Sunday, November 24, 2013

Lumber Liquidators (LL) - The Finger Print of Fraud; Stock Gaps Down on Fraud Accusations; The "Expense Recognition" Game. Is Volatility Mis-priced?

LL closed Friday trading at $101.81, tumbling down 11.7% with IV30™ popping 26.8%. The Symbol Summary is included below.

Provided by Livevol

Lumber Liquidators Holdings, Inc. (Lumber Liquidators) is retailer of hardwood flooring, and hardwood flooring enhancements and accessories. The Company offers an assortment of wood flooring, which includes prefinished domestic and exotic hardwoods, engineered hardwoods, unfinished hardwoods, bamboo, cork and laminates, as well as resilient flooring.

I found this stock looking for the day's largest losers, and as is usually the case, there's quite a story behind this drop.  The end results is both a stock and volatility story surrounding some scathing remarks made by a short-seller implicating management in multiple types of fraud.  Oh, and by the way, the stock was up more than 650% in two-years before this news.

Let's start with the the two-year BLOX Charts Tab is included (below). The top portion is the stock price, the bottom is the vol (IV30™ - red vs HV20™ - blue vs HV180™ - pink).  Then get into the accusations and the volatility.

Provided by Livevol

On the stock side we can see a monumental appreciation following a frighteningly calm ascent.  The stock was trading at $15.29 two-years ago, and opened Friday at $115.36.  That's a 650% gain in two years on a surprisingly level headed upward trend that has turned a $420 million market cap company into one that was worth nearly $3.2 billion before Friday's drop.

Here's the news, and it is ugly:

Shares of Lumber Liquidators  were getting taken to the woodshed, falling 12% after Whitney Tilson, head of the Kase Capital Management hedge fund, announced a short position in the high-flying wood-flooring specialist. At an investor conference, Tilson noted a government investigation into potentially illegal timber imports by Lumber Liquidators, and suggested the company's gross margins, which have improved to better than 40% lately, were too good to be true. The hedge fund manager also cited a report from the non-profit Environmental Investigative Agency that said Lumber Liquidators' purchases "have fueled rampant illegal logging in Eastern Russia." Shares of the flooring retailer had more than doubled this year before today's drop, riding the broader housing recovery.

Source: The Motley Fool via Yahoo! Finance; Dow Hits Another Record, but Lumber Liquidators and Fresh Market Tumble, written by Jeremy Bowman.

I have added the italics and bold font to draw out the real news.

1. Kase Capital is shorting LL stock.
2. Whitney Tilson pointed out a government investigation into potentially illegal operations.
3. The gross margins for LL could be falsified.
4. Other potential shenanigans in Russia.

The accounting fraud game of expense recognition is often times seen in gross margins.  It can be done in several ways, but two of the most common are:

1. Blatant falsification of costs (under reporting).
2. Knowingly mis-classifying costs from COGS into SG&A and thus artificially boosting gross margins (operating revenue - COGS).

Either of these games is a major no-no, number one being worse than number two, but both, if true and discovered, likely result in an SEC Enforcement Action of Accounting Fraud.

Now remember, these are claims from a short-seller, not claims or actions from the regulators.  But, if there is an existing investigation, that means... there is a volatility story to be told.  So let's tell it.

Let's turn to the two year IV30™ chart in isolation, below.

Provided by Livevol

We can see the spike from Friday's news, but still, that red line is kind of "middle-of-the-road" relative to the last two-years.  Here's my question: "If a stock is up 650% in two-years, has been accused openly by a short-seller of Accounting fraud while a government investigation appears to be open regarding shenanigans into operations of the firm and the stock gaps down on a reminder of that news, shouldn't volatility be elevated?"

I'll let you decide, but I can tell you that not only is the IV30™ in the 46th percentile on an annual level (so right about the middle), but the back month (Jan'14 options) show even lower volatility.  Huh?...

Let's turn to the Skew Tab, below.

Provided by Livevol

I use this image simply to show that Jan vol (the yellow curve) is lower than Dec vol (the red curve).  Why does the option market reflect less risk in Jan than Dec when Dec itself is tame if not low for the year?  It appears that the option market reflects that this news will pass relatively soon and relatively quietly.  Hmm...

To read more about skew, what is and why it exists you can click the title below:

Understanding Option Skew -- What it is and Why it Exists.

Finally, let's look to the Options Tab (below).

Provided by Livevol

Across the top we can see the monthly vols are priced to 42.02% for Dec and 40.30% for Jan, so the vol reflects lower risk in Jan.  I'd keep an eye on this one  I'm nit sure this was a one and done story.  Not for a stock that was up 650% and has multiple accusations of fraud and a government inquiry into operations.  I believe we would call that, "risk elevating" news.

This is trade analysis, not a recommendation.

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