flooring a home is not a trivial expense, and there are some safety concerns for families.  As such, most families will do some research into the company providing the flooring; at this point, even a cursory internet search will turn up the devastating accusations facing LL. As such, I find it hard to fathom how LL maintains much of its current business profile. At the very least they will have to cut prices dramatically (destroying margins) and it’s likely they will also have to spend a lot of money to source much higher-quality floorboards (again, killing their margins). And this presupposes consumers don’t abandon the brand entirely (a possibility).

This brings us back to the stock and the forward for the company’s earnings. The stock trades at $35, and earned $2.31 per share last year; this equates to a 15x multiple. I would be shocked if the company sniffs $2 a share this year, given likely huge sales and margin pressure. But even if earnings fall just 20% to $1.9 per share and we put a more discounted multiple of say 10-12x on the stock – given the huge business risk, this is not really a small multiple, if you look at where other similarly-challenged businesses trade – that implies a $19-$22.8 share price, or about 40% downside from where we are today ($34).

Hence, ‘heads I win, tails you lose.’ There are risks here, of course (the stock is extremely heavily shorted, and the company will try to spin the story their way, which could, potentially, affect sentiment). But to me it seems very much that the risks remain skewed to the downside in this name.

Disclosure: short LL

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