Lumber Liquidators Holdings, Inc.

(NYSE: LL)

Prepared by:

B ROY H I L L A F F I N I T Y F U N D

800 Golfview Park

Lenoir, NC 28645
(828) 758 6100
www.broyhillasset.com

December 2010
 DISCLAIMER

The analyses and conclusions of Broyhill Affinity Fund LLC (“Broyhill”) contained in this presentation
are based on publicly available information including SEC filings and numerous other public sources
that we believe to be reliable. We recognize that there may be confidential information in the
possession of the companies discussed in this presentation that could lead these companies to
disagree with our conclusions. If we have made any errors or if any readers have additional facts or
corrections, we welcome hearing from you. This presentation and the information contained herein is
not a recommendation or solicitation to buy or sell any securities.

Our purpose is to disseminate publicly available information that we believe has not been made
readily available to the investing public but is critical to an evaluation of the company. The analyses
provided may include certain statements, estimates, and projections prepared with respect to the
historical and anticipated operating performance of the company. Such statements, estimates, and
projections reflect various assumptions by Broyhill concerning anticipated results that are inherently
subject to significant economic, competitive, and other uncertainties and contingencies and have
been included solely for illustrative purposes. No representations, expressed or implied, are made as
to the accuracy or completeness of such statements, estimates or projections, or with respect to any
other materials herein.

Assets managed by Broyhill and its affiliates have shorted common stock and purchased equity put
options on Lumber Liquidators Holdings, Inc. (“LL”). Broyhill manages a fund that is in the business of
trading – buying and selling – securities and financial instruments. It is possible that there will be
developments in the future that cause Broyhill to change its position regarding LL. Broyhill may buy,
sell, cover, or otherwise change the form of its investment in LL for any reason. Broyhill hereby
disclaims any duty to provide any updates or changes to the analyses contained here including,
without limitation, the manner or type of Broyhill investment.
Background

Lumber Liquidators (LL) is a low cost provider of flooring which operates discount stores across the
United States. They maintain this “advantage” by locating stores in low-rent areas (translation – inferior
locations), developing direct relationships with mills, and most importantly, sourcing about 40% of their
total product from China. Typical stores are 6,400 to 6,600 square feet and leased for five years with
renewal options. Each store has a manager and a few associates paid a low base salary plus bonus. The
company was founded in 1994 and went public in 2007. Tom Sullivan, founder and chairman, owns
roughly 13% of the shares outstanding.

Hardwood floors represent 57% of their sales with the company’s flagship Bellawood product making up
20% of net sales in 2009. LL also sells laminates (18%), moldings (13%), and bamboo/cork products
(11%). 1 Their top ten suppliers accounted for 69% of 2009 flooring purchases with 44% sourced from
Asia, 37% from North America, 13% from South America and 6% from other locations. All foreign
purchases are negotiated and paid for in USD. In 2009, 88% of orders went through their Virginia
distribution center. They are expanding a new program where goods are shipped directly to stores from
China. LL’s hardwood flooring market share was roughly 10% in 2009 2 (8-9% in 2008 and 7% in 2007). 3

Da Bulls

Bulls view LL as one of the few remaining retail growth stories as management aims to open a few dozen
stores annually for the next several years in a roughly equal mix of new and existing markets. About half
of the company’s stores have opened in the past three years. It is easy to understand why when new
stores are typically profitable within three months and have returned the initial cash investment within
a year. But while a rapidly expanding store base has produced revenue expansion throughout the
housing bust, same stores sales fell off a cliff during this period. We wonder how quickly bullish
optimism over new store growth might turn into concerns for cannibalization as comps at mature stores
continue to deteriorate. As we discuss in detail below, we believe demand for LL’s core products are set
to decline next year as the foreclosure moratorium and expiration of homebuyer tax credits will have a
meaningfully negative impact on existing home sales. With “the street” forecasting a much stronger
outlook for home prices (we struggle to find anyone calling for a decline more than 0% - 5%), investors
in LL shares are set up for a major disappointment.

