Tile Shop Holdings (NASDAQ:TTS) is a specialty retailer of floor and wall tiles serving the home remodeling market. The company has grown revenues at a 17% annualized rate over the past three years, benefitting from what appears on the surface to be a stable recovery in the housing market. We argue that Fed stimulus and ZIRP are primarily responsible for the "recovery" in housing, and that the US economy remains fundamentally weak. The recent trends in housing and consumption are unsustainable, and a recession looms over the horizon. The home improvement industry as a whole is overvalued, but specialty retailers such as TTS are especially at risk. With a forward P/E of 39.6, TTS is significantly more expensive than its main rivals Home Depot (NYSE:HD) and Lowe's (NYSE:LOW), which possess better businesses and a greater capacity to withstand economic downturns. TTS will have trouble competing when the next recession hits, an event that markets have yet to price in. Analysts expect TTS to grow earnings 28% during 2016, and while Tile Shop may hit its targets in the short run, the company's lofty valuation is not justified when taking the long-term outlook into consideration.
Tile Shop Holdings sells manufactured and natural stone tiles, setting and maintenance materials, and related accessories. The company offers over 4,000 products, including tiles made of ceramic, porcelain, glass, metal, marble, granite, quartz, sandstone, travertine, slate, and onyx, sold under the Rush River and Fired Earth brands. TTS's customers are primarily homeowners and professional home remodelers. The company has historically focused on the do-it-yourself customer, but is now turning its attention to the professional customer based on the belief that rising home prices and incomes will encourage homeowners to hire professionals for remodeling projects rather than do the work themselves. As of September 2015 the company operated 111 stores in 31 states, up from 68 stores in 2012. The company plans to continue growing through new store openings in both new and existing markets.
On the surface, the housing market looks healthy. Existing home sales are strong, home prices are rising, housing starts are increasing, and low inventories by historical standards suggest there is plenty of room for future growth. Retailers throughout the housing sector continue to post impressive numbers. In the prior quarter, Home Depot grew US same-store sales by 8.9%, Lowe's delivered a 5.2% comp, and Tile Shop reported comp growth 13.2%, supporting the idea that economic fundamentals in the US have significantly improved since the financial crisis. But we believe the "recovery" occurred for reasons that had little to do with improved fundamentals, and that these trends cannot be sustained.
The Federal Reserve is responsible for the housing activity. By executing multiple rounds of quantitative easing and keeping interest rates near rock bottom levels for ten years, the Fed created bubbles in the stock, bond and real estate markets. Much of the money from QE went directly into mortgage-back securities, which pushed mortgage rates to all-time lows and stimulated demand for housing. The wealth effect from owning higher priced assets made homebuyers feel more confident in their ability to meet mortgage obligations, and further boosted demand. At the same time, real income growth has remained flat, so the ratio of housing prices to incomes continues to trend up, and is now at pre-crash levels (Figure 1). By manipulating interest rates, the Fed has driven loan growth across the economy, but the demand for money has not reflected natural improvements in the capacity of homeowners to invest in housing.
Figure X: Ratio of Housing Prices to Incomes
Much of the home price appreciation that has occurred is not a result of market demand but rather institutional buying. Institutional investors such as The Blackstone Group have invested billions of dollars in homes with the intention of renting them out to generate shareholder returns. But this type of demand will not sustain a recovery. The home improvement industry (and the overall economy) needs households to invest in housing because this drives growth in consumer spending. According to the US Census, the home ownership rate of 63.8% for Q4 2015 was just above a 30-year low. There are a number of reasons that explain the decline in home ownership rates. The institutional buying that lead to inflated prices has crowded out many buyers whose incomes have not kept pace with inflation. But the bigger problem is the weakening labor market and the shrinking size of the work force. Fed officials site falling unemployment rates as evidence that the economy has not entered a recession. But the unemployment rate is distorted by all-time low labor force participation, and the fact that most of the jobs being added are low-paying, part-time service sector jobs. Instead of holding one full-time job, many workers hold two or three part-time jobs, each of which counts as much as a full-time job in the unemployment calculation. Today's weak labor market bodes terribly for future housing market and consumption growth. According to the National Association of Realtors (NAR), first time homebuyers in 2015 declined for the third consecutive year to 32%, close to the lowest point in three decades. Millennials stuck with low-paying jobs and student loans are either renting or living with their parents, and pushing up the average age of first home purchase.
Tile Shop's status as a specialty retailer, and the lack of economic moat to protect against increased competition when demand falls, leaves the firm highly exposed to a housing correction. The tile retailers industry is a niche sub-segment of the overall home improvement market. The industry is fragmented with many small regional players, and TTS accounts for just 2.2% of the market. High shipping and transportation costs prevent most firms from covering a large area or developing nationally recognized brands, so companies rely on local customer bases. But the reliance on local demand combined with the infrequent nature of home improvement purchases means that firms must eventually expand into new geographic markets to sustain revenue growth and reduce volatility. The entry into new markets where customers are less familiar can be challenging for TTS and other specialty retailers, who lack nationally-recognized brands.
As demand for remodeling purchases declines industry competition will naturally increase. Low disposable incomes will make customers more price-sensitive, and significant fixed costs in firm cost structures will lead to additional pricing pressures as companies try to protect volumes. The extent to which industry operators can withstand these growing pressures will hinge upon their ability to lower prices without completely eroding margins. The biggest threat to Tile Shop does not come from rival tile retailers, but rather the nationwide home improvement centers, Home Depot and Lowes's. These companies offer a comparable selection of tiles to TTS, but can sell them at lower price points thanks to their significant scale advantages (HD and LOW together account for 85% of the home improvement market) that allow them to negotiate prices for inputs that smaller, more specialized retailers cannot match.
