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GOTHAM CITY RESEARCH'S OPINIONS

  1. Tile Shop's (NASDAQ:TTS) 2013 LTM earnings are overstated by over 200%. TTS's actual 2013 LTM EPS is closer to $0.18/share.
  2. TTS will restate several years' historical results as a result of the issues covered in this report.
  3. The company has used its China-based undisclosed related party and improper accounting to overstate profits.
  4. Gross margins will continue to decline through 2014, as TTS must reverse prior years' accounting overstatements.
  5. Tile Shop's shares are worth no more than $1.54-$3.34/share, implying 84%-93% downside.
  6. TTS's creditors will likely restrict additional indebtedness & capital expenditures until TTS's accounting is corrected.

SUMMARY OF THE BASIS OF OPINIONS

  1. TTS's largest supplier, Beijing Pingxiu, is an undisclosed related company, and accounts for 20-30+% of TTS's COGs.
  2. Beijing Pingxiu is secretly controlled by Fumitake Nishi. Mr. Nishi is the CEO's brother-in-law and a TTS employee.
  3. Beijing Pingxiu invoices sent to the Tile Shop are directed to Fumitake Nishi. Beijing Pingxiu has no presence in one of its listed addresses, and a minimal presence in another.
  4. Days sales' inventory for FY2011 & LTM 2013 exceed 365 days, at 396 & 414 days respectively.
  5. TTS inventory growth exceeds sales growth by 3x, as of 9/30/2013. Inventory growth has, on average, exceeded sales growth by 2.1x over the last 5 years.
  6. The CEO believes TTS is worth somewhere between $83.6 and $180.4 million ($1.0-$2.2 million per store).
  7. Free cash flow has gone negative over the last 9 months.
  8. Tile Shop has had 3 different auditors in the last 2 years.
  9. TTS has missed EPS guidance 4 out of the last 5 quarters.
  10. Color Tile, Inc., the only other national specialty tile retailer in US history, filed for Ch. 11 bankruptcy in 1996. CEO Bob Rucker worked for Color Tile.
  11. Gotham City Research contacted the Tile Shop on several occasions and did not hear back from the Company.

To download the Report in its original form (PDF format), go to our website: The Tile Shop: Like Crazy Eddie's, But With An Undisclosed Related Party & A Chinese Twist

INTRODUCTION

GOTHAM CITY RESEARCH first heard about Tile Shop Holdings last summer, when the company entered the US public equity markets via a SPAC (special-purpose acquisition company). Many low quality companies and outright frauds have historically entered the public markets via SPACs and reverse mergers. We decided to monitor TTS closely, as we suspected that it too is a low quality company. Our interest in the Tile Shop story increased recently, after we found a few smoking guns.

We found that Beijing Pingxiu, Tile Shop's largest China-based supplier (accounts for over 30% of TTS's COGs), is an undisclosed related party, and that invoices sent to Tile Shop from Beijing Pingxiu, originate from phantom addresses.

We also found that Fumitake Nishi, who is the CEO's brother-in-law and a TTS employee, seems to send invoices from China, directed to none other than himself (sent to Tile Shop addresses).

These set of facts would explain why Tile Shop's gross margins seem too good to be true and why recent DSI numbers seem unrealistically high. We decided it was important to go public with our findings after we uncovered these smoking guns, and got a sense for how the many seemingly disparate red flags, all tie-in together. We are confident that Tile Shop is similar to Crazy Eddie's of the 1980s, and that the company will meet a similar fate. For example:

  1. Tile Shop secretly controls Beijing Pingxiu1 (and probably other) suppliers to overstate profits. Crazy Eddie's used a quasi-captive distributor, Wren Distributors, to overstate profits2.
  2. TTS's inventory growth exceeds sales growth by a factor of 2x-3x. Crazy Eddie's inventory growth exceeded sales growth by over 2x, before it went bankrupt3.
  3. Family members and close friends play important roles within Tile Shop. Family and friends infamously played an important role in the Crazy Eddie's fraud.

Tile Shop May Be Worse than Crazy Eddie's

While Tile Shop and Crazy Eddie's inventory growth vs. sales growth figures appear equally bad, Tile Shop's most recent days' sales of inventory ("DSI") looks far worse4:

(click to enlarge)

As Crazy Eddie's, Symbol Technologies, and other famous inventory accounting frauds remind us: if margins seem too good to be true (and too smooth to be true), they probably are. We believe that the chickens are about to come home to roost for Tile Shop and CEO Bob Rucker. We recommend you sell shares immediately.

TTS Uses an Undisclosed Related Party to Overstate Earnings

Tile Shop Gross Margins are Exceptionally High and Smooth - Are Margins Too Good to Be True?

"When I see a bird that walks like a duck, swims like a duck, and quacks like a duck, I call that bird a duck" - James Whitcomb Riley

The Tile Shop is a specialty retailer of tile in the United States. The retail tile market is highly-fragmented, yet TTS has somehow managed to report exceptionally high and smooth gross margins1:

(click to enlarge)

The now defunct Color Tile Inc., the Tile Shop's only truly comparable company, achieved gross margins between 41%-48%2. That is, Color Tile's margins were nearly half of TTS's and twice as volatile.

What is Tile Shop's secret sauce? The company attributes its apparent success to the following factors3:

(click to enlarge)

We are confident that Tile Shop's gross margins are too good to be true, just as Bernie Madoff and Allen Stanford's extremely high and smooth investment returns were proven to be too good to be true.