Wall Street claims that LL’s low cost advantage provides the company with a market niche that is
difficult to lose. Bulls point to its focused product assortment, direct sourcing and “good customer
service” as core competitive advantages over “big box” retailers. We think “the street” is missing several
key issues that are likely to present major challenges in the year ahead. First, gross margins are likely to
come down more than expected due to rising energy and transportation costs and increasing wage
pressures in China. Because labor is a greater percentage of the total cost for engineered wood flooring,
increasing Chinese labor inflation would quickly put a big dent in any “cost advantage” assumed by the
bulls. In addition to downward pressure on gross margins, we also anticipate upward pressure on SG&A
due to continued difficulties with the implementation of SAP into next year. Management guidance and
“the street’s” acceptance that this is a one or two quarter blip runs contrary to past experience. Last but
certainly not least, we are shocked by investors’ total and complete disregard for the pending US
International Trade Commission investigation into Multilayered Wood Flooring (MLWF) imports from
China. At best, this investigation introduces substantial uncertainty into the business and serves as a
distraction to management’s limited time and resources. At worst, if the ITC were to set a tariff
anywhere near the maximum level requested, we believe LL’s business model and “cost advantage”
would be severely challenged.

Six Minutes of Pleasure

Shares of LL rose 375% from a low of $7.02 in March 2009 to a high of $33.41 earlier this year. It’s
worth noting that Tom Sullivan has sold roughly five million shares since the March lows with the great
majority of sales at prices north of $20. 4 At last week’s closing price of $23.42, the stock changed hands
at 24x and 18x 2010 and 2011 consensus earnings expectations, respectively. Analysts are looking for
30% earnings growth next year driven by new store openings, operating leverage, and stabilization in
the domestic housing market. We have our doubts. Taking management at their word that MLWF only
represents 10% - 11% of total sales, we estimate that a 50% tariff on Chinese imports would reduce next
year’s earnings to $0.94, other things being equal. An earnings miss of this magnitude would likely
result in multiple compression, as valuations of “high growth” retailers are inherently unstable. For
perspective, note that LL has traded as low as 8.6x and as high as 27.6x forward earnings since the
company went public. Even giving the company the benefit of the doubt, and maintaining the stock’s
current forward multiple, shares could easily trade down toward the $11 to $16 range based on the
midpoint of our estimates highlighted in this report. If our estimation that LL’s exposure to MLWF
represents a much larger share of the hardwood segment is correct (our research points to anywhere
from one half to two thirds of segment sales), the impact would be much, much greater. And a higher
tariff (potentially north of 200 percent), when combined with greater exposure to engineered flooring
(as we believe), could present a disaster scenario for LL shares.

Recent Results

At quarter end, LL was operating

out of 213 stores in 46 states.
Management is expecting 9 to 11
additional openings in the current
quarter. 5 New store growth
continues to drive top line results
as total sales increased 4.7%
during the quarter. Importantly,
comparable store sales were
down an ugly 5.7% alongside the
expiration of an important tax
credit for home buyers. While management blames the poor results on the implementation of SAP
during the quarter (more
on this below), we think
there is sufficient evidence
to suggest bigger issues
lurking below the surface.
Despite earning over $20
million year to date, the
company’s free cash flow
has fallen more than $11
million as LL’s cash position
has swung from $50.7
miilion earlier this year, to $26.8M at the end of the most recent quarter.

Inventory increased over 50% year-over-year during the quarter versus the 4.7% increase in sales. While
management attributes the significantly increased inventory levels to the systems implementation, we
suspect there is more to the story and estimate that inventory would have increased materially even
excluding the impact from SAP. Our contacts in the industry have warned that sales have “fallen off a
cliff” post the expiration of the home buyer’s tax credit. It’s certainly possible that LL is only now peering
over this cliff as the great majority of the company’s floors are bought for existing homes rather than
new construction, so a lagged effect relative to industry peers could also drive a free fall in comps. Gross
margins declined during the quarter due to higher transportation costs, less efficient finishing costs and
SAP implementation. We think these headwinds are likely to continue into next year, as Quantitative
Easing predictably results in significant commodity inflation and increasing transportation costs,
aggravated by a weaker dollar. SG&A was also higher than expected due to increased labor costs - more
stores to staff and more overtime from SAP. Management warned investors to expect additional
reductions in productivity in the current quarter due to the use of greater resources than expected for
SAP implementation. We’d warn investors that these issues are likely to be a headwind through next
year and simply represent the tip of the iceberg. We think LL has “over-earned” as a public company as a
confluence of benefits propped up gross margins at unsustainably high levels. It now appears that many
of these tailwinds (i.e. cheap sourcing, cheap fuel, cheap transportation, excess capacity, etc.) are likely
to recede in coming quarters and should represent strong headwinds ahead.