Falling prices and margins will discourage new store openings in new markets, which means TTS will increasingly rely on same-store sales from existing markets. Compared to Home Depot and Lowe's, specialty retailers such as TTS experience higher revenue volatility because their products are more discretionary. Whereas HD and LOW sell a wide variety of essential materials used for homebuilding, repair, and maintenance, Tile Shop's tiles are not considered an essential element of any house, and are typically used for remodeling projects that are more sensitive to disposable income fluctuations. A comparison of the three company's betas (which measures a stock's volatility relative to the overall market) illustrates this fundamental difference between general and specialty retailers. Home Depot and Lowe's have betas of 0.96 and 0.98 respectively, whereas TTS has a beta of 2.16. This means that when economic conditions deteriorate and stocks fall, Tile Shop's stock price should fall much farther than the overall market.
Like most firms in the industry, TTS has benefited from rising home values and low gas prices that have boosted discretionary spending on home improvement items. The company grew revenues at a 17.1% annualized rate over the past three years, thanks to a combination of new store openings and strong comps growth (with the exception of 2014 when comps fell 0.4%). However, expenses have grown faster than revenues due to significant variable costs associated with new store openings, and limited economies of scale at existing stores. As SG&A increased as a percentage of sales between 2012 and 2014, operating margin declined from 18.8% to 8.4%, before rebounding slightly in 9.9% in 2015. The company credits the work of new CEO Chris Homeister and a smaller store format that reduces store opening costs, occupancy expenses, payroll and capital expenditures for the improved profitability. However the combination of low oil prices (which lowered transportation costs) and a stronger dollar (TTS purchases only 10% of its tiles from domestic suppliers) certainly had an impact. SG&A margin is expected to fall in the near term as the percentage of new store growth relative to existing stores declines, leading to a greater proportion of fixed costs in the capital structure. This operating leverage will work against the company when sales begin to fall. The company's degree of operating leverage of 2.55 (measured as the % change in EBIT divided by the % change in sales) implies that many of the firm's costs cannot immediately be cut during periods of weak demand, which will cause margins to deteriorate.
Compared to its more thinly capitalized peers, TTS is in good financial shape. The firm has a D/E of 0.45 versus an average of 1.8 for the industry. Last year Tile Shop used free cash flows to deleverage, causing debt as a percentage of assets to fall from 35% to 21%. However the disproportionate amount of capital tied up in inventory presents a potential liquidity concern. The firm has a current ratio of 2.18 but a quick ratio (adjusted for inventory) of less than 0.50. Compared to more liquid assets, inventory can be difficult to convert to cash during economic downturns. The increase in TTS's inventory turnover over the past three years reflects strong sales growth. But when demand falls in the years ahead, difficulties liquidating inventory will jeopardize the firm's ability to meet short-term obligations. TTS may have to resort to deep discounting, or see its inventories pile up and incur write-downs.
Based on our comps valuation model, Tile Shop is overvalued by almost 60%, relative to our fair value estimate of $11.05. The discrepancy is due the difference in P/E ratios. Compared to the peer average of 19.5, TTS trades at approximately 40 times forward earnings, which reflects higher growth expectations relative to the industry. With the company poised to open 9-12 new stores, analysts anticipate EPS growth of 28% in 2016, versus 14.3% and 20.4% for HD and LOW, respectively. Our fair value estimate is not a one-year price target, as we believe TTS will continue to generate strong growth next year, assuming the Fed does not significantly raise interest rates. However, we do think it accurately reflects the long-term picture for Tile Shop, as the company will go from outperforming the housing sector to underperforming, once the correction sets in.
Figure 2: Comps Valuation
To estimate fair value, we took a weighted average of the peer-derived prices. We applied a 50% weight to the P/E, which we believe is the most comparable and meaningful metric among peers, a 40% weight to the P/S, and a 10% weight to P/B, which is less meaningful given the radically different capital structures between TTS and its peers (TTS has a D/E of 0.3, versus a peer average of 1.8). One of the drawbacks to the peer-based market valuation approach is that its utility becomes compromised when the comparable companies are not accurately priced. In this case we believe the housing sector (and the companies on which TTS's fair value is based) are overvalued, which reinforces our conviction that Tile Shop has a long way to fall.
The bear case for TTS is a long-term thesis that recognizes that the trends we've seen in housing and consumption since 2008 cannot be sustained. It is difficult to establish a price target based on projections of future cash flows because we don't know when exactly the next recession will hit. All we know is that it will, and when it does, Tile Shop will fall more than most housing stocks. A shot of heroin may provide a temporary fix for a recovering drug addict, but it only exacerbates the underlying problem of addiction and strengthens the user's dependency. Similarly, the use of Fed stimulus to drive the economy did not improve the economy's underlying structural weaknesses, and in many ways made them worse. We don't expect the Fed to hike rates before the election, as the economy is too weak to handle it. But in the coming years the Fed will feel pressured to raise rates for the sake of credibility, much like last December when a 25 bps lead to the worst start to a year in history for the S&P 500. We are in a bubble and when the Fed pricks it, TTS will get roasted.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.