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Whitney Tilson Responds to Lumber Liquidators' Rebuttal of His Short Thesis

November 26, 2013 | About:
Canadian Value

Canadian Value

128 followers
Whitney Tilson sent an e-mail to his followers on Monday.

Whitney-Tilson-photo-low-res-e1380592331

Here are the details:

Lumber Liquidators issued this response to my presentation:

Mr. Tilson did not contact the company in compiling his presentation and we have never met with him to discuss our business. Mr. Tilson’s presentation is based entirely on his own speculation and the contents of a report released almost two months ago which we had previously stated contained numerous inaccuracies and unsubstantiated claims. Lumber Liquidators is committed to uncompromising integrity in how the Company operates, across all areas of the business. We have policies and procedures in place for the sourcing, harvesting and manufacturing of all of our products, monitored by professionals located around the world. We support the protection of the environment and responsible forest management, and we invest significant time and resources to safeguard quality control and compliance. As a result of our processes, we diversify our sourcing across more than 100 suppliers, which affords us the flexibility to make changes to meet consumer trends and move business away from any supplier unwilling to comply with our policies. If we find that any of the Company’s suppliers are not adhering to our standards, we will discontinue sourcing from those suppliers. It is important to note that no single mill provides more than 4% of our hardwood purchases and no single hardwood product represents more than 1% of our sales mix.

Here is my reply:

Lumber Liquidators asserts that the EIA report “contained numerous inaccuracies and unsubstantiated claims”, but has yet to provide even one fact to rebut the report, which I found to be an extremely impressive piece of investigative work – and 100% consistent with everything we know about the wild-west business environment in Russia and China: widespread corruption, weak rule of law, little concern for the environment, etc.

Federal authorities obviously think the EIA report is credible, as agents from the Department of Homeland Security’s Immigration and Customs Enforcement and the U.S. Fish and Wildlife Service on September 26th raided LL’s headquarters, executing sealed search warrants “which relate to the importation of certain of the Company’s wood flooring products.”

Lumber Liquidators’s only response has been to say (on the Q3 earnings conference call), “We are continuing to cooperate fully with the authorities to provide them with the requested information and there is no update or additional information pertaining to the request that we can provide at this time.” The company’s silence speaks volumes.

Lumber Liquidators’s second line of defense appears to be that even if the EIA report is correct, it focuses on only one supplier, which the company can simply stop sourcing from with minimal disruption since “no single mill provides more than 4% of our hardwood purchases and no single hardwood product represents more than 1% of our sales mix.”

I’m skeptical that this is an isolated problem limited to one rogue supplier. Rather, the combination of a) the evidence in the EIA report, b) the unusually rapid increase in Lumber Liquidators’s margins to unprecedented levels immediately after acquiring a Chinese supply chain company, and c) the hugely corrupt business environment in both Russia and China lead me to believe that Lumber Liquidators has a big problem on its hands. Though I can’t prove it, the evidence I see, combined with common sense, makes me think it’s highly likely that what EIA has uncovered is a pervasive problem across Lumber Liquidators’s Chinese supply chain.

Since the raid, I assume that the company is scrambling to show the authorities that whatever problems are in their supply chain are isolated cases, they didn’t know about it, etc. But keep in mind that the authorities raided Lumber Liquidators based on the EIA report, so they’re not going to be easily fooled by some spin and token actions. Rather, I think Lumber Liquidators right now has no choice but to very quickly clean up its act to avoid major sanctions by the authorities.

Specifically, I think Lumber Liquidators will have to: 1) immediately stop sourcing from suppliers they even suspect are trafficking in illegal wood; 2) find replacement suppliers; and 3) ensure their entire worldwide supply chain is pristine. Doing all of these things is likely to be very costly and disruptive to the business – not to mention management being distracted by having to deal with the authorities for the foreseeable future.

These things might not matter if the stock were cheap, but it’s not: after a 7x run-up in less than two years, it trades at 40x trailing earnings and 22x trailing EBITDA.

My two-year price target is $53 (and I think I’m being generous) based on the following back-of-the-envelope math:

  • · Sales grow 16% annually in the next two years, as analysts expect (resulting in revenue of $1.35 billion)
  • · Operating margins give back half of the 830 basis point increase in the last nine quarters and fall to 9% (still far above the long-term average)
  • · The market responds to this by assigning the stock a 20x P/E multiple
  • · Result: $1.35B x 9% – 39% tax rate / 28M shares = $2.65 EPS x 20 = $53


2) I short LL knowing it’s been carnage in short-land (see below), but here’s an interesting data point from a speaker at the Robin Hood Investors Conference (if you know the study he’s referring to, please let me know): stocks with the highest short interest underperform by 7% annually, but sometimes they go parabolic and this is the 2nd worst case of this in the last 25 years, trailing only 2003.

About the author:

Canadian Value
http://valueinvestorcanada.blogspot.com/

Rating: 3.0/5 (3 votes)

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