Tile Shop Holdings (ticker: TTS)

Tile Shop Holdings is a reverse merger stock that found itself a SPAC, just as the SPAC clock was running out, in order to go public.  The Company is rapidly building out its store base because it has to in order to make Wall St happy, not because it is a prudent business decision to do so in this environment.    The SPAC marketed deal at $10 per share and couldn't raise enough to close the transaction.  It now it bizarrely trades near $30!  The stock features:

-       An absurdly high valuation.

-       A low quality private to public transaction path.

-       Questions of aggressive accounting and weakness in internal controls.

-       A bet that is highly contingent on a robust housing recovery/renovation cycle.

-       Insiders that have sold substantial stock.  In a signal of low confidence, SPAC insiders sold ~$10mm of privately held warrants back to tile shop for retirement.  This is also a gross misuse of corporate funds as far as Tile Shop is concerned.  SPAC insiders have also been selling in heavily in secondary offerings.

• On Dec 13^th, 2012, insiders sold 4.5m shares at $15 a piece with no proceeds to the Company.
• On June 4^th 2013, insiders sold 4.25m shares at $24.25 a piece with no proceeds to the Company.

-       Low current free cash flow generation as the concept is expanded nationwide.

-       Far greater downside potential than upside potential given ‘priced to perfection’ status.

-       A CEO that was sued for fraud by his ex wife for misrepresenting the value of the business.

-       Antiquated corporate governance standards (staggered Board, only the Chairman can call a Special Meeting, advanced notice requirements, etc.)

Wall Street loves The Tile Shop.  Why?  Set against the backdrop of the housing recovery, The Tile Shop gives Wall Street all of the key levers it needs to justify the momentum earnings story:

-       Attractive growth story, doubling the number of stores over the next few yrs.

-       Aggressive square footage profile (23,000 sqft on average, making it the largest specialized tiling format)

-       Large private label component that keeps gross margins high (over 70%) and EBITDA margins at ~28%.

-       Largest position in niche market.

-       Robust four wall model that claims a very solid 40% ROI in new stores, based on average “adjusted4-wall contribution” (= store level operating profit before preopening costs and depreciation & amortization) during the first 3 years of operation divided by net cash investment.)

Valuation

At $28.96 per share, and with 51m fully diluted shares outstanding, The Tile Shop has a $1.5b Enterprise Value.  This values the Company at 20x next year’s projected EBITDA and 44x next year’s projected earnings.

Tile Shop’s valuation leaves no room for error. 

The current store base of 73 stores can produce revenues of around $200m.

With a current ttm EBITDA margin of 27%, this implies $54m of EBITDA (27x)

The likely potential near term (4-5 years) store base of 150 stores could produce $400m of sales.

At a 28% EBITDA margin (give them some pick-up in the margin for scale) this would equate to $112m of EBITDA.  Note that the Company has already given guidance that EBITDA margin will fall 200 bps due to both acceleration of new store openings as well as public company costs, professional fees and infrastructure build out

Let’s give TTS the benefit of the doubt however, and stick with the 28% EBITDA margin.  This $112m of EBITDA, at a 13.4x multiple this would approach the current share price; However, this requires around $120m (or $2.31 per share) to build out, so even if these stores were all built today the stock would only be worth $26.00.  No matter which way you slice it, this valuation is hard to ‘grow into’. Note that Home Depot and Loews trade a lot lower than 13.4 x EBITDA currently (see table below).

On Form 10-K for the fiscal year ended December 31, 2011, Tile Shop reported the existence of a material weakness in its internal control over financial reporting relating to deficiencies in the financial statement close process. Specifically, Tile Shop 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.

On a Form 8-K dated February 18, 2013, Tile Shop reported that its 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 Tile Shop 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 Tile Shop’s common stock purchase warrant agreements, including not utilizing qualified external experts to supplement internal resources.

Competition / Sourcing

The Tile Shop also competes in a highly competitive space.  Their competitors include large national home centers (such as Home Depot and Lowe’s), regional and local specialty retailers of tile (such as Tile America, World of Tile, Century Tile, and Floor and Décor), factory direct stores (such as Dal-Tile and Florida Tile) and privately-owned, single-site stores.  While The Tile Shop tries to market its products as being sourced from the exotic regions of the Mediterranean, the reality is that more than half of their product is sourced from 10 Asian manufacturers.

Since tiles are essentially commodities, and since the Tile Shop has no proprietary sourcing or manufacturing advantage as far as I am aware, it stands to reason that the current high margins will be eroded away by the competition eventually.

$1.5b also equates to an implied ‘enterprise value per door’ of $19.8m, based on the current 73 locations.  While TTS does enjoy higher margins than Loews and Home Depot, $20m a store for what works out to be $671k (on average) in inventory, strikes me as high. TTS’ inventory turnover is just 1.1x, versus 3.5x for LOW and 4.4x for HD, which negates the margin benefit TTS has, and puts another nail in the valuation metrics of TTS. An average cash conversion cycle of 288 days is not the Hallmark of a great retailer.

Trading Metrics, Home Improvement Stores:

*Note Avg Store Size:

Home Depot: 104,000 sq ft + 24,000 sq ft for garden area

Loews:  113,000 sq ft

Tile Shop:  23,000 sq ft

On July 15, 2013, reported US Retail Sales missed analysts’ estimates and posted the biggest drop in almost 12 months.  Leading the way were building material & garden/suppliers and dealers.  See the chart below.  It is clear that Tile Shop’s fortunes are tied to renovation and home improvement.    Lackluster results in this space are a sign of weaker sales to come.  Whereas the existing store base may enjoy the benefit of some longevity and maturity, rolling out this concept nationwide into a shaky environment for this type of activity should be a challenge.  Gone are the days where home equity loans financed home improvement.

While foreclosures are certainly dropping, the robust recovery in housing is truly difficult to get behind.  As many well-known pundits have said, the housing market will only improve when real home buyers buy homes, not investors.  This does not seem to be happening if you look at the mortgage data.  According to the Wall Street Journal, for the week ended June 28, the number of completed mortgage applications in the U.S. economy plummeted 12% from a week earlier—the biggest drop in two years. The applications filed for refinancing a home decreased 64%—the lowest since May of 2011.  The Tile Shop is trying to grow in an environment where regular folks simply don’t have the equity or the courage to buy a house.  Hurricane Sandy could have also caused a temporary spike in demand.  Home Depot acknowledged this in their February 2013 numbers.

 In Summary

The Tile Shop, at $1.5b of enterprise value, has its work cut out for itself. Even if the ‘housing recovery story’ continues for a foreseeable future, TTS is priced for perfection. Any headwind in the form of a housing slowdown, higher roll-out costs, margin erosion because of competition, or lower LFL sales, will hit TTS extremely hard, as there simply is no discernable margin of safety.