How a 25-Year-Old Investor Helped Crush Lumber Liquidators

March 4, 2015

(Bloomberg) — Lumber Liquidators Holdings Inc.’s stock plunge over the past week, fueled by allegations of excessive formaldehyde in its flooring, can be traced back to a blog post from an obscure 25-year-old short seller.

Xuhua Zhou, who had dropped out of UCLA’s doctoral program in finance and become an individual investor, took an interest in Lumber Liquidators about two years ago. After seeing a surge in the company’s gross profit margin, Zhou learned that it sourced some products from China. That raised his suspicions that safety might have been skirted in pursuit of lower costs, he said in an interview.

Zhou, who was born and raised in China, already had experience researching suppliers in the country, so he began investigating. His digging ultimately led to lawsuits, a “60 Minutes” report and accolades from the well-known short seller Whitney Tilson, who also bet against Lumber Liquidators.

 “It’s pretty amazing what he did on his own,” said Tilson, head of Kase Capital Management, calling Zhou “the pioneer” of the Lumber Liquidators story.

Lumber Liquidators, a retailer of hardwood flooring and accessories, is now under fire for allegedly selling products with more formaldehyde than is allowed by California law. The “60 Minutes” piece, which relied in part on undercover reporters and hidden cameras, showed managers at three Chinese factories admitting to using false labeling that made it look like the products met regulations. In a response to the allegations, Lumber Liquidators said that “60 Minutes” used flawed testing in its reporting and that its floors are safe.

The “60 Minutes” piece contributed to a more than 40 percent stock decline in the past week. While Lumber Liquidators rebounded 5 percent to $40.78 on Tuesday, it remains down 39 percent this year.

When Zhou began looking into the Toano, Virginia-based company back in 2013, he says he found online complaints about its Chinese-made flooring. So he decided to buy products from Lumber Liquidators and pay to have them analyzed. The results led him to publish a post on investing website Seeking Alpha on June 20, 2013, that advocated shorting the stock because the tests showed levels of formaldehyde above California requirements. The stock fell almost 5 percent that day.

“This report shows that Lumber Liquidators lacks a proper product quality control system, and its products may be hazardous to the unsuspecting consumers,” Zhou wrote in the post.

Since Zhou began posting on Seeking Alpha, he’s also raised questions about other companies. The Los Angeles resident only manages his own money and doesn’t work for a fund, he said. Zhou made a profit shorting Lumber Liquidators and increased his bet when the company warned on Feb. 25 that the unfavorable story by “60 Minutes” was coming.

Denny Larson, executive director for environmental advocate Global Community Monitor, appeared in the “60 Minutes” piece. His group brought a complaint against Lumber Liquidators in 2014 for violating California regulations. It first learned about alleged formaldehyde issues at Lumber Liquidators from Zhou’s story, and the suit cites his reporting.

Zhou also was contacted by Tilson, who says he discovered Lumber Liquidators as a short opportunity in September. Tilson then found Zhou’s story and bet against the stock in October.

In November, Tilson announced his position at an investment conference. While his presentation concentrated on the company being investigated by the U.S. government for sourcing lumber from protected habitats, it also referenced Zhou’s story on the formaldehyde issue.

Lumber Liquidators gave an update on the case last week, when it said that the Department of Justice may file criminal charges stemming from an inquiry that began in 2013. The company expects to be charged with a misdemeanor or felony in connection with the case, Daniel Terrell, the chief financial officer, said on a conference call.

Early last year, Tilson shifted his focus to formaldehyde after gathering more information. He did his own testing on flooring from Lumber Liquidators and it showed elevated levels of the chemical, Tilson said. After that, he pitched the story to “60 Minutes” and he was part of Sunday’s broadcast.

Zhou said he has made money from his short bet, though he declined to say how much.

“I made a profit, but it’s more than that,” Zhou said. “These are real people, real lives.”