TTS Uses Beijing Pingxiu and Improper Accounting to Overstate Earnings

We believe Tile Shop's true key to success has been Beijing Pingxiu, its undisclosed related supplier, and improper accounting. Specifically, we believe the company is engaged in two parallel schemes:

  1. TTS uses Beijing Pingxiu ("BP") and its other captive, phantom suppliers to overstate inventories, understate cost of sales, and overstate gross profits in its 10-Ks, 10-Qs, and other filings:
  2. BP sells goods to TTS at (or near) cost, allowing TTS to achieve an artificial cost advantage:

Consequences of Tile Shop's Undisclosed Related Party Malfeasance

  1. The artificially high and steady gross margins will decline significantly going forward.
  2. TTS will restate several years' historical results as a result of the issues covered in this report.
  3. The SEC, DOJ, an independent investigation, and/or Tile Shop itself will validate our beliefs.

The following facts support our beliefs:

TTS's Largest Supplier, Beijing Pingxiu, is an Undisclosed Related Company

  1. Beijing Pingxiu is an undisclosed related party supplier that accounts for over 30% of TTS's COGs.
  2. Beijing Pingxiu is wholly owned by Fumitake Nishi, who is CEO Bob Rucker's brother-in-law, and a Tile Shop employee.
  3. Beijing Pingxiu's invoices sent to Tile Shop are directed to Fumitake Nishi.
  4. Fumitake Nishi, Bob Rucker, and Lee Shoon Rucker (CEO's wife) have a history of selling each other assets and sharing addresses.
  5. 2 of Beijing Pingxiu's addresses (listed in SAIC filings) appear to be phantom addresses.

Beijing Pingxiu Accounts for over 30% of TTS's COGs

According to Tile Shop's SEC filings, "approximately 58% of our purchased product was sourced from Asia, 9% from North America, 4% from South America, 29% from Europe, and less than 1% from other locations. Over 95% of our foreign purchases are negotiated and paid for in U.S. dollars."

Asia accounts for over 50% of Tile Shop's cost of sales, which means that Beijing Pingxiu is particularly important to TTS, even amongst its Asia-based suppliers. According to PIERS ("Port Import Export Reporting Service") data, Beijing Pingxiu accounts for over 30% of Tile Shop's supplies as of 2013:

Tile Shop's SEC filings do not mention Beijing Pingxiu in any of its SEC filings. TTS also never mentions the words 'China' or 'Chinese' in any of its SEC filings. Given the materiality of the relationship between Beijing Pingxiu and Tile Holdings, we find this suspicious (at best).

We believe Tile Shop deliberately omits Beijing Pingxiu from its SEC filings because BP is owned by the CEO's brother-in-law, and because BP plays a key role in TTS's malfeasance.

Beijing Pingxiu may simply exist as nothing more than a phantom company, such that Tile Shop uses BP to achieve whatever margin it so wishes. This would explain why BP operates out of month-to-month, obscure locations in China, as indicated by our visit to its listed locations.

Beijing Pingxiu and its Ghost Addresses

We visited the Zhang Zhou Hotel, and Beijing Pingxiu has no presence at the hotel:

  1. Visited the hotel at Room 3408, Zhang Zhou Hotel, G area, 46 Enjizhuang.
  2. The desk clerk said the hotel currently has a Yunnan restaurant on the first floor, a Karaoke (KTV) bar on the second floor, and a hotel on the third.
  3. All offices were moved out of the building in 2011 and she has worked at the hotel for four years but was not familiar with Beijing Pingxiu.

Recent import and shipping records provided by PIERS clearly lists Zhang Zhou Hotel as BP's address:

(click to enlarge)

We also visited the Long He location. It is a very small office with minimal activity. One would think Beijing Pingxiu, TTS's largest supplier, would have a little more of a presence at a key location:

  1. Visited the hotel at Room 202, Long He office building, N 78 Andignem Outer Street, Dongcheng District Beijing.
  2. Desk clerk recognized Beijing Pingxiu & directed the contact to the Long He office building 2 doors down. When referring to the company, she used the term "zhuang xiu" (to decorate).
  3. In the lobby of the Long He office building was a sign listing the various companies, including Beijing Pingxiu in room 202. The 2nd floor, which consisted of a series of doors with no nameplates, is like the floor of a hotel. Room 202 is a very small premise with no nameplate.
  4. Other offices on the floor with open doors contained no more than a desk, a few chairs and a shelf. So the businesses operating in this hotel are clearly quite small. There wasn't much activity relating to room 202 and not much movement in the other offices.

It's unclear how the Long He location has the capacity to process the volume of recent activity (as shown below), per PIERS shipping data:

(click to enlarge)

Pictures of the Zhang Zhou hotel, the sign inside the Long He building, and Long He office building:

Xingyang Xinfeng (Another TTS Supplier) Shares the Same Address as Beijing Pingxiu

Xingyang Xinfeng shares the same address as one of the addresses provided by Beijing Pingxiu. We found 7 recent records of shipments from Xingyang Xinfeng to Tile Shop:

(click to enlarge)

Beijing Pingxiu Profit Margins Are Approximately 0%4

Income Statement

('000 RMB)

2008

2009

2010

2011

2012

Sales

0.0

42.8

324.9

888.1

16,536.5

COGS

0.0

30.0

288.6

-

15,426.3

Business Tax

2.4

17.8

-

-

Gross Profit

0.0

10.4

78.4

-

-

SG&A

11.7

8.5

71.5

-

-

Finance Cost

(2.8)

(1.5)

(1.1)

-

-

Operating profit

(8.9)

3.4

8.0

2.8

119.9

Other expense

0.0

0.0

0.0

-

-

EBT

(8.9)

3.4

8.0

-

-

Net Income

(8.9)

