Yesterday, SAC capital disclosed a passive 2.57 million share or 5% stake in Tile Shop Holdings (TTS). While SAC Capital is no activist like Icahn Enterprises or Third Point, I expect more fund managers to join given the fact that this high growth company is now valued in line with Home Depot (HD) and Lowe's (LOW) and has lost around $750 million in market cap after the recent short attacks questioning inventory levels and gross margins of the company. The company, meanwhile, has continued with its expansion plan and opened its new store in New Jersey yesterday.
One of the first things which came to my mind post Gotham's report was why would Tile Shop's management get involved in a fraud? Tile Shop has a good thing going. Its store economics are excellent, market penetration is low and it continues to expand fast. So, why in the world its CEO, who has spent last three decades building this company, would need to be involved in a fraud? Why would its chairman who is also currently the chairman of another listed company Mattress Firm (MFRM) and was ex-CEO of GNC (GNC) will destroy his reputation and an illustrious career by helping this fraud? I couldn't find any motive.
When we look at a company like NQ Mobile (NQ) it is not really difficult for find a motive. The company's core antivirus business in China is in decline with rising competition and chances of international monetization are low. Although it has acquired a couple of businesses to show its growth continuing they are unlikely to help it for long. So there is a motive and even otherwise it is not a business I will recommend investing in.
On the other hand, Tile Shop's case looked much similar to Disney's (DIS) case which happened in 2004 where Disney signed a consent order. Here's the link if you want to read more. It was kind of surprising that market reacted this way but given the way Gotham had put up the story it was possible to get carried away.
Second thing, I noticed was that there were internal conflicts in Gotham's thesis and it made little sense. He started with an illustrative invoice of "fake inventory". Then he went to suggest gross margins are inflated because of off book payments. His fake inventory and off the books payment theory don't go with each other. If the company is trying to inflate its gross margins and even paying off the books to increase it, then why would it buy "fake inventory" which will lower its margins? His gross margin argument also seemed a bit weird as I have described in one of my previous article. There are several other holes and misrepresentations in his report which make little sense.
While the report on the face of it looked impressive like a famous fund manager's short thesis on a MLM last year, I believe this is a similar case in which a short seller has completely misunderstood the company's model and has unfairly targeted a good business. Although the company's direct sourcing model led to an increase in inventory as described in my previous article, it also improves profitability and ROCE and thus makes a good business sense. I believe the company's valuations are too attractive to ignore and expect more fund managers to get involved.