Sapped by SAP

LL began implementation of SAP, a retail management system, during the third quarter. This is
ultimately a positive for the company as it will integrate systems, increase efficiency and potentially
reduce SG&A. But if the current quarter is any indication, investors should not expect any such benefits
until the latter part of 2011. We expect nothing but headaches between now and then.

Shortly after implementation, management claims to have experienced problems satisfying existing
customer orders, distributing product to stores, and allocating resources needed to operate.
Management estimates that reduced productivity cost an estimated $12-14 million in lost sales during
the quarter, and increased costs associated with inefficient product transportation and increased
inventory reduced gross margin by 30 basis points. Importantly, LL had still not reached pre-
implementation productivity even by the end of quarter. Capitalized costs for SAP were expected to be
$13 million. The implementation cost $13.9 million last quarter, with another $1.5-2.5 million expected
next quarter. 6 We wouldn’t be surprised by larger numbers ahead.

LL store managers we spoke with highlighted continuing difficulties with the integration and agreed that
it was continuing to impair their ability to address customer demand. This sentiment broadly confirms
our findings of others in relation to SAP systems. Conversations with people familiar with SAP
integration indicate that when a company is having this much trouble, there is likely more to come. We
expect SAP to be a net drag on performance for the next year or so, much longer than “the street”
anticipates. On the recent call, management explained that they “have very ambitious plans to make
our whole allocation and planning process more complex and we . . . just did not have the tools to do it . .
. Having said this before, we had a lot of manual processes that are running a lot of things off of Excel
spreadsheets.” 7 This is not exactly confidence inspiring for a company operating over 200 stores and
generating sales in excess of $500 million, but we imagine it’s typical for retail “growth stories” to
outgrow the spreadsheets put in place a decade ago when managing two or three dozen stores. Once
again, this is a long term positive for the company, but it’s almost impossible to imagine a smooth
transition. While SAP headaches are likely to drag on for several more quarters, we believe that many of
the difficulties experienced in the latter part of the quarter and attributed to systems integration are
also masking a fall-off in demand from the expiration of significant housing stimulus earlier this year.
Existing home sales and changes in home prices are the most significant determinants of demand for
LL’s products. In the section below, we’ll examine these demand drivers more closely.

Going Back to Cali

Demand trends across the home improvement industry are largely dependent on several key variables.
Most critical for LL is the pace of existing home sales as roughly 90% of their products are sold to people
that have been in their home for several years and are remodeling. 8 Turnover in the housing market
encourages renovation, which is a leading indicator of traffic to home improvement retailers. Existing
home sales fell nearly 20% in September as the end of the homebuyer tax credit caused existing home
sales to fall off a cliff. The expiration of this tax credit should become an increasing headwind for LL in
2011.
 Negative equity is a major
problem with one in four
mortgages underwater and
the national loan-to-value
rates 75% higher than the
long term average.
Importantly, in two of LL’s
largest markets, Florida
and California, over 40% of
all mortgages are
underwater. Given the
severity of the problem, a
homeowner’s ability to
extract equity from a home
to purchase a new home,
or to renovate their
existing household, is
largely impaired. Making matters worse, those mortgages currently close to being underwater are likely
to get wet with a further decline in home prices. Just a few months ago, Deutsche Bank projected that
the negative equity rate may rise to 48% in 2011. All of this is to say that the existing foreclosure issue is
likely to get worse before it gets better greatly inhibiting the natural level of housing churn, which home
improvement retailers have learned to depend on. If homeowners lack mobility due to negative equity
(an issue also aggravating today’s elevated structural unemployment levels), LL’s store traffic should
slow. This traffic is a powerful driver of wood flooring demand as the average new home owner spends
an incremental $2,000 - $3,000 on improvements in the first 12-18 months of residence. 9

Dare We Say Double Dip?

