TTS Q2 2015

Hi all,

Below is my take on TTS Q2 2015 earnings.

Anirban

TTS Ticker Guide

Useful Links

Earnings release:http://investors.tileshop.com/phoenix.zhtml?c=241568&p=i…

Transcript: http://seekingalpha.com/article/3343135-tile-shop-holdings-t…

Jason Hall’s excellent take (IMO) on the earnings: http://www.fool.com/investing/general/2015/07/21/tile-shop-b…

Quick Q2 2015 Takeaways

o TTS has 110 locations in 31 states. As discussed in the Q4 2014 call, management has decided to take it slow and steady for this year, taking time to address staffing, branding, and advertising before increasing the pace of store growth. The company opened one new stores in Q2 2015 and it was in an existing market.

o Net sales grew 13.6% to $75.7M up from $66.7M in Q2 2014. The revenue numbers set a new quarterly record.

o Gross profit margins came in at 67.8% versus 69.9% in Q1 15 and 69.8% in Q2 14. This drop in gross margin was attributed to some pricing tests and was noted to be isolated and management expects gross margin to go back up to the 69% level’s.

o Comparable store sales growth for Q2 was 5.7%, continuing to build upon the positive comp for Q1 15. Recall that Q1 15 reported 4.5% comp growth. The $9.0 million increase in sales was due to incremental net sales of $5.3 million from stores not included in the comparable store base, while comparable store sales increased 5.7% or $3.8 million in the quarter. In my Q4 2014 (FY) notes, I had noted the following with respect to the -0.4% same store sales growth compared with the revenue growth of 12%:
So, this essentially says that the revenue growth came all because of new store openings. It also says that 2013 was a good year and 2014 was a bad year, which means the comps for 2015 are with respect to a weaker set of numbers. 2013 benefitted from strong home sales growth, while, 2014 was hurt by a decline in home sales growth and other macro-economic factors.

o Non-GAAP net income was $4.8M versus $4M in Q2 14; non-GAAP eps was $0.09 versus $0.08 in the prior quarter.

o Adjusted EBITDA grew to $15.5M up 16% versus Q2 14. Adjusted EBITDA margin was 20.5%.

o As of 30 June 2015, TTS had $12.8m cash up from $9M cash at Q1 2015 end; they had $63.8m in long-term debt versus $73.7M long-term debt at the end of Q1 2015. They have been steadily paying down debt using cash flow from the business. They should be able to continue to pay down debt for the remainder of 2015 given their slow store build out activity for the year.

Notes from Conference Call

In the Q4 2014 conference call, CEO Chris Homeister stressed on management’s three pillars for the next phase of TTS’ growth. The three pillars were:
(1) Training and retention of sales staff,
(2) Growing the professional customer segment, and
(3) Sustainable store opening plan.
As in in the previous quarter, Homeister gave us an update on how things were progressing on these fronts.
My key takeaways were:

  • They added three “market managers” this quarter. Recall that one market manager manages multiple stores. About two-thirds of the store base is now led by market managers and these stores continue to exceed sales expectations and are also reducing talent turnover. Turnover dropped relative to Q1 2015 as well. They also seem to be improving retention of store managers. They plan to have the entire store base covered by market managers by end of 2015. They are also developing solid bench strength of store managers in anticipation of resumption of store base growth in 2016.
  • The profession customer segment seems to be growing as well. It was noted that this segment again grew faster than the remainder of the business. The PRO business represented about a third of the total revenues. I was previously under the impression that this was a small portion but it is not and I ‘m encouraged by the growth of this segment. Management believes this segment can be a meaningful driver of growth. If this does work well, it will be great as growth will be squeezed out from existing stores alleviating the need for a rapid expansion of store footprint.

The company has also focussed on advertising to drive foot traffic and online traffic. They allocated marketing dollars to a subset of 2013 and 2014 stores, just as they did in Q1 2015, and it appears this can meaningfully driven sales growth. This focus on the class of 2013 & 2014 stores will continue for the remainder of the year.

TTS revised down the number of stores they plan to open in 2015. Instead of earlier expectation of 8-10 new stores, they now see opening 7-8 new stores in 2015. All openings are expected to be in existing markets. They had planned to open couple stores in new markets but they weren’t able to find sites matching their selection criteria.

The CFO gave us a bit more colour on the store level growth. Some details:

  • 2013 stores that have been open for about 2 years had mid teens comparable store sales growth. Sequentially, these stores had about a 6% increase over Q1 2015, which we should note was on the back of a 20% increase in sales from Q4 to Q1.
  • Stores opened in 2012 or earlier, i.e. the “mature stores” were flat in terms of sales between Q1 and Q2. These mature stores had low single digit comps with respect to prior quarter.
  • 2014 stores had about 14% sequential increase b/w Q1 and Q2 and high double digit comparable same store sales growth. It appears these newer stores are making good progress towards hitting the sales numbers of more mature stores, but CFO Kirk Geadelmann did note that many of the underperforming 2014 stores remained below the desired revenue levels for their current age. Given the state of the non-mature 2013/14 stores, it makes sense to focus on these (e.g., in terms of advertising dollars allocated to some of the 2013/2014 stores plus staffing improvements made by the management team) to get these performing at expected levels.