2.6

6.0

2.1

89.9

Balance Sheet

Cash

490.1

38.2

342.8

-

-

A/R

0.0

0.0

500.0

-

-

Prepaid exp

0.0

473.7

0.0

-

-

Other ST Assets

1.0

0.0

0.0

-

-

Total ST Assets

491.1

511.9

0.0

-

19,907.2

LT Assets

0.0

0.0

5.0

-

-

Total Assets

491.1

511.9

847.8

14,990.8

19,910.5

A/P

0.0

0.0

0.0

-

-

Other Payables

0.0

12.0

346.5

-

-

Deferred tax liability

0.0

1.3

2.6

-

-

Other ST liabilities

0.0

5.0

(0.9)

-

-

Total Liabilities

0.0

18.3

348.1

14,489.4

19,319.3

Paid-in Capital

500.0

500.0

500.0

-

-

retained earnings

(8.9)

(6.3)

(0.3)

-

-

Total Equity

491.1

493.7

499.7

501.4

591.2

Tile Shop Secretly Controls Beijing Pingxhou Through Fumitake Nishi, the CEO's Brother-in-Law

So far, we know that:

  1. Beijing Pingxiu is Tile Shop's largest supplier.
  2. BP's physical presence at some of the provided locations is doubtful.
  3. BP operates at nearly no profit.

In the next few pages, we show how Beijing Pingxiu is, in substance, Tile Shop (i.e. secretly controlled by Fumitake Nishi, a Tile Shop employee and the CEO's brother-in-law). We also show invoices that are sent from Fumitake Nishi of Beijing Pingxiu to Fumitake Nishi of the Tile Shop.

Fumitake Nishi Owns 100% of Beijing Pingxiu, According to Chinese SAIC Filings

As of Nov 8, 2011, 西文武 owns 100% of Beijing Pingxiu5:

(click to enlarge)

The page shown below, directly from the Beijing Pingxiu SAIC filing, states that 西文武 holds Japanese citizenship, and provides a Japanese Passport number6:

西文武 when translated is Fumitake Nishi in Kanji (Fumitake is the given name, Nishi is the surname)

A Japanese translator stated the following:

The Kanji (the Chinese characters) for Nishi's name is 西文武, which is pronounced as ''Xi Wenwu'' in Chinese pinyin (Chinese characters and Kanji are oftentimes the same or extremely similar in terms of stroke composition and meaning). However, ''Xi Wenwu'' is not a PRC national, nor is ''Xi Wenwu'' the Japanese pronunciation of his name. The proper romanization of his name is NISHI Humitake (note: Humitake is also sometimes romanized as ''Fumitake'').

We consulted two other Chinese/Japanese translators and they independently verified that 西文武 is Fumitake Nishi. The translators also noted the following:

  1. 西文武 is not a Chinese name, nor does it make sense as a Chinese name.
  2. Fumitake Nishi is not a common Japanese name. If I hear this name, I would wonder if this person would be originally from China but living in Japan or something.

Fumitake Nishi Owns Beijing Pingxiu and Invoices Are Sent to Him and the Tile Shop

Patent records and shipping records indicate that Fumitake Nishi is a Tile Shop employee. Shipping records sent from Beijing Pingxiu to Tile Shop state "attn: Fumitake Nishi" (please see the appendix for full sized versions of the documents shown below)7:

(click to enlarge)

(

Fumitake Nishi is CEO Robert Rucker's Brother-in-Law

We believe Fumitake Nishi is CEO Robert Rucker's Brother-in-Law (through his wife, Lee Shoon Hammond, who also goes by Xun Li) for the following reasons (please see the appendix for more information):

  1. Ex-employees say Fumitake Nishi and CEO Bob Rucker are related. They also say that Fumitake Nishi goes by 'Ben Lee' in the US.8
  2. Fumitake Nishi's daughter XXXXX Nishi lists YYYYY Hammond as her cousin:

Lee Shoon Hammond is CEO Rucker's wife. YYYYY Hammond is her son:

  1. Bob Rucker and his wife Lee Shoon Hammond sold a home located on 6489 W 168th Avenue in Eden Prairie, MN to Fumitake Nishi9.
  2. Fumitake Nishi and Lee Shoon Hammond's businesses (e.g. China Link Consultants), share a common business address, 5245 Silver Maple Circle:

(click to enlarge)

TTS 2013 LTM Earnings Overstated by Over 200%

Sam Antar, former CFO of Crazy Eddie's ("CRZY"), describes how CRZY's cozy relationship with one of its distributors/suppliers helped it commit accounting fraud1:

"Crazy Eddie's had a very cozy relationship with a vendor known as Wren Distributors (Wren). We were Wren's largest customer, accounting for 35% of its revenues. We purchased over 10% of our merchandise from Wren. In order to inflate our inventory without adding to our accounts payable, I asked Wren to ship us $3 -$4 million in merchandise before 1986 year-end, but to hold off billing until after the auditors completed the year-end audit. Because the merchandise was included in the year-end inventory count without recording the corresponding accounts payable to Wren, we were able to inflate income by $3-$4 million.

In 1987, we continued to take advantage of our relationship with Wren. I pressured Wren to ship us about $5-$7 million in merchandise before year-end. The merchandise was included in the year-end inventory count without being included in the amount owed to the vendor."

Just like Crazy Eddie's, we believe Tile Shop is using its captive suppliers in order to overstate earnings. We think TTS may prove to be worse than CRZY, as it secretly controls at least one of its largest suppliers.

Evidence that Reported Gross Profits are Overstated

  1. Day sales' inventory for FY2011 & LTM 2013 exceed 365 days, at 396 & 414 days respectively. Inventory is a current asset, which means it should be converted to cash within 365 days.
  2. Inventories growth exceeds sales growth by over 3x for 2013 TTM, September 30th, 2013. Inventories growth has exceeded sales growth by over 2x, on average, over the last 6 years.
  3. Color Tile Inc., (TTS's only true historical comparable company), DSI stood between 80-90 days.
  4. Lumber Liquidators' inventory growth has tracked sales growth over the same period. Some on Wall Street believe that Tile Shop is like LL. Inventory and sales growth figures show otherwise.
  5. Gross margins are unusually high and smooth, just as Bernie Madoff and Allen Stanford's purported investment returns were unusually high and smooth.