After existing home sales, home

prices are the next most important
driver of home improvement
demand. As home prices increase,
consumers are more willing to
undertake major renovation
projects such as wood flooring.
But in a deflating home price
environment, few major
renovations are undertaken.
Continued foreclosures, high and
stagnant unemployment,
consumer deleveraging, and
growing fiscal headwinds should keep pressure on home prices and slow a recovery in big-ticket home
improvement purchases. As the backlog of housing inventory is likely to cause a double-dip in home
prices, we should see further declines in LL’s average ticket.

We have yet to see any meaningful improvement in the national housing inventory overhang. The chart
at right highlights months of supply
of homes on the market. Currently,
there are almost 11 months of
supply on the market, which is near
the highs of 2008. There are now
over 4 million housing units on the
market, a number which has
accelerated throughout the year. In
addition to the “official” inventory,
there are also an estimated 6 million
houses that are not on the market,
but are considered “shadow”
inventory. The good folks at
Hedgeye calculate that supply of
housing is in the top two deciles of inventory levels, and historically prices have typically fallen more
than 15% over the following 15 months when at these levels. 10

We believe home improvement demand is set to decline next year as the foreclosure moratorium and
expiration of homebuyer tax credits will have a meaningfully negative impact on existing home sales.
When considering the “shadow inventory” overhang alongside these factors, a further 10% - 20%
decline in home prices from existing levels is not difficult to envision. Any growth in the industry is likely
to be focused on smaller projects driven by more regular traffic, neither of which bode particularly well
for LL, whose focus on high dollar renovations should result in underperformance within an already
weak industry. With “the street” forecasting a much stronger outlook for home prices (we struggle to
find anyone calling for a decline more than 0% - 5%), investors in LL shares are set up for a major
disappointment.

More Talk About Consumer Deleveraging 11

Beyond pure housing industry data which does not paint a pretty picture, it is important to consider the
state of the consumer. We view changes in consumer confidence and the level of private sector credit
for indications of consumers’ willingness and ability to take on debt. Declines in credit can have a
material impact on home improvement spending as can a fall in consumer confidence. Needless to say,
the U.S. consumer remains extremely over-indebted, with aggregate private debt to GDP now at 267%
versus the peak level of 298% achieved back in February 2009. With debt levels as high as they are, the
potential for further deleveraging still exceeds the worst experienced during the Great Depression.
 So the consumers’ ability to take on
additional debt is questionable at
best. We’d argue that their
willingness to take on additional
debt is equally as low based upon
the lackluster “rebound”
experienced by the Conference
Board’s Consumer Confidence Index
and this year’s surprising decline.
Contrary to bullish beliefs, lower
mortgage rates do little to spur
incremental demand, as the
marginal buyer has already
refinanced, and those that haven’t
already refinanced may run into
difficulties swimming that far under
water. Against this consumer
backdrop, we expect comps to
remain under pressure next year
due to the company’s high average
ticket and declining selling prices. A
few years ago, Today’s Homeowner
indicated that flooring replacement
was low on consumers’ priority list,
far below minor kitchen and bath
remodels, deck additions, siding and
window replacement, and
additions. We’d imagine it is even
lower today given the credit
constraints and high price tag relative to cheaper alternatives. The U.S. consumer’s new fervor for
frugality means her preference for LL’s “bamboo earrings . . . at least two pair” 12 is clearly waning. On
LL’s recent earnings call, management confirmed our suspicions warning that “average ticket indicates
that it is a person doing one room at a time.” Most store sales contacts we spoke to also indicated that
the average spend remains lower than they ever remembered due to: less expensive products, reduced
potential for incremental sales (peripherals, glues, sheeting, etc.) and increased push back from
customers in terms of price. Almost all of them noted the continued preference of customers towards
lower priced flooring products. And speaking of lower priced goods . . .

