Lumber Liquidators: Research, Not Hyperbole

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By Max Vision :

I first heard about Lumber Liquidators ( LL ) two years ago when I read an article in Grant's Interest Rate Observer. Technically, this was the "original short piece" (although I have since found one from 2010 - that must have been a painful short). Grant's short thesis was based solely on valuation. I followed the story closely when Xuhua Zhou's article appeared regarding high levels of formaldehyde. That was a little more interesting. The side-show regarding Lacey Act violations never really raised my interest. Gibson Guitar had endured a similar issue and paid a miniscule fine; a blip on the radar. However, when I heard that 60 Minutes was going to air a piece, I was intrigued. After viewing that segment, my first thought was: It doesn't matter what price the stock opens at on Monday morning, anything greater than zero is too high - and a good short.

However, I prefer to do my own diligence rather than rely on Mr. Cooper for investment advice, so I started digging.

What follows is the first entry into what may become a series of articles regarding my observations on the facts, the myths, and what we can, can't and may never know regarding Lumber Liquidators. I hope what I write will clarify some of the much discussed, but little understood issues in this controversy and help you decide - whether you want to stick with your long or short position or switch sides.

As for my own position, I subscribe to the quote above from Keynes, "When the facts change, I change my mind..." I am happy and open to consider new facts as they become available.

My first thought was to call the labs where the tests were performed. 60 Minutes released the lab data on their testing, so I picked up the phone and starting asking questions.

I spoke with HPVA Laboratories , specifically the signatory on each of the test results provided by 60 Minutes . My first question revolved around comparing the results between Home Depot ( HD )/Lowe's ( LOW ) and Lumber Liquidators. The response from HPVA was that 60 Minutes only asked HPVA to test LL's products. The other lab, Benchmark International , confirmed this same point - that its lab had only tested Lumber Liquidators' products. I thought this was odd. From a consumer standpoint, which I thought was the thrust of 60 Minutes ' efforts, one would want to test a wide variety of stores' products to confirm the products' safety. This was my first nudge in the opposite direction, forcing me to rethink my initial conclusions.

In this entry, I will focus on CARB 2 compliance and the testing methods used by the enforcement division of the Air Resource Board. This may be long, but hopefully, it will be worth it.

The CARB 2 standard that is now well discussed stems from a law passed in 2008 called the Airborne Toxic Control Measure to Reduce Emission from Composite Wood Products ("ATCM"). Here is a link to the law.

The final statute is 60 pages long, but not very complicated. The ATCM has two points that are important to note in this discussion. First, the focus of the ATCM is the regulation of platform materials. These materials may end up in a variety of different finished goods: furniture, doors, windows, toilet seats (yes, this example was in the law's legislative history), or, what we are all most concerned about - laminate flooring.

Second, the ATCM is heavily biased towards a "process-based" regulatory framework.

By this, I mean the ATCM requires of Lumber Liquidators the following five items (I am paraphrasing from the statute):

  1. Use a third-party certified facility.
  2. Only use platform materials that comply with the applicable emissions standards.
  3. Take reasonable precautions to ensure that the platform materials are in compliance with the applicable emissions standard. And I quote here: "Reasonable prudent precautions include, at a minimum, instructing each supplier that the goods they supply to the fabricator must comply with the applicable emission standards, and obtaining written documentation from each supplier that this is so."
  4. Maintain records for a minimum of two years.
  5. Certain product labeling requirements.

The formaldehyde levels that are applicable to this situation vary from .11ppm (parts per million) to .13 ppm, depending on the size of the composite panels.

These specific emission standards are very exacting, and are applicable to the platform materials that make up all different kinds of "finished goods."

What follows here is how it has been described to me by certain TPCs (third-party certified labs). The list of TPCs is available on the Air Resource Board's website, and I found many, if not all, of the labs very open to discussing these issues. They are enjoying their 15 minutes of fame.

Imagine a production process that starts with a specific piece of platform material at point 1. At point 1 in the process, this piece will be called Eric1. (This whole process reminded me of the children's book "The Very Hungry Caterpillar" by Eric Carle.) Keep in mind, the ATCM and its associated CARB 2 emissions standards are applicable only to Eric1. However, in order to become a piece of laminate flooring (or toilet seat) that ends up on the shelves of a local Lumber Liquidators store, Eric1 must go through approximately 15 steps to arrive at its final step (the number of steps is irrelevant and made up for this example). These steps include many at the manufacturing site: heating, adding decorative and protective layers, stains, glues, and a variety of other steps. Additionally, the packaging materials, shipping time, time on shelves, all are additional steps along the way before the original piece of platform material will end up in its final resting place. Each of the steps along the way from 1 to 15 have an impact on Eric1 - he becomes for a brief time Eric2, Eric3, Eric4... before ending at Eric15. Some of these changes are fairly significant.

Now, fast-forward a little bit to something called the "Deconstructive Method."

The Summary of Procedure on the deconstructive method can be found here .

The goal of the deconstructive method is to turn Eric15 back into Eric1, and then test the emissions levels to see if Eric1 complied with CARB 2 at step 1.