Tile Shop's Explanations are Dubious or Demonstrably False

Some investors and others have questioned TTS gross margins and inventory levels. TTS management's explanations (regarding their gross margins, and inventories) are dubious, if not demonstrably false:

  1. Management recently claimed inventory levels are high because they need to build out inventory in advance because "A lot of production and shipping shuts down in China in January." Shipping records say otherwise.
  2. Management claimed inventory rose in Q3 2013 due to its new Durant related distribution center . TTS used the same explanation to explain why inventory rose in Q2 2013.

TTS Bears an Eerie Resemblance to the Crazy Eddie's Accounting Fraud

Gotham City Research has seen many variations of the inventory accounting fraud story, and we know how it always ends. TTS exhibits all the classic symptoms of a company that is overstating reported gross profits, by improperly overstating inventories, just as Crazy Eddie's did before it filed for bankruptcy.

Crazy Eddie's used a captive distributor to inflate profits, as described in the prior page. Tile Shop secretly controls its largest supplier (as we detailed in the prior section), and we believe it uses this dubious entity to report fictitious margins. The similarities don't end there.

For starters, Tile Shop's inventory growth exceeds sales growth by 2x-3x2:

(click to enlarge)

Crazy Eddie's inventory growth exceeded sales growth by over 2x as well, just before it went bankrupt3:

Lumber Liquidators' and Color Tile's Inventory Growth Does Not Meaningfully Exceed Sales Growth

Many on Wall Street claim that Tile Shop is the next Lumber Liquidators, yet Lumber Liquidators' inventory growth looks quite healthy relative to sales growth, unlike Tile Shop4:

And if we compare Tile Shop against its only true comparable company, Color Tile, Inc. (which went bankrupt in the 1990s), we find that its inventory growth vs. sales growth trends seem plausible5:

Color Tile Inc.'s sales declined in 1994 and inventories rose. This would makes sense, as a decline in sales would lead to a buildup in inventory. In 1995, sales grew at a blistering 21% rate, yet inventories only grew by 4.6%. This too makes sense, since the prior year's excess inventory buildup diminishes the need for aggressive inventory purchases in 1995.

Here's what happened to Crazy Eddie's (and what we believe will happen to Tile Shop)6:

The 'Actual Pretax Earnings' line above shows what the earnings would have been had the inventory accounting fraud not occurred. Crazy Eddie's inventory accounting fraud allowed the company to report fictitious growth in pretax earnings. By 1987, the inventory accounting fraud was so egregious that Crazy Eddie's true earnings were losses (CRZY reported very positive pretax earnings to conceal the truth). See the appendix for a more granular breakdown of the above calculation.

Tile Shop's Inventory Accounting Malfeasance May Exceed Crazy Eddie's

Gotham City Research believes Tile Shop is currently overstating gross profits more than it has ever done before (as of September 30, 2013) as evidenced by a DSI of 414 days7:

(click to enlarge)

Given that inventories are reported as a current asset, and that the Company classifies all its inventory as current assets, a DSI over 400 days makes no sense. It seems like Tile Shop wants to have its cake and eat it too, i.e. classify whatever it wants as inventories, so that gross profits are artificially boosted.

We asked none other than Sam Antar, the former CFO of Crazy Eddie's and a forensic accountant to comment on the DSI of 414 days:

"Tile Shop, like many companies, categorizes inventories as a current asset, meaning that inventories should be converted to cash within one-year. However, DSI is 396 days in 2011 and 414 days as of September 30, 2013"

Gotham City Research believes that the 2011 and 2013 YTD DSI figures indicate that those years' inventories are overstated, cost of sales understated, and gross profits overstated.

Not only do TTS's DSI figures for 2011 and 2013 make no sense, their DSI levels seem abnormally high compared against Lumber Liquidators and Color Tile, Inc.8:

Allowance for Doubt Accounts No Longer Disclosed and Sales Return Reserve Looks Odd

Tile Shop used to disclose its allowance for doubtful accounts (in its S-4 filings):

(click to enlarge)

Yet once TTS stock started trading publicly, it stopped disclosing this information: "As of December 31, 2012 and 2011, the allowance for doubtful accounts was not significant."9 This seems quite strange for a growing company, and a consumer-facing retailer.

Sales return reserves look odd as well. TTS sales increased from 2011 to 2012, and the company has a very generous return policy yet sales return declined from 2011 to 201210:

(click to enlarge)

Tile Shop's 2013 TTM Earnings Overstatement Calculation

We estimate that TTS's 2013 TTM earnings, after adjusting for the company's inventory accounting malfeasance, is around $9 million:

We estimate the inventory overstatement by calculating what the inventories would be if it had grown at a rate in-line with sales and COGS growth. We calculate the difference between the reported inventories and our estimate for actual inventories, and then add that difference to cost of sales. Profits decline, and we arrive at $9 million in true earnings. This means reported adjusted earnings of $28 million is overstated by over 200%. We used the adj. EBITDA, EBIT figures shown from below11:

(click to enlarge)

Tile Shop's Explanations Regarding Gross Margins are Dubious or Demonstrably False

We are huge fans of the Dialectic/Socratic method of skeptical inquiry. We like to ask ourselves, "how can we be wrong? What might we be missing?" We have looked to the company for answers. None of their answers are satisfying. In fact, we believe management recently made provably false statements to investors. TTS management recently told investors last week12:

"50% of our product comes from China. A lot of production and shipping shuts down in China in January, so we have to build (inventory levels) for that as well. So we saw parts of that in Q3, stepping up that [inventory] level.