Punked by Protectionism

On October 21, the Coalition for American Hardwood Parity (CAHP) filed a complaint with the US
Department of Commerce and the US International Trade Commission regarding Chinese MLWF
products. The complaint alleges that the Chinese are unfairly subsidizing the product, dumping below
cost on the US market, and stealing intellectual property from domestic producers. On top of this, the
petition cites the low cost of labor and low cost of raw material sourced from illegally logged lumber as
unfair advantages. For the first six months of 2009 and 2010 value per square foot were $1.50 and $1.49
from China, less than half the cost of domestic products which carried a value per square foot of $3.18
and $2.99 over the comparable periods. 13

CAHP supports our view that improvements in the wood floor market in late 2009 and early 2010 were
the direct result of the homebuyer tax credit, which was applicable from Jan 1, 2009 to April 30, 2010. If
a contract was signed prior to April 30 and closed before Sep 30, it also qualified, which would help
explain the lagged decline in LL comps relative to already falling existing home sales. Obviously, CAHP is
upset that the massive stimulus intended to benefit American consumers and industry did not have a
meaningful impact on domestic producers. We don’t blame them, although we recognize that being
rightfully angry probably doesn’t warrant slapping a massive tariff on your competitors. More
importantly, we believe the evidence clearly points in that direction, regardless of domestic emotions.

China’s share of the US market increased from 10% to 27% between 2002 and 2007 as US imports of
Chinese MLWF increased by 76% over this period, and China’s total wood flooring production increased
by 64%. China’s total MLWF output increased by a further 49% from 2008 to 2009 to 1.27 billion square
feet. US MLWF market share held by Chinese imports hit a peak of 34.7% in June 2010. Due to
underselling by Chinese imports, domestic producers have curtailed product lines (or eliminated them
altogether) leading to plant closures and employment reductions. The petition requests a 242% tariff be
placed on multi-layer wood flooring from China for these reasons and notes that even if the housing
market recovers, the recovery will likely be dominated by cheap imports. An initial hearing in early
November determined that the United States International Trade Commission will investigate the issue
and potentially put a tariff in place on Chinese MLWF imports. 14 We expect the ITC to determine if
there’s enough evidence to hold a preliminary hearing this Friday, December 3rd. Given the extensive
evidence we’ve reviewed, we are confident this will pass. At the end of the preliminary phase, which we
understand will conclude during the second quarter, the ITC will implement a preliminary tariff if there is
enough evidence to support it. Investors should mark their calendars accordingly, as these are important
dates. We have yet to find a single “sell side” research piece that properly considers these hearings (the
first time it was even mentioned was a few sentences in a report this week) and management has yet to
say a word about them publically despite filing an earnings release and hosting a conference call since
the initial hearings, where an army of LL representatives were present. Hmmmmmm.

Chinese MILF MLWF

MLWF has a more advantageous raw material yield when compared with solid wood flooring (20-30% of
the log ends up in the final product for solid wood flooring compared to 70-80% for MLWF). 15 Therefore,
labor is a greater percentage of the total cost for engineered wood flooring, providing China with an
advantage over domestic producers. The increase in the volume of imports has been a result of home
centers and direct distribution centers such as Home Depot, Lowes, and Lumber Liquidators. This growth
has come at the expense of smaller distributors. LL is estimated to account for 10% of the total US wood
flooring market, up from 5.1% in 2006. 16 At a September conference, LL noted that 40% of their product
is sourced from China. We estimate that a good portion of these imports are engineered flooring, and as
such, it is curious that management has yet to even mention the potential for such a large increase in
costs. Perhaps they don’t believe it is significant or a realistic threat to their business model. But while
management downplays the potential impact of a tariff, industry insiders we’ve consulted put the odds
of a 50% (or higher) tariff at 70%, 75% (or higher) tariff at 50% and a tariff in excess of 100% at a 30%
probability. If assigned at the conclusion of the preliminary hearings (likely sometime in Q2-11), an
escrow tariff would be charged immediately and any difference between the final tariff and the
preliminary tariff would be collected retroactively after a final decision was concluded.

