Tile Shop Holdings, (TTS) is a tile retailer that went public in September of 2012. Since then, it has benefited form the markets re-infatuation with anything housing related and currently trades at a ridiculous 26x EV/EBITDA. In the past month the share price has declined 29% due to an earnings miss and allegations by short seller, Infitialis, research that the company's products contain hazardous amounts of lead. After reading Infitialis' otherwise excellent report, and hearing the company's response on the most recent earnings call; I deem it unlikely that any action by regulators will be forthcoming. With that in mind, I wrote this article to demonstrate that, even without the threat of poisoning its customers, Tile Shop has issues that, from an investor perspective, are just as poisonous as lead. These include, a fundamentally flawed business model, an overleveraged capital structure, aggressive expansion strategy, declining insider ownership, management misconduct, and oversight failures - all packed into a company that is overvalued in even the rosiest scenario imaginable.
Margins & Model
"Everyone sort of lives with their rulers in the past and doesn't look at coming changes." - Stanley Druckenmiller
TTS exhibits gross margins close to 75% - this is simply not sustainable. The biggest reasons for this are that tile is by and large a commodity product, and retailing it is a business with low barriers to entry. Home Depot (HD), Lowes (LOW) and smaller competitors can just as easily buy it from vendors, and sell it for cheaper. But even if it wasn't a commodity product, the company's margins are way higher than those of other national retailers that sell highly differentiated goods. For instance, Apple sports a gross margin of around 40%, and remember, they invented the iPhone! Other premium brands with lower gross margins include Coach 72%, Lulu Lemon 50%, and Abercrombie & Fitch 62%. TTS isn't selling Gucci loafers or Louis Vuitton bags, and its margins will come to reflect that as it tries to become a national franchise.
The best case a reasonable TTS investors should hope for is that it can replicate the gross margin of U.K. based Top Tiles (TPT), and achieve a 60% gross, a margin that would leave TTS firmly on the wrong side of profitability.
The other problem at TTS is the SG&A spend. As a percentage of revenue it was ~ 56% in the most recent quarter. And while management is hopeful they can bring that down to the historical 50%, they give no indication of having the ability or even the intention to lower it any further (despite helpful hints by sell-side analysts to suggest otherwise). This high margin-operating model may have worked for a few specialty stores in Minnesota but as the Tile Shop is soon to learn, what works in the minors doesn't always cut it in the big leagues.
Capital Structure & Strategy
For FY 2013, the company has plans to expand its store count by 17 stores, and hinted at another 20 in 2014. With only $3.85 million of cash on hand as of September 30th and $85.4 million in debt, the company is taking a big risk attempting such an aggressive expansion. Simply put, the company is overleveraged and any bump in the road may be detrimental not only to equity holders but also to lenders willingness to extend credit.
In addition to the daredevil capital structure, investors should be concerned with the speed of the undertaking. Difficult as growing a business is under any conditions, it becomes exponentially more difficult when you try and do it quickly. Issues such as inventory management, location selection, employee quality and supervision, to name just a few, don't get any easier to manage when you have Wall Street eying you with a stopwatch. Sprinting ahead at full speed increases the odds of a stumble, a stumble TTS cannot afford.
Never underestimate strong ownership is what I like to say, and I can't say that about TTS. As of November 2012 Nabron International, a trust controlled by the Chan brothers (one of which is a former Enron board member), was the largest single stakeholder with an interest in ~36% of the outstanding shares. As of June 18th 2013, Nabron had reduced its interest in the company to ~20%, a near 56% reduction in a little over six months. Similarly JWTS, a private equity firm, has reduced its stake from 13% in November 2012, to 8.4% as of June 10th. Finally, despite receiving share-based compensation, CEO and founder Robert A. Rucker has also reduced his stake from 19.9% in November 2012, to 15% as of June 2013.
All of these investors obviously have better places to put their money than TTS equity - why don't you?
Management & Conduct
As short sellers Infitialis mention in their report, the CEO of TTS was convicted of fraud in civil court related to divorce proceedings from his now ex-wife. For me, this isn't a good thing but it's not necessarily the end of the world.
The other management issue brought to light by Infitialis is the fact that the former Senior Vice President of Operations, Mr. Joseph Andrew Kinder is on probation due to his involvement in a domestic dispute - another bad sign. Since then, it appears Mr. Kinder has been demoted in favor of the recently hired Chris Homeister. Mr. Homeister was previously Senior VP at Best Buy (BBY), a company with a poor record of competing on the national stage.
Last but not least, in 2012 the company was found to have a material weakness in its disclosure controls and procedures. As I understand it, the company didn't have enough people in place at headquarters that were financially competent, nor did they have a sound process for closing the books at the end of year.
In and of themselves none of the aforementioned issues is detrimental to the company's future. However, when taken together, the picture sure isn't pretty. At the very least, it should cause investors to think twice about the business they are buying into, as well as the team that will be managing it.
Now, for a moment, lets try and forget about all the things I just mentioned. Let's put on our optimist hats, and see if we can make the current valuation make sense.
Looking out to FY 2016, I put together the below valuation model that makes the following (heroic) assumptions.
First and foremost, TTS EBITDA margin goes to 30% of revenue. Historically the company has earned about 27.5%. Therefore this assumption extremely generous, especially given that its peers are earning EBITDA margins around 12%. Gross margin remains at the princely 74%, well above peers, while SG&A reverts back to 50% of revenue.
TTS expands its footprint to an average of 150 fully operational retail locations in FY 2016. This would correspond to a 23% compound annual growth rate for stores. To achieve such a rapid expansion without any margin contraction is highly unlikely, but hey we're looking on the bright side here. Not only does the store count expand, but also increases revenue per store to $3.00 million per store or 7% more than they did in 2012.
We're going to assume an 11.5x EV/EBITDA multiple in 2016. That's a higher than what Home Depot currently commands, and it's a national franchise with a honed operating model, experienced and competent management. I also assume debt will increase to $150 million to finance this growth, while cash moves up to $20 million.
What's the result of all this future gazing? Despite our psychedelic concessions to the gods of delusion the company still stands ~ 17% overvalued based on Friday's closing price.
Stepping away from never, never land for a moment, I've put together a set of sensitivity analyses to get a sense of where more realistic assumptions might value TTS. Below are two sensitivity analyses that still assume the generous revenue per store and store growth assumptions included in the first model but employ more reasonable margins and enterprise multiples.
Highlighted in peach are the areas that I consider plausible. As you can see, even the most optimistic scenarios of this subset still mark the company as overvalued by around 50%.
In addition to the all the fundamental problems, from a more technical and/or psychological standpoint, whatever lollapalooza effect was propelling the stock to its previously astronomical levels has clearly broken-down, and when that magic's gone, it's hard to get back. In sum, for TTS the party is over, and the hangover is just beginning.
Additional disclosure: No position in HD, LOW, or TPT.