CPSC likely to Rule in favor of Lumber Liquidators Holdings Inc (NYSE:LL)

This article summarizes the issues Lumber Liquidators Holdings Inc (NYSE:LL) is facing and includes my opinion.  Let's start with the facts and continue to my opinion.

Facts:

  1. 60 minutes brought to light a problem with Chinese laminates old by LL
  2. LL's market cap declined by more than $2 Billion
  3. LL bought laminate flooring from China that was not Carb2 compliant
  4. The Chinese suppliers marked the packaging as being Crab2 compliant
  5. LL probably did not know that this was happening.
  6. 60 minutes did not ask the suppliers why they were marking the packages incorrectly when they knew they were not compliant (A supplier admitted the lack of compliance to 60 minutes).
  7. LL did test the laminate flooring it received from China regularly and the tests suggested that the flooring was within the adopted standards or better.
  8. LL tests did not deconstruct the flooring but instead tested them in real-use environments
  9. This was a major compliance oversight.
  10. CA tests require that laminate flooring be deconstructed to test for formaldehyde
  11. Only after a laminate has been deconstructed and tested again after it has been deconstructed can it be considered to have passed Carb2 compliance.
  12. Only CA requires Carb2 Compliant at this time.
  13. CA regulations suggest that LL sold products in CA that were not compliant with Carb2
  14. LL will surely face fines and costs related to those actions.
  15. LL has secured a $100 million line from Bank of America
  16. The CPSC is investigating the safety of LL laminate flooring based on the 60 minutes piece and could issue a recall if it is determined to be unhealthy
  17. The CPSC is not using the CA method of deconstructing the laminate flooring for testing.
  18. The CPSC seems to agree with LL and is using a 'real use' testing environment.
  19. LL stopped buying laminates from China
  20. LL proactively sent testing kits to customers to help determine air quality in real use
  21. 97% of those tests were returned with normal air quality results.
  22. The EPA has warned that the results of these tests are not conclusive because they do no pinpoint the sources of formaldehyde.
  23. LL never suggested that the results would be conclusive
  24. LL wanted customers to know if there were elevated levels in their homes
  25. The CFO, President, and Chief compliance officer have all resigned from LL
  26. The problems above happened under their watch.
  27. They all deserved to go.
  28. Resignation vs. Termination could have played a role here.  A resignation is far less of a burden to LL than a termination might be, especially when severance packages are considered.

Sign Up for Free Trial

My Opinion:

Under the Watch of executives, most notably the chief compliance officer Ray Cotton, LL seems to have clearly violated Carb2 compliance regulations in California and I believe it will face fines and will replace hardwood flooring or compensate customers accordingly in California.  I estimate there to be 10,000 - 20,000 instances in California which will cost LL about $2500 each.  I am taking into account a 30% profit margin ratio and backing into that estimate of actual cost.  My estimate is that the problems in CA will cost LL approximately $50 million.

However, I do not believe that the CPSC will issue a recall.  The laminates used by LL are healthy in a 'real use' environment and CPSC is testing the flooring in 'real use' environments.  If the CPSC were to be testing the flooring using the CA method of deconstructing the flooring the tests would not likely pass, but CA is the only state to require this.  The EPA does not have a standard for this either.

The accepted resignations of the CFO, President, and Chief Compliance officers were most likely in lieu of termination to avoid additional costs to LL as those might have related to severance packages.  All of these persons needed to be fired, and rightfully so.  Whenever situations like what has happened to LL surface heads need to roll, and that has clearly happened.

LL has stopped buying laminates from China, they are cleaning house and getting the responsible parties out of the firm, and they are taking the needed steps to right the ship.  The final tallies are not in, and the CPSC decision is not in, but the moves taken so far were needed and in the right direction.

LL has a good business, they have a solid growth rate, and they can continue along that path and will in my opinion once this issue is quantified.  The lingering question though is that quantification. 

I have quantified some of this, suggesting that the costs for the CA Carb2 compliance issues will be about $50 million, the Bank of America Line is twice that amount, but if there is a recall the costs are going to be much higher than that.  A recall could cost as much as $200 million.  So the question really is will there be a recall?

In my opinion the answer is no.

If the CPSC was using the CA method of deconstructing the flooring I believe the answer would be yes, but because they are using 'real use' testing and because we already have evidence suggesting that 'real use' testing is within accepted standards I conclude that there will not be a recall.

If there is not a recall and the damages are limited to CA and probably a few additional isolated ones (we should expect that at least) the costs will be contained and investors will ask themselves if the $2 Billion market cap deterioration in shares of LL was warranted.  Because I am not expecting a recall I expect that to be the question everyone asks themselves when the dust settles.

I cannot be sure, I do not know if I am right or wrong about this, but the facts suggest that the probabilities of me being right are high.  I am happy that prior executives are gone, and I would love to see new blood come in soon.  If the tides start to turn on a public perception basis, the 37% short interest in this stock will also need to be bought back.  A CPSC decision in favor of LL would be such a catalyst, but risks exist and recent articles have been damning; my point is that current valuation looks great if the costs are contained have outlined here.

This is not a recommendation to buy or sell shares of LL or any stock and substantial risks exist in the stock market so every investor should consult with his or her personal financial advisors before making any investment decisions whatsoever.

share_linkedin