2011 EPS Estimates

Tariff
20.0% 50.0% 70.0% 100.0%
20% 1.14 0.94 0.81 0.62
MLWF as % of Total

30% 1.08 0.78 0.58 0.29

Hardwood

40% 1.01 0.62 0.35 (0.04)

50% 0.94 0.45 0.12 (0.37)
60% 0.88 0.29 (0.11) (0.70)
70% 0.81 0.12 (0.34) (1.03)

In 2009, Lumber Liquidators derived 57% of its revenue from solid and multi-layer wood flooring
combined. While management will not publically disclose what percentage of this is MLWF in company
filings, checks with stores and industry experts reveal that it is the majority of their wood sales.
Curiously, most of the research we have conducted produced very different answers than those verbally
suggested by management, who claim that engineered flooring only represents 10% - 11% of total
sales 17 (although even using these lower figures, the potential margin impact from a tariff on Chinese
imports would be substantial as shown in the above matrix). A company contact in customer care
suggested it was a roughly even split between hardwood and MLWF. The 2011 Edition of The U.S. Floor
Report indicates that MLWF is closer to two thirds of LL’s wood flooring segment. We also thought it was
interesting that not a single sales person we spoke to tried to sell us solid hardwood products, even
when we specifically asked about them. Most store contacts we spoke with indicated that they have
received direct instructions from their managers to continue to push engineered products.

LL’s Ears Should be Jingling Baby

Importantly, we believe that the vast majority of Lumber Liquidators MLWF is sourced from China. A
salesman at the LL call center, after checking with the relevant department, informed us that 80% of
their MLWF was sourced from China. They followed up on this by checking with one of LL’s buyers, who
reported that only the Bellawood line (20% of 2009 net sales) is sourced domestically. Another manager,
when asked if they carried any products not sourced from China, replied that they carried many
products by Schön. But after confirming with a more knowledgeable store contact, he replied that
despite the Swedish name, these products were also sourced from China. He concluded by saying,
“Nope, never mind, everything’s from China.” By far our favorite response came when we inquired
about domestically sourced engineered flooring. A store manager told us to “go to the nearest hardware
store and buy an ax. Solid hickory handle - 100% US. Then go to the nearest forest and cut down a tree.
Next, go buy a band saw and mill it yourself.” Perhaps a bit of an exaggeration, but it makes our point
nicely.

The magnitude of any tariff is unknown (we’ll learn more by March 2011) but the effect that it will have
on Lumber Liquidators is clear. If this petition is passed in any form, we believe it would kick off a
scramble for cheap supply causing costs to surge before substantial product can be re-sourced or
mitigated in any way. In the event of a more extreme tariff, producers would predictably attempt to re-
source away from China. One flooring executive even commented in the ITC hearing that he expected to
be on a plane the day
after Thanksgiving to
Indonesia. 18 But due to
the insignificant capacity
in other inexpensive
locations, this is not a
viable option on any
significant scale in the
short term. While
Indonesia is the cheapest
alternative, it represents
roughly a tenth of
Chinese capacity and our
sources tell us much of it
is illegally sourced. Those
unfamiliar with the Lacey
Act may want to quickly acquaint themselves with illegal logging practices as an important addition to
the act calls on vendors to be accountable for documenting the path of a product from harvest to sale.
According to an industry report by Catalina Research, only 18.8 million square feet of MLWF is imported
to the US from countries with an average cost within 100% of China. This compares to 71.2 million
square feet imported from China and 98.6 million square feet of total US imports. 19 Critically, we believe
that re-sourcing any significant portion of the Chinese production will result in greater demand for lower
capacity locations, ultimately increasing the price of imports anyway. The net result in any scenario is a
major impact on costs and margins, neither of which is being discussed by “the street” or by LL
management. We wonder why Armstrong felt it was material enough to include the language below in
their latest filing despite having a much smaller impact to their business than LL in our estimation
(emphasis added):
On October 21, 2010, a coalition of U.S. producers of multilayered wood flooring (not including
Armstrong) filed antidumping (“AD”) and countervailing duty (“CVD”) petitions regarding multilayered
hardwood flooring from China. The AD petition requests that the Department of Commerce impose
duties of up to 242% on imports of multilayered hardwood flooring, which it claims is needed to offset
unfair pricing from Chinese imports that injure the U.S. industry. The CVD petition requests an
unspecified level of duties be imposed on importers to offset alleged unfair subsidies provided by the
Chinese government (such as the undervaluation of the Chinese currency, various tax benefits for
foreign-invested enterprises, VAT and tariff exemptions on imported equipment, and electricity being
provided at artificially low rates).