Tile Shop's above explanation is not credible for the following reasons:

  1. 37 out of 72 Tile Shop import records were from China-based suppliers in January of 201313.
  2. Tile Shop had nearly a year's worth of inventory leading into the Q3 quarter.
  3. Tile Shop has never disclosed this seasonal dynamic in SEC filings or earnings calls. Recall, TTS does not even mention the word 'China' or 'Chinese' in its SEC filings.
  4. If China were to hypothetically cease all shipping activities for a month, TTS would not have to load up on inventory, given TTS's DSI has consistently exceeded 340 days in the last few years.

Tile Shop Claims Inventories Increased Due to Purchases Related to its New Distribution Center

In the recent Q3 quarterly call, management claimed that inventories increased by $10 million due to its new Durant, OK-based Distribution Center14:

With respect to the balance sheet as of September 30, let me make a few additional comments, we ended the quarter with approximately $3.9 million of cash, $2.1 million of restricted cash, and $90.1 million of debt. The increase in debt in the quarter of $15 million is the result of first, an increase in inventory of $10 million, primarily related to the opening of the Durant distribution facility and in preparation for the expected increase in revenues in the upcoming months.

The problem we find with the explanation above is that TTS claimed that inventories rose in the prior quarter, for the very same reason15:

Cash flow from operations in the second quarter was a use of cash of $3.6 million, as we added substantial amounts of inventory to prepare the new distribution center for operation.

So Tile Shop is saying: we loaded on inventory in Q2, for our new DC… and we loaded up on even more inventory in Q3? Even as DSI exceeded 400 days?

As they say: fool me once, shame on me. Fool me twice, shame on you.

Additional Accounting and Oversight Issues

In the prior sections, we stated our belief that Tile Shop the bird is a duck, not a swan. TTS looks like a duck, swims like a duck, and we've provided detailed photos and video footage showing as much. Yet Wall Street and Tile Shop will have you believe TTS is a swan. In this section, we explain how Tile Shop not only looks and swims like a duck, it sounds, sleeps, and smells like one too:

  1. Tile Shop has had 3 auditors in 2 years - McGladrey, Deloitte, and Ernst & Young. Tile Shop's reported inventories during that period look particularly dubious.
  2. TTS audit fees is less than one half its peers' audit fees. Its audit fee is even lower than Ebix's.
  3. Material weaknesses in internal controls were identified in 2011 and 2012. 2011 and 2013's DSI seems mathematically impossible, which suggests material weaknesses remain outstanding.
  4. TTS went public via the backdoor reverse merger/SPAC, just as many frauds in the past have.
  5. Bob Rucker's immediate family and friends are employed by Tile Shop.
  6. No one in the Audit Committee has a CPA or a background in accounting/financial reporting.
  7. The current CFO has been with Tile Shop for just over a year, and there was an indefinite period in 2012 in which TTS was without a CFO.
  8. CEO Bob Rucker's failure to disclose Beijing Pingxiu as a related party resembles his intentional failure to disclose vital information during his divorce proceedings.
  9. CEO Rucker's 2012 compensation exceeded Lumber Liquidators' CEO's 2012 compensation by 5x.
  10. Ronnie Chan, a former board member of Enron, is a large shareholder of Tile Shop.

Before we go through all the above-mentioned, consider how Tile Shop may be explained by the 'Fraud Triangle' framework (especially given our focus on its undisclosed related party):

(click to enlarge)

Tile Shop has had 3 Different Auditors in 2 Years

We believe Tile Shop will restate historical results significantly. Our belief seems strengthened by the fact TTS has had 3 different auditors in 2 years. Investors should view TTS's reported financial statements with a healthy dose of skepticism, given the myriad of accounting and oversight issues.

McGladrey LLP

From SEC filings:

On November 18, 2011, the board of managers of The Tile Shop dismissed McGladrey LLP, or McGladrey, as its independent registered public accounting firm effective as of November 25. Further, The Tile Shop engaged Deloitte & Touche LLP, or Deloitte, as its independent registered public accounting firm during the first quarter of 2012. Deloitte is the independent registered public accounting firm of the Company.

McGladrey's report on The Tile Shop's consolidated financial statement as of December 31, 2010, and for the fiscal years ended December 31, 2010 and 2009, did not contain an adverse opinion or disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit scope or accounting principles.

Deloitte and then Ernst & Young

From SEC filings:

Effective April 9, 2013, the Audit Committee of the Board of Directors of Tile Shop Holdings, Inc. (the "Company") approved the dismissal of Deloitte & Touche LLP ("Deloitte") as the Company's independent registered public accounting firm, and engaged Ernst & Young LLP ("E&Y") as its independent registered public accounting firm effective immediately.

Shockingly Low Audit Fees

Given all the problems we've identified thus far, it should be unsurprising that Tile Shop's audit fees are unusually low1:

(click to enlarge)

Just by way of comparison, even Ebix's (a subject of SEC, DOJ, and IRS investigations) historical audit fees exceed Tile Shop's2:

(click to enlarge)

Lumber Liquidators and Francesca's audit fees also exceed TTS's by 2x3:

Lumber Liquidators

(click to enlarge)

Francesca's

(click to enlarge)

Material Weaknesses In Internal Controls

Given TTS's auditor turnover, CFO turnover, low audit fees, and other problems we've identified, we doubt that the material weaknesses described below have been remedied4:

On Form 10-K for the fiscal year ended December 31, 2011, the Company reported the existence of a material weakness in its internal control over financial reporting relating to deficiencies in the financial statement close process. Specifically, the Company lacked sufficient personnel with requisite competencies within its finance function for a company of its size and complexity and did not maintain financial close processes, procedures, and reporting systems that were adequately designed to support the accurate and timely reporting of its financial results. The Company reported the remediation of this material weakness in Item 9A of its Annual Report on Form 10-K for the fiscal year ended December 31, 2012.