The drop in gross margin was also commented upon. Three factors were identified:

  1. They tested some regular price changes in newer and more competitive markets. Specifically, they are testing price elasticity of some of their product and trying to figure out how price increase/decrease affects sales. This program focussed on about 15% of the SKUs at its height and was applied at about half their store base. It appears this didn’t work as planned as they are training staff to better handle these pricing changes. There’s a fair bit of question & answers related to this and anyone interested in the details should have a peek into the conference call linked above.
  2. The sales mix had higher than usual customer delivery sales at some of the newer stores, and this portion of the business is generally run at flat to negative margin. CFO Kirk explained this later in response to a question. Essentially, if there are more deliveries out of stores that haven’t matured with respect to their sales mix and target, then they end up negatively impacted because of the cost involved in getting stuff moved from the distribution centre to the store. This should moderate as these stores move up the maturity curve.
  3. They had some significant inventory turnover this quarter. This is expected to ease in the second half.

Management is guiding for store base growth in the 8 - 12% range for 2016 and beyond. They want to focus on existing markets first and slowly penetrate new markets. Part of the rationale here is their ability to quickly ramp-up stores in existing markets. I guess this has the advantage of improving cash flow for the business.

Guidance for the Remainder of 2015

The company tightened its 2015 guidance. I was expecting to see a bump in guidance but that didn’t eventuate.
o Revenue b/w $280M and $290M.
o They expect comparable store sales growth in mid-single digits. This was an uptick from the low single digits in Q1 2015.
o Gross margin is expected to be 69%, so more or less inline with 2014, but they removed the guidance to include 69-70%, likely because of the drop in margins this quarter.
o Non-GAAP EPS is expected to be b/w $0.28 and $0.33 (they upped the lower end from $0.27 to $0.28). At mid-point, this represents about a 30% YoY growth.
o Adjusted EBITDA of $54m to $60m.
o They expect to open b/w 7 and 8 stores in 2015.

Valuation and Concluding Remarks

We saw some sell off in the shares post earnings release although everything seemed to be inline with expectations and guidance. I guess some of this had to do with the drop in gross margins. One big takeaway for me was that this new management team really likes to explain what they are doing, and are quite candid about what did and didn’t work. I appreciate the team’s long-term focus, like how they are thinking about cash flow, and generally like their strategy for long-term growth. I would have liked to see slightly higher pace in terms of store adds compared to the 8-12% set as the team’s objective. I haven’t seen any insider sales yet; these are the guys who were buying lots when the shares were sub $10. On 21 July 2015, the shares closed at $13.77. The shares had closed at $14.85 following Q1 2015.

Let’s look at valuation:
TTM EPS of $0.23 (Non-GAAP)
TTM Sales of $274.8m
P/E (TTM) of 59.8, and
P/S (TTM) of about 2.7.
Looking out to end of 2015, I think TTS is likely to easily hit the mid-point of their guidance.
P/E (end of 2015) of 46, assuming forward eps of $0.30.
P/S (end of 2015) of about 2.6, assuming FY 2015 sales of $285m.

So, how does this place the long term share holder. This looked like another good quarter, where they made good business progress (improving cash flow, paying down debt, talent retention etc). It looks to me as if TTS management is doing the things they need to do to make the concept scale. I would say that the brand itself has zero moat but as it grows it gets some scale advantages and that should help its bottomline. It’s competing with big box retailer and smaller regional stores but I do think this concept has legs and this management team seems to be getting the job done. I am encouraged by management’s openness in the conference call.

Is the valuation rich? As I noted in the last set of notes following Q4 2014, I think the forward valuation of 45 is may be a bit rich but still probably okay if they can maintain a 30% earnings growth, manage store growth without major blunders, and keep working on staff improvements. Professional customers and advertising should help bump up the numbers. They still have a big opportunity in terms of store growth.

With TTS, I like keeping an eye on the short interest data:
http://www.nasdaq.com/symbol/tts/short-interest
Short interest was at 6.4m shares as of 30th June 2015. This is about 12.5% of the 51M shares out. The days to cover is sitting at 24 days. It appears short interest is down since Q1 2015 when I had noted it around 7.1M shares. Note that insiders hold about 7.7M shares. I ‘m guessing some more shorts were taken following the report. We might get a clearer picture when the next short interest update is available.

I have a pretty large exposure to TTS at about 2.5% of my portfolio. It’s no longer my second largest holding but that’s mostly because I had some others pick up including INBK (my largest holding), NFLX, SBUX, WETF, and FB. I still very much like TTS and I might look to sell some puts for income if share price remains depressed for sometime.

I guess I should thank my erstwhile MDP membership for this position. I started this one based on some thorough MDP research.

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