Armstrong World Industries, Inc. is a domestic producer of multilayered wood flooring. We also import
multilayered wood flooring from suppliers in China and we have a plant in China that manufactures
multilayered wood flooring for export to the U.S. Armstrong is specifically mentioned in the AD and CVD
petitions as an importer. Under the U.S. AD and CVD laws, a U.S. importer may be responsible for the
payment of any antidumping and countervailing duties. The Department of Commerce and the
International Trade Commission have only just commenced their investigations and the outcome of the
cases are uncertain. As a result, at this time we cannot say whether an adverse ruling is probable or
estimable. However, if such an adverse ruling were to be issued, Armstrong could be subject to duties on
multilayered hardwood flooring imported from China, and it is possible such duties could be
material 20.

Score One for Consensus

While “the street” remains willfully blind to the potential business-busting tariff on Chinese imports, we
have noticed more than a few analysts correctly mentioned “sourcing” as a risk to LL shares going
forward. Compliments of our beloved Fed, most domestic retailers can now look forward to spiraling
commodity costs in the year ahead. This factor, which should be familiar since they faced a similar
dynamic in early 2008, is compounded by a weaker dollar and labor inflation in China. All of which
should keep steady downward pressure on gross margins. And while most goods sold in home
improvement stores have a relatively small labor cost, engineered flooring is much more labor intensive,
which of course, explains why most of it is imported from China in the first place. Once again, this
negative gross margin cocktail does not bode well for the LL profit outlook. Labor costs have already
begun to increase as a percentage of net sales, perhaps signaling inefficiencies and diseconomies of
scale.

Don’t Wake the Beast

The home improvement industry remains largely fragmented despite the dominance of two “big box”
retailers, Home Depot and Lowe’s. Bulls claim that there is plenty of room for LL to “grab share.” We’d
prefer not to agitate the sleeping giant in the market as these boys bring product selection and
efficiency that is impossible for the niche players to match. Home Depot and Lowe’s have built
tremendous brand franchises with powerful logistical capabilities and strong vendor relationships. We’d
rather not get in the ring with the big boys, but it seems that LL has gotten their attention. In the first
quarter, Lowe’s took on additional flooring inventory with the aim of taking share in this category. 21 We
would not want to be seen as an emerging threat to these industry powerhouses. Come to think of it,
given Home Depot’s lower ticket products, rigorous cost controls, substantial free cash flow generation
and 3% dividend yield, HD/LL appears to offer compelling risk/reward for a pair trade.

Fanfare for the Low Cost Provider

Customer reviews on the company’s website are wonderful. What we found more interesting was that
when searching for the company’s website, the second auto-fill option in the Google search bar is
“Lumber Liquidators Complaints.” We’ve highlighted just a few of these mostly for entertainment
purposes. The general idea is that you get what you pay for both in product quality and customer
service.

“Shame on Bob Vila for representing this company.”

“Lumber Liquidators should change their name to "Customer Liquidators." The service is the worst I have
ever encountered! Stay away from these people; they should not be in business.”

“They are by far the worst company I have ever dealt with in my 23 years in the trade. Deceitful, poor
quality and the WORST CUSTOMER SERVICE.”

“Bought Supreme Bamboo with 15 yr finish warranty. The finish has worn off in 8 months. Sought the
help of customer care to settle a claim. It literally took 3 months for them to resolve the issue and finally
send a letter denying the claim. Lumber Liquidators was the worst customer experience I have ever had -
and the ONLY online vendor that has prompted me to submit this type of e-review. Bottom line, buy a
nicer wood from another vendor if you want long lasting beauty and quality. Their price was great, but
now I have a worn scratched, dented floor that will have to be removed and replaced much earlier than
I'd ever imagined.”

“When I tried to pick up an order from one of the stores, the store manager persuaded me to submit a
new order because "they were upgrading their software and couldn't retrieve my order information,”
saying I could easily cancel the internet order. However, one month passed, 4-5 phone calls have been
made, and still they haven't refunded the credit back. Horrible customer service.”

