Trades

Tilson’s Reversal on LL Creates Short Term 233% Profit Opportunity

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The acclaimed investigative reporting show 60 Minutes turned 50 years old last year. In its long history, the program has uncovered political corruptions, foreign espionage and countless tales of gross corporate mismanagement.

While the show does often feature follow-up pieces years later, you don’t have to wait to find out what has happened in the aftermath of its March 1, 2015 episode.

In that Anderson Cooper story, Lumber Liquidators (LL) came under fire for the amount of formaldehyde in its flooring. You read that right, formaldehyde in LL flooring.


Apparently, it is an ingredient in certain glues. The state of California actually regulates how much can be in flooring. Lumber Liquidators’ surpassed those limits by more than 2,000% in some cases. That amount causes serious health issues in anyone exposed… like say, someone that recently installed the flooring in their home.

The product in question came from Chinese mills the company used to produce its flooring. The Cooper story took investigators with hidden cameras into three of these mills and found that the supplier was deliberately mislabeling the flooring as Carb-2, which meets the California emissions standards. It wasn’t.

60 Minutes broke this story. But the reason the show even looked into it came from short sellers. Specifically, hedge fund extraordinaire Whitney Tilson took a large short position in the company initially because of a completely separate scandal.

Lumber Liquidators was already beginning to get wrapped up in an investigation into illegal lumber smuggling from Russia that was under sanctions. One thing led to another and Tilson began getting concerned over the emissions from the flooring at these China mills.

His bet paid off. As you can imagine, numerous lawsuits and investor complaints – let alone legal headaches over the end customers of the flooring itself – sprung up after the airing of this episode. Since then, shares of LL have fallen 90%:

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A while back, Tilson cashed out, along with the other short sellers who rode this train wreck of a company off the tracks. But in a new interview aired just this week, Tilson announced that he is going long shares of LL. He’s even put the flooring in his own home.

This complete reversal, he claims, is based on the fact that Lumber Liquidators is almost a completely different company these days.

The entire management team and supply chain has been completely changed around. It took several years, but the company is now run by a very different group of people… ones Tilson believes can turn things around.

But it’s more than just management, new mills and emission-passing product. All of those legal headaches are finally over too. A year after the 60 Minutes piece, the company settled its Russia lumber sanctions scandal for $23 million. Now, just a few months ago, it has settled this formaldehyde problem too for $33 million.

For a now $285 million company, that’s a large chunk of change. But that’s the end of it… at least according to Tilson.

Now, it’s hard to tell if he’s going to be right. At the time of his last bet on LL, he looked silly. The company was on fire, with shares soaring above $100 and rapidly expanding margins. We now know that was because of greed and cheap, dangerous product. But Tilson was right in the end.


The company now faces a different challenge. This turnaround effort isn’t cheap. Lumber Liquidators is sitting on $155 million in long term debt after paying off all these fines and fees. Yet, it has a negative cash flow position that makes its job of repaying it even more challenging.

And it too has to deal with a slowdown in the housing market and Chinese tariffs affecting its now-legal flooring made in the country. So, it takes guts to make a long bet on the company like Tilson just did.

Still, there’s a way we can still play this turnaround story – or at least the new interest from Tilson’s bet — in the short term… without risking a lot of money to do so.

A Strategy For Short Term Bulls

A bull call spread is a type of options trade that involves buying a near-the-money call option on a stock you believe will rise in price and selling a second call that is further out-of-the-money.

The income received from that sold call option helps offset the cost of the long call. This reduces the total amount at risk, making this a conservative way to use a leveraged options position on a stock you believe will rise.

The reduced risk does come with a capped maximum potential profit, however. And any share price rise above the strike price of the sold call is forfeit to the trader. But it’s pure profits up to that point.

You can see how this trade works here:

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Source: The Options Industry Council

As you can see, with both the risk and the maximum potential profit capped, they are known right up front. For a play like Lumber Liquidators right now, that’s a tradeoff worth taking.

The company reports its next earnings early next month. So, a trader looking to use this strategy on the stock might consider an expiration date just afterwards.

Let’s look at a specific trade one might use.

A Specific Trade on LL

Right now, a trader could buy an August 16 $10 call on LL for $0.65 per share and sell an August 16 $11 call for $0.35 per share for a total cost of $0.30. On 100 shares of LL, that’s a total cost of just $30.

That $30 is the total amount at risk for the duration of this trade. But like we said, the potential profit is capped too. To find out what that amount is, take the difference in strike prices ($11 – $10 = $1), and subtract the cost ($1 – $0.30 = $0.70). On 100 shares, that’s a potential profit of $70.

In other words, the trader would be looking at a return on risk of 233%. Now, shares would have to rally about 10% to see that full return. But it is possible. The company has a crucial earnings season coming up. If it can hit its mark on revenue growth, it could easily start trading well above $11 per share… more than tripling this trader’s money in less than a month.

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