On a Form 8-K dated February 18, 2013, the Company reported that it's previously-issued financial statements for the three and nine months ended September 30, 2012 contained a misstatement relating to its accounting for outstanding common stock purchase warrants, and on a Form 10-Q/A filed March 18, 2013 restated such financial statements. As a result of the restatement, on Form 10-K for the fiscal year ended December 31, 2012 the Company reported the existence of a material weakness in its internal control over financial reporting relating to its identification and analysis of the complex accounting and financial reporting attributes associated with certain non-routine transactions such as the Company's common stock purchase warrant agreements, including not utilizing qualified external experts to supplement internal resources. The Company plans to implement additional procedures to remediate this material weakness.

No One on Tile Shop's Audit Committee Has a CPA or Financial Reporting/Accounting Experience5

Peter Jacullo III, Adam Suttin, and Peter Kamen sit on the Audit Committee, yet none of them appear to be CPAs or former CFOs. None of them have disclosed any accounting or financial reporting experiences. Peter Kamen serves as the chair of the committee, yet his experience seems limited to investing in publicly traded securities or sitting on other boards.

Where is the CFO?

In an investor presentation dated June 27, 2012, there is a slide that touts TTS's 'Experienced Management Team'. A CFO is conspicuously absent:

(click to enlarge)

It seems that the SEC noticed the absence of a CFO as well. According to a SEC correspondence letter dated July 19, 2012:

We note you have not listed a Chief Financial Officer as part of your management following the Business Combination. Please add a footnote to your list or otherwise expand your disclosure to address this position. Please also disclose how or by whom the functions and duties typically performed by a Chief Financial Officer will be exercised.

The company responded:

In response to the Staff's comment, the Company has added disclosure on pages 134 and 135 of Amendment No. 1 that the Company intends to hire a chief financial officer and addressing how or by whom the function and duties typically performed by a chief financial officer will be exercised until such time.

CEO Bob Rucker's Lies of Omission

In the early 2000s, Bob Rucker underwent a bitter divorce with his ex-wife, Katherine Rucker. It turns out that Bob Rucker deliberately misrepresented the prospects of Tile Shop's business to the court. For example, TTS internally estimated 2002 sales of $56.2 million and 63% gross margin, yet told the court it expected sales of $48 million and 56% gross margins6:

Rucker provided the following Tile Shop financial forecast to the court7:

(click to enlarge)

In 2001, TTS was internally forecasting $6.9 million in net income before taxes. 2001's actual reported profits before tax was $6.7 million. Internally, Tile Shop estimated $6.3 million. Both the internally projected and actual 2001 results are nearly 2x the estimate they provided the court.

We understand that divorces can be complex. However, we find Rucker's material misrepresentations, and defensive posturing disturbing. In deposition transcripts, he seems quite unapologetic8:

I'm not going to go and show McGladrey what to look for. I'm not an accountant. I wouldn't go and show the bank what to look for. I'm not an accountant. I wouldn't go show Kaminsky [the independent appraiser] what to look for. Misled? I didn't mislead him whatsoever.

We only highlight his divorce-related misrepresentations because we see a similar misrepresentation with Tile Shop's business.

CEO Bob Rucker's Compensation Seems Excessive

Rucker's 2012 compensation stood at $5.85 million. Lumber Liquidator's CEO compensation was $1.2 million in 2012. LL has 3x-4x more stores than TTS, yet TTS CEO made 5x more in compensation9. Tile Shop has an "Omnibus Award Plan" that sets aside 2,500,000 shares annually for compensation through 2022 unless altered by the board ($55,000,000 annually at a stock price of $22.00/share); in 2013 the full 2,500,000 was set aside for compensation. Additionally the plan provides for cash bonuses, limited to $5,000,000 annually per individual (or 300% of base salary, whichever is greater). This level of compensation seems extraordinarily high for a company the size of The Tile Shop.

Tile Shop Elected to Go Public via a Special-Purpose Acquisition Company

The Tile Shop went public via a SPAC transaction just over a year ago at $10.00/share. Within 50 days (between 05/08/12 and 06/27/12), the transaction structure was negotiated, "due diligence" completed, and the merger agreement, executed10.

In light of all the problems we've identified in this report (and in this section specifically), we feel that the company deliberately avoided the traditional IPO listing process, so that it could avoid the spotlight. SPAC investments have not historically fared well, as the average return for 111 SPACs between 2004 and 2013 returned -14.4%11. SPACs have a history of churning questionable companies.

A Former Board Member of Enron is a Significant Shareholder of Tile Shop

We have included direct excerpts and paraphrased from the Infitialis Research Collective's piece on TTS, below, as we believe they articulated the Chan brothers' involvement very well:

Ronnie and Gerald Chan of Hong Kong currently control ~22.5% of The Tile Shop's equity via their Bahamian shell company Nabron International, Inc. After acquiring an original 30% equity interest in The Tile Shop for only $12.0mm in total consideration in October 2002 (for an approximately $2.2mm per store enterprise valuation versus the current market valuation of $19.1mm per store), they have been highly motivated sellers at $15.00/share and $24.25/share of the Company since going public via the SPAC at $10.00/share. As their 150-day lockup from the most recent secondary share sell-down expired at the end of this month, it would not be surprising if they are dumping a significant portion of their remaining $360mm equity value ownership stake on the market (~60 days trading volume) at these current stratospheric valuation levels.

In addition to the share overhang, the Chan Brothers' intertwined involvement in the situation raises further questions about the Company's lead contaminated tile product sourcing relationships in China in light of the numerous accusations of their involvement in significant corruption and fraud throughout Asia.