I will provide support for this statement below, but what some individuals - let's call them the "Gotcha Camp" - have done here (I won't judge their intentions) is to mistakenly think that the deconstructive process can take Eric15 and turn him back into Eric1. This is incorrect. What the process does is create Eric1A, an entirely different "platform material." This is purely a scientific-based mistake. The platform material in its original form, Eric1, after having gone through a variety of significant changes to become Eric15, can never truly be returned to its original state as Eric1 - instead, after the deconstructive process, it has become Eric1A. At this point, the emissions standards applicable to Eric1 serve as rough screening guide, but not the "gotcha" or smoking gun that certain Brockovich-esque testers have assumed.

The Gotcha Camp will have you believe that the deconstructive method is a universally accepted procedure whose summary of procedure can flawlessly transform Eric15 back into Eric1, after which any layman can determine if the product you bought from the store meets the emissions standards.

This is just not true. Very limited research and discussion with industry contacts will very quickly disabuse anyone of this notion.

In fact, of the 13 labs that I have spoken to in the past 2 weeks, only one has indicated to me that this is procedure is "somewhat reliable" in simulating the platform material in its original state. Unsurprisingly, this is the lab associated with the domestic hardwood association (read: lobbying arm).

To further support this position, Benchmark International, one of the two labs 60 Minutes used in its testing, recently put out a statement on its website . Below is the most relevant portion to this subject:

Let me take one step back before we go further. On July 7, 2010, President Obama signed the Formaldehyde Standards for Composite Wood Products Act into law. This legislation establishes limits for formaldehyde emissions from composite wood products: The national emission standards in the law mirror standards previously established by the California Air Resources Board for products sold, offered for sale, supplied, used or manufactured for sale in California.

Since 2010, the EPA has been trying to develop regulations for the implementation of this law. Since this process has been going on for over 4 years now, there is a robust wealth of information available in the form of comments from various industry participants.

You can read through the comments and various draft rules and presentations here :

I will share just two comments (there are over 2,000) - one from IKEA and one from the Environmental Defense Fund. You can suspect what IKEA will have to say, but I will share it anyway, because I think it provides support to Lumber Liquidators' statements that the deconstructive method has its drawbacks.


Other industry trade groups are even more specific about the unreliability of the deconstructive method as it relates back to Eric1. The following link provides an industry statement; however, there is understandable bias in presenting this statement from the trade groups.

To show that this is a "contested" area, I would point you to the minutes of a meeting before the EPA titled, "Review of Recommendations on the Treatment of Laminated Products." At this meeting, groups from various groups, including Lynn Baker, head of California Air Resource Board, voiced their thoughts and suggestions regarding the regulation of laminate flooring and emission standards.

Deconstructive testing made a strong showing among all groups, but I will quote from the comment letter that Tom Neltner of the Environmental Defense Fund submitted to the EPA after testifying before the committee - I should note that Mr. Neltner is a chemical engineer and an attorney.

You can read more about the Environmental Defense Fund here .

This isn't exactly LL's spokesmen who is going on the record to the EPA that the "deconstructive method" is "controversial in the industry with respect to its reliability and validity for enforcement purposes."

I use this statement as a good example, because I don't think anyone would argue that the EDF is a shill for "industry" of hardwood and laminate importers. However, there are numerous other comments in the link I provided above from industry trade groups that go into great details on the problems with the reliability of setting an emission standard for Eric1, and then, after the deconstructive process, trying to apply that standard to what is now Eric1A.

By far the most complete and substantive is an experiment conducted with Ashley Furniture and the American Home Furnishing Alliance. These groups engaged an approved third-party certified lab, SGS Laboratories, to try to determine if one could accurately take a composite panel from steps 1 to 15 (in this experiment, there were actually fewer steps to reduce the amount of variables in the process) and determine if they could create accurate, verifiable and reproducible results that show a correlation, using my terminology from above, between Eric1 and Eric1A - in other words, the composite panel in its original form and a composite panel after it had been processed to its "finished goods" state and then brought back to its "original" state through the deconstructive process.

You can read about the testing and in-depth results here .

However, if you want the cliff notes, here is the lab's conclusion:

In other words, Eric1 and Eric1A are different products, and the application of emissions standards set forth to regulate Eric1 are not necessarily applicable to Eric1A.

For investors, the future of Lumber Liquidators may be murky to the upside, given the obvious brand damage that the media sensationalism has caused. However, unless Lumber Liquidators is completely fabricating its documentation on CARB 2 compliance, investors can profit by selling put protection to those investors who believe this company will file for bankruptcy in the near future. The long-dated put options, August, or January 2016 and 2017 are a possible strategy - selling the puts and collecting the premiums as the fear subsides.

This article is becoming long. However, the next article will feature evidence from the Enforcement Division of the Air Resource Board that support the conclusions above regarding the "severe limitations" (this is ARB's language) and reliability of the deconstructive method as it relates to enforcement. In case you thought this was a dull subject without any humor, I thought I would provide a little evidence to the contrary. See this link for the best comment submitted to the EPA, from Kip's Koffins .

See also What's The Story With The Sears Holdings-Simon Properties Deal? on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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