It’s the American Dream: a nice home with a yard, white picket fence and beautifully finished hardwood floors. But if those floors come with high levels of cancer-causing formaldehyde it might be time to reconsider those priorities.
Lumber Liquidators (LL) has allegedly been cutting costs on its hardwood floors by manufacturing in Chinese factories that use exorbitant amounts of formaldehyde in wood, according to a report by CBS's '60 Minutes." The CBS report claims that Lumber Liquidators was using glue in some of its wood products that contained six to twenty times the legal California limit of the known carcinogen. Despite independent testing by CBS that affirms these claims, Lumber Liquidators chairman and founder Tom Sullivan denies these accusations and claims his wood is up to code.
Cutting corners on the American Dream
A survey by the National Association of Realtors found that 54% of home buyers were willing to pay an average of $2080 more for a home with hardwood floors, but the cost of refurbishing a home with wood flooring can easily range into the tens of thousands of dollars. A call to the local Home Depot (HD) in Peoria, Illinois found that the cost of installing new wood flooring in a 1,000 sq. foot home costs a minimum of $6760 while the local Lumber Liquidators will do the same job for just $2740.
Yahoo Finance’s Rick Newman says that hardwood has become the new linoleum flooring and that people who buy older homes tend to upgrade. It’s not so much about increasing home value as it is keeping up with the Joneses. As America recovered from the housing crisis and more homeowners decided to upgrade, Lumber Liquidators was there to grab the market. The discount wood store currently has 360 stores throughout the U.S. and revenues reached more than $1 billion last year. About 100 million square feet of its cheaper, allegedly formaldehyde-heavy wood floors are installed in American homes each year.
Lumber Liquidators quickly “downscaled upscale stuff,” says Newman, but they may have fallen into the trap of trying too hard to provide luxury on the cheap. “They’re trying to cut corners on the American Dream by providing it through cheap, Chinese manufacturing.”
Cheap manufacturing and faulty housing products have been a problem in the past. Between 2001 and 2007, defective drywall manufactured in China was imported to the U.S., largely by the Knauf Group, which settled with 4,500 homeowners for $1 billion in damages in 2010. The drywall contained elevated levels of hydrogen sulfide as well as some radioactivity which caused asthma, headaches, and respiratory problems, according to the lawsuit. Eventually, in 2010, Congress signed a bill requiring the Department of Housing and Urban Development to study the problem. Class action lawsuits were also brought against Lowe's (L).
The short sell
Lumber Liquidators claims that its wood is safe and that the formaldehyde does not surpass legal limits. Instead the company largely blames the controversy on short sellers. In a statement to Reuters they wrote, “These attacks are driven by a small group of short-selling investors who are working together for the sole purpose of making money by lowering our stock price." Sullivan reaffirmed his beliefs to Anderson Cooper on "60 Minutes," saying, “This is a group of lawyers who are suing us, selling short on our stock,” he told Cooper.
The short sellers have a point, says Yahoo Finance Senior Columnist Michael Santoli: “Somehow, [Lumber Liquidators] were making [wood floors] really cheap and they were getting people to finance them but at the same time they had incredibly high profit margins; how’d they do it?” Corners may have been cut in order to beat out the competition. In the case of Peoria, Illinois the cheapest wood at Lumber Liquidators is only $0.49 per square foot while the cheapest wood at Home Depot (HD) comes in at $3.79-- more than seven times as much.
Lumber Liquidators' stock was down 25% in early trading after falling 26.4% last week when President and CEO Robert Lynch indicated on a call that a negative report around the company would be aired on "60 Minutes". The company also revealed that the Department of Justice might seek legal action against it for importing illegally sourced wood products. Trading of the stock on the NYSE was halted Monday morning.
“It’s way too soon to say this is the end for the company,” says Santoli. “But they do have a huge crisis on their hands and it’s not just a PR crisis.” Santoli agrees that Lumber Liquidators has been a target of short sellers for a very long time for aggressive accounting and over-promising on profit margins. “It’s going to be one of these battleground stocks for a long time,” says Santoli, reminiscent of the Herbalife (HLF) fight between activist investors Carl Icahn, Dan Loeb and Bill Ackman.
Santoli does believe that the company’s “blame the activist investors” strategy might work, at least on a short term basis. “You will have some fans of the company who discount those criticisms because of them,” he says. But, Santoli also points out that we’re in a difficult market for short sellers, the Nasdaq (^IXIC) crossed 5000 for the first time since 2000 on Monday and markets are in an upward trend, and people have ignored accounting concerns swirling around many companies. “It’s really hard to make the case that short sellers can just snap their fingers and get people to pay attention to the bear case and the stock goes down.”
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