Overall, this situation appears disturbingly similar to Enron Corporation, where Mr. Ronnie Chan served as a Board of Directors and Audit Committee member leading up to its infamous Chapter 11 bankruptcy filing and was selling shares from his personal account up to the firm's sordid collapse. Finally, the Chan Brothers are not the only insiders selling, as a variety of other Board of Directors and management team members have been selling shares and indicating more shares are forthcoming over the next 90 days via multiple form 144 registrations.

TTS Shares Are Worth No more Than $3.34 per Share

The art of valuation is only as good as the assumptions behind one's techniques and calculations. As a result, we are not dogmatic about which methods should or should not be employed. We do strongly believe, however, that investors must base their investment decisions off reliable and accurate information. Because we believe the Tile Shop's reported earnings are inaccurate, it is far more important for shareholders to determine what the true economics earnings of this company is, rather than obsess over valuation methodologies. Information accuracy precedes everything else.

That being said, all valuation techniques suggest that TTS shares face significant downside, even after avoiding the malfeasance we've highlighted earlier in this report. We believe the shares are worth no more than $3/share, and arrive at a price target between $1.54 and $3.33 per share.

While our price target may seem low at first glance, note that Tile Shop is not a true growth company. It is, at best, a capital intensive and cyclical business that has benefited from a housing boom and an exuberant stock market. Gross margins have steadily declined over the last several years, and the company currently generates no free cash flow. TTS cannot grow further without external capital.

Valuation Method #1: 20x-30x earnings on restated 2013e TTM

  1. As mentioned earlier in this report, we estimate that TTS's 2013 TTM true earnings are closer to $9 million, or $0.18/share:

We apply a generous 20x -30x earnings multiple and arrive at an estimate of $180-$270 million in value for the equity of the company. Because we believe the profit overstatements predate 2013, we expect additional inventory write-offs and accounting restatements. Therefore, we think the shares warrant a discount to the $180-$270 million valuation range.

Valuation Method #2: TTS is worth $82-$165 million, or $1.0-$2.2 million per store, per CEO Rucker's estimates

  1. 50% of Tile Shop's equity was valued at $7.125mm, according to the financial forecast CEO Robert Rucker presented, per legal filings1. This comes out to $1.02mm per store on an enterprise value basis.
  2. The same court found that Bob Rucker deliberately misrepresented the prospects of TTS'sbusiness. The court revised the appraisal of Tile Shop utilizing the correct financial forecast, and arrived at a $30.7mm enterprise valuation. This implies the business is worth $2.2mm per store (including penalties and interest due).
  3. There are 82 stores as of the most recent earnings release.
  4. Bob Rucker and the other sellers of the Company, considered a merger whereby TTS would be valued $450mm in enterprise value (9.0x expected EBITDA for 2012).

Valuation Method #3: Comparable Companies Analysis

  1. Absent the issues identified in this report, TTS looks rich relative to peers (especially given it lacks the ability to grow absent additional outside capital)
  2. The company is trading at a meaningful premium to other high growth concerns (that lack the issues we believe TTS faces)2:

(click to enlarge)

  1. Because Tile Shop is a capital intensive business, book value matters. Tile Shop currently trades at 14x book value.
  2. We believe TTS will trade at a discount, not a premium to its peers, as the issues we identify in this report become clearer to other investors.
  3. TTS may have been a 'housing play' at one point in time, but as Select Comfort shows, there is room for both winners and losers in a housing boom and a rising stock market.

DCF Considerations

We don't believe DCF is the appropriate valuation technique in the case of Tile Shop for several reasons (one big reason: TTS's numbers aren't reliable). However, if one must build a DCF model, here is what we would consider:

  1. We believe TTS's true 2013 TTM earnings is around $9 million. One must forecast future cost of sales and inventory levels that are in-line with peers, in order to do a proper DCF analysis.
  2. Future gross margins are guaranteed to tank if one makes the conservative (and realistic) modeling assumption that inventory growth is in-line with sales growth.
  3. TTS has little to no cash, sizeable debts, and covenants.
  4. There are signs of store saturation. New stores are being built in highly competitive locations and new store productivity is low.
  5. Taxes are trending up, as evidenced by the most recent 10-Q:

(click to enlarge)

  1. Color Tile Inc., Tile Shop's predecessor, filed for bankruptcy in the week of January 27, 19963:

Color Tile Inc., a flooring retailer that filed for Chapter 11 bankruptcy protection earlier this week, said Friday it's closing 234 stores nationwide, including 12 in Illinois. After the closings, the retailer said it will have 387 stores in 48 states. The closings will be spread out geographically

The company subsequently liquidated4:

Color Tile, once the nation's largest retailer of floor coverings, is closing its doors under pressure from lenders and sliding sales. The company confirms that it will shut down all of its 195 company-owned stores and lay off 831 employees.

Perhaps tile retailing is, at core, a terrible business. Color Tile's reported gross margins ranged between 41%-49%, according to the SEC filings we reviewed. Tile Shop may experience a diseconomies of scale (as Color Tile was much larger than Tile Shop), going forward.

TTS has Missed EPS Guidance 4 out of the Last 5 Quarters

Typically, growth stocks exhibit momentum in their reported earnings as well as in their stock price. They also tend to consistently meet and/or beat expectations to the upside. Surprises tend to be "positive surprises."

