Will Lumber Liquidators Choose Door Number #1, Number #2 or Number #3?

Lumber Liquidators (LL) cancelled an investor presentation that its management was slated to make on March 4, 2015, just two days after the punishing broadcast on 60 Minutes that alleged that LL's China-sourced laminate flooring emitted excessive formaldehyde, in violation of California regulations, and in contravention of LL's product warranties that the products were in compliance with these regulations.

Just the prior day, LL issued full-throated assertions that their products were safe (and that LL stood behind every plank they sold), criticized 60 Minutes for employing what LL claimed was a faulty "destructive" testing method, and decried short sellers of LL common stock who were out to enrich themselves at LL's expense.

After this initial defense, LL took a breath and stated that it would conduct an investor conference call on March 12, 2015 to address the matter, and placed a voice message on its investor relations telephone line saying that LL would make no disclosures about the matter until then.

So, LL displayed a normal crisis reaction: first, deny categorically the accusations and blame the motives of the accuser, and then pause to construct a carefully planned business response.  It is curious that LL requires 8 days in the midst of this crisis to prepare this response.  Curious enough that I thought I would play Monty Hall and provide you a little scorecard as to what I expect LL's alternatives might be for this momentous conference call.

Before proceeding further, let's examine just how much of a pickle LL finds itself in.  You may recall Crazy Eddies, the electronics reseller run by the Antar family whose prices were insane.  It turned out their inventory accounting was equally insane, and Crazy Eddies went into bankruptcy and liquidation because of the mounting securities fraud governmental investigations and private securities litigation.  But at least Crazy Eddies had this much going for it: its customers weren't suing Crazy Eddies, who liked the insane prices very much, thank you.

Imagine Crazy Eddies' predicament if it had to fend off governmental consumer fraud investigations and consumer class action litigation, in addition to securities fraud governmental investigations and private securities litigation!  Well, you don't have to imagine this, you would just have to gander at what's coming down the pike for LL, all this while the negative publicity negatively impacts its store sales.  Also, you can throw in a prospective federal criminal indictment under the Lacey Act for selling illegally sourced wood from Siberia.  Also, you can throw in that as of the end of 2014, LL had only $20 million of cash, and only a $47 million credit line secured by inventory that, just maybe, breaches a covenant or two about such inventory in the credit agreement.  Also, Note 10 to LL's 2014 audited financials discloses a nasty federal investigation into anti-dumping and duties regulations, ongoing since 2010, which has been decided adversely to LL but which is now on appeal in the federal circuit court, and may result in a charge of $12.7 million (which LL has not reserved for).  All this for an LL that was not cash flow positive for 2014, even without the negative publicity.

So, what will LL say on its conference call on March 12?

Let's look behind door #1,  This is the continuation of the full denial, vigorous defense mode.  LL may feel that it has already painted itself into this corner based upon its strident management denials immediately after the 60 Minutes broadcast.

In my view, choosing door #1 will only seal (and accelerate) LL's eventual demise.  LL needs to be able to clearly demonstrate the merits of its safety claims for this choice to work, and this depends upon whether it was appropriate for 60 Minutes to use the "destructive" testing method on its laminate flooring (which resulted in the excessive toxicity recorded levels).  But it is hard for LL to explain away this testing method when it is clearly set forth in the California regulations, the hardwood trade association to which LL belongs has confirmed that this is the correct test, and 60 Minutes has stated on its website that it first confirmed with the California regulator that this was the correct test for it to use in connection with the broadcast.

LL would be foolish to choose door #1 because, as Kenny Rodgers would put it, you got to know when to fold them.

Let's look behind door #2.  This is the ring-fence, we were wrongly duped mode.  LL would say that it is a victim of the unscrupulous Chinese factories (one of which LL itself owned), and that LL was voluntarily establishing a restitution program.  That program would fund the flooring replacement for any California customer who, after hiring a formaldehyde testing company to test its indoor ambient air quality, produced a test result that showed an excessive formaldehyde concentration, and who can demonstrate that the toxic level was due to LL's flooring product and not some alternative source.  LL would also decide to stop sourcing product from China, it would rename itself inasmuch as its current brand equity was now negative (maybe a name such as Great American Hardwood Floors), and reduce costs by closing underperforming stores (although none of the 10% of all LL stores that are leased from the LL CEO).

In my view, this strategy underestimates the scope of the potential liabilities that any clear-headed examination of LL's current predicament would reasonably anticipate.  It is unlikely that California regulators will let LL create a restitution program on LL's terms, and there is no reason why additional state regulators, as well as federal consumer fraud regulators (at the recent urging of Senator Nelson), will not require a stronger nationwide restitution program.

And then there is the securities litigation exposure to all of the class action plaintiffs that will use the "fraud on the market" theory to claim that LL is liable for all of its false and misleading safety and legal compliance disclosures in LL's periodic securities filings.  This liability would be measured based upon the difference between the trading value of LL common stock before and after the true facts have been disclosed.  A good proxy for this might be the trading day before and after the 60 Minutes broadcast.  Every LL common stock shareholder at the time would be entitled to be a class member.

As far as I can tell, the only way for LL to remain a viable business entity going forward is to choose door #3, and file a Chapter 11 petition in bankruptcy. This will stay all legal proceedings and provide some senior DIP financing for LL to continue in business, while the legal claims are assessed and allowed, likely through mediation.  The future shareholders of LL will likely comprise the old LL class action flooring customers and common stockholders (in such proportions as are based upon their respective damages) that will replace the legacy LL common stockholders in that newer, revitalized Great American Hardwood Floors.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Follow me on twitter.