“We ordered 23 boxes of product, which came from 2 different mills with production years stamped on
the end of the boxes between 2006 and 2010. The tongue and groove did not interlock and the color
variation between the product (natural birch) in the various product runs were not even close. We
purchased a premium Bellawood product - not a cheap or close-out product.”
What If We’re Wrong?

While we have long believed that interest rates will remain lower for longer than current consensus
expectations, we’ve been wrong often enough to know that we’ll likely be wrong quite often in the
future as well. In this particular case, if we are wrong on rates, we should be very right on LL as the real
negative demand shock would come in the form of a spike in rates. With nearly $1 trillion of option
ARMs and Alt-A mortgages resetting by 2012, if Bernanke is successful in engineering inflation, and
these rates reset higher alongside a rising CPI, it is game over for homeowners, who would default en
masse. Not exactly a happy ending for home improvement demand.

We recognize that the current investigation may not materialize into an import tariff and that the
potential impact of any tariff may be negated by LL’s ability to pass costs through to the consumer. But
we wonder how a low cost provider maintains its “competitive advantage” when costs increase. Aside
from a dramatic recovery in the domestic housing market, it is difficult to envision material upside for
shares at today’s valuation. Such a magical rebound would clearly fly in the face of historical evidence.
As Carmen Reinhardt detailed in a recent NBER Working Paper, about 90% of historical observations
examined surrounding a financial shock showed real house prices below their pre-crisis levels with
cumulative declines as large as 55% and median real estate prices 15% - 20% lower, a full decade later.
We wouldn’t bet the ranch on a major resurgence of the home as an ATM machine in America.

Perhaps expansion into international markets will provide the upside bulls are hoping for? Management
recently pushed back its planned expansion into Canada from the fourth quarter into 2011 as it struggles
with the implementation of SAP. We think this is a good idea and might suggest shelving any northern
expansion at least until some of the air is let out of that bubble. The Canadian housing market looks
eerily similar to another commodity-related housing market we are quite familiar with. While
residential real estate prices at home are well off their highs, Canadian home owners have enjoyed a
continued surge after a brief blip lower in 2008. Historical data clearly indicates that the ratio of home
prices to income has always fluctuated around a stagnant long term average. The reason is that income
acts as an anchor limiting the price homeowners are able to pay, and has always pulled prices back to
earth in every instance. It is only a
matter of time. The average family can
afford a home about 3.5 times their
income. In 2005-2006, new homes in
the U.S. were selling for well over 5
times median income while other real
estate bubbles have grown to 6 or 7.5
times. Canadian real estate is at 6.5
times family income today – nearly
double the price it should be. Not
exactly a market we’d consider ripe for
expansion.
Endnotes

1
Lumber Liquidators 2009 10-K
2
Catalina Research, Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood
Flooring from the People’s Republic of China, Coalition for American Hardwood Parity
3
Lumber Liquidators 2009 10-K
4
FinViz.com, LL Insider Trading
5
Lumber Liquidators Q3-10 10Q
6
Lumber Liquidators Q3-10 10Q
7
Thomson Reuters, LL Q3-10 Earnings Call Transcript
8
Lumber Liquidators 2009 10-K
9
ISI 2011 Home Improvement Outlook
10
Hedgeye Risk Management
11
Broyhill Asset Management, The Great ‘flation Debate
12
James “LL Cool J” Smith, “Around the Way Girl,” Mama Said Knock You Out 1990
13
Catalina Research, Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood
Flooring from the People’s Republic of China, Coalition for American Hardwood Parity
14
Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood Flooring from the
People’s Republic of China, Coalition for American Hardwood Parity
15
Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood Flooring from the
People’s Republic of China, Coalition for American Hardwood Parity
16
Catalina Research, Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood
Flooring from the People’s Republic of China, Coalition for American Hardwood Parity
17
November 23, 2010 Call with LL Management
18
ITC Hearing Transcript
19
Catalina Research, Petition for the Imposition of Antidumping and Countervailing Duties: Multilayered Wood
Flooring from the People’s Republic of China, Coalition for American Hardwood Parity
20
Armstrong World Industries Q3-10 10Q
21
Thomson Reuters, LOW Q2-10 Earnings Call Transcript