This is not the case with Tile Shop. TTS earnings and cash flow growth have been irregular, and gross margins have actually trended down. As we show below, Tile Shop has missed earnings 4 out of the last 5 quarters:

(click to enlarge)

Credit Agreement and Negative Covenants

If Tile Shop restates historical results as we believe it will, that means TTS is in violation of credit covenants and qualifies for an event default. We believe that the issues we expose in this report should (and will) lead TTS's creditors to:

  1. Restrict capex spending
  2. Prevent any share buybacks
  3. Prevent TTS's ability to take on additional debt capital
  4. Demand that TTS start paying back debt immediately, if not in full

From TTS's Credit Agreement, amended July 8, 20131:

ARTICLE VII. NEGATIVE COVENANTS

So long as any Lender shall have any Commitment hereunder, any Loan or other Obligation hereunder shall remain unpaid or unsatisfied, or any Letter of Credit shall remain outstanding, Holdings and each Borrower shall not, nor shall they permit any Subsidiary to, directly or indirectly:

7.08 Transactions with Affiliates . Enter into any transaction of any kind with any Affiliate of Holdings, whether or not in the ordinary course of business, other than on fair and reasonable terms substantially as favorable to Holdings or such Subsidiary as would be obtainable by Holdings or such Subsidiary at the time in a comparable arm's length transaction with a Person other than an Affiliate , provided that, subject to Section 7.05(NYSE:D) , the foregoing restriction shall not apply to transactions between or among Loan Parties .

ARTICLE VIII. EVENTS OF DEFAULT AND REMEDIES

8.01 Events of Default . Any of the following shall constitute an Event of Default:

Representations and Warranties . Any representation, warranty, certification or statement of fact made or deemed made by or on behalf of any Borrower or any other Loan Party herein, in any other Loan Document, or in any document delivered in connection herewith or therewith shall be incorrect or misleading in any material respect when made or deemed made (except to the extent such representation or warranty is qualified by reference to materiality or Material Adverse Effect, in which case it shall be true and correct in all respects);

Remedies Upon Event of Default. If any Event of Default occurs and is continuing, the Administrative Agent shall, at the request of, or may, with the consent of, the Required Lenders, take any or all of the following actions:

(NYSE:A) declare the commitment of each Lender to make Loans and any obligation of the L/C Issuer to make L/C Credit Extensions to be terminated, whereupon such commitments and obligation shall be terminated;

(NYSE:B) declare the unpaid principal amount of all outstanding Loans, all interest accrued and unpaid thereon, and all other amounts owing or payable hereunder or under any other Loan Document to be immediately due and payable, without presentment, demand, protest or other notice of any kind, all of which are hereby expressly waived by the Borrowers;

(NYSE:C) require that the Company Cash Collateralize the L/C Obligations (in an amount equal to the Minimum Collateral Amount with respect thereto); and

exercise on behalf of itself, the Lenders and the L/C Issuer all rights and remedies available to it, the Lenders and the L/C Issuer under the Loan Documents;

End Notes

Introduction

  1. Beijing Pingxiu SAIC Filings
  2. Sam Antar, http://whitecollarfraud.com/947660.html
  3. Tile Shop Holdings 10-K and 10-Q filings. Crazy Eddie's 10-K filings.
  4. Tile Shop Holdings 10-K and 10-Q filings.

TTS Uses an Undisclosed Related Party to Overstate Earnings

  1. Tile Shop Holdings 10-K and 10-Q filings.
  2. Color Tile Inc. 10-K filings.
  3. Tile Shop Holdings November 2013 Investor Presentation
  4. Beijing Pingxiu SAIC Filings
  5. ""
  6. ""
  7. http://www.patentbuddy.com/Inventor/Nishi-Fumitake/11996328, http://portexaminer.com/trade-data/beijing-pingxiu-decorating-material-the-tile-shop-llc/dewcsd220423/, http://www.importgenius.com/suppliers/beijing-pingxiu-d-cor-material-co
  8. GCR Private Investigation
  9. Minnesota property records

TTS 2013 YTD Earnings are Overstated by Over 200%

  1. Sam Antar, http://whitecollarfraud.com/947660.html
  2. Tile Shop Holdings 10-K and 10-Q filings.
  3. CRZY 10-K filings
  4. LL 10-K filings
  5. Color Tile 10-K filings
  6. Sam Antar
  7. Tile Shop Holdings 10-K and 10-Q filings.
  8. TTS, LL, and Color Tile 10-K filings.
  9. Tile Shop Holdings 10-K 2012 filing.
  10. ""
  11. Q3 2013 earnings presentation
  12. Baird hosted TTS investor meeting and Q&A
  13. PIERS data
  14. TTS Q3 2013 conference call
  15. TTS Q2 2013 conference call

Additional Accounting and Oversight Issues

  1. TTS proxy filing
  2. Ebix proxy filings and Copperfield Research's first report on Ebix
  3. FRAN and LL proxy filings
  4. TTS SEC filings
  5. TTS proxy filings
  6. Katherine M. Rucker vs. Steven B. Schmidt and Rider Bennett, Appellant's Brief and Appendix
  7. ""
  8. Katherine M. Rucker vs. Robert A Rucker, Finding of Fact, Conclusions of Law and Order of Judgment
  9. TTS and LL SEC filings
  10. TTS S-4 filings
  11. SPAC Analytics

Shares are Worth No More Than $3.34 per share

  1. Katherine M. Rucker vs. Steven B. Schmidt and Rider Bennett, Appellant's Brief and Appendix,

Katherine M. Rucker vs. Robert A Rucker, Finding of Fact, Conclusions of Law and Order of Judgment

  1. Infitialis Research Collective Seeking Alpha article
  2. http://articles.chicagotribune.com/1996-01-27/business/9601270135_1_color-tile-stores-closing
  3. http://www.questia.com/read/1P2-33086471/color-tile-once-no-1-in-floors-is-closing-liquidation

Credit Agreement and Negative Covenants

  1. TTS Q3 2013 10-Q filing

Page 12 of 58

Source: The Tile Shop: Like Crazy Eddie's, But With An Undisclosed Related Party And A Chinese Twist