Is the flooring manufacturer AFI in a legal problem?

It is strange that a cheap stock like Armstrong Flooring (AFI) is going down in the last couple of weeks when the overall market moves up. Is something bad is going here?

Well, recently, a Florida couple filed a class action suit against Armstrong Worldwide (the former parent company of Armstrong Flooring, AFI), claiming that the hardwood floors it and Lowe’s Company (LOW) sell contain excessive levels of formaldehyde (one of the ingredients used to make hardwood flooring). Lawyers of both companies denied the allegations and guaranteed their products do not contain formaldehyde above the level limit allowed by law.

It turns out that this is not the first lawsuit against Armstrong Worldwide. In 2015 10 of the company’s employees sued it for the excessive use of banned substances in its manufacturing facilities, something they claimed had caused irreversible health damages.

So far, Armstrong Worldwide and AFI have managed to hide these claims under the radar of investors and the media, but if it is true it may explode sooner or later. What kind of harm can it cause the company? A good example for this is the case of the floors manufacturer Lumber Liquidators (LL) that turns out that it had used banned substances at a high level in the floors it sells. The case blew up in February of 2015 on the show 60 minutes, and since then the stock has lost 76% of its value!

Surprisingly, at least until now, AFI actually benefited from the negative story of Lumber Liquidators. AFI is one of the two leading US brands for wooden floors, and as the CEO said, in times of uncertainty consumers turn to the big brands.

One of the writers in Seeking Alpha has recently written that despite the big upside he notices for AFI shares, he decided to abandon it because of the fear of what happened to LL could happen to AFI as well. Most companies manufacture their floor materials in China, so it is likely that if one company used hazardous substances in prohibited levels, most companies do not meet the required standards as well. The thing is that in the last two years more such cases are revealed. LL is not the only company “caught red-handed”, Lowe’s has, Ark Flooring has, and recently Floor & Decor has too. When I analyzed AFI in the past I almost hadn’t given any importance to this kind of risk, but due to the many action suits, the risk may be more significant and should be weighed in this equation.

On the other hand, AFI is not only a market leader, but also traded at a cheap price, hence my difficulty to give up on it, especially in the times of absence of available attractive stocks. I’m not worried about dropping prices due to temporary negative headlines after which it will turn out that everything is in working order. My concern is that there are deeper things which can cause long-term negative impact on the Company’s revenues. At the moment, I do not believe this is the case, so the down side of the investment is not terrible.

Bottom line, at this stage I will continue to hold the stock and will explore the issue in more depth. It is likely that the third quarter report, due to be published on November 11, will be very strong and what I talked about in this post will have no effect on the results. Therefore, rush conclusions about the share should not be made. I will, of course, update you if there is a change in my decision about the stock.

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