Gotham's Tile Shop Gotcha!
Board: Value Hounds
The Tile Shop got taken out and hung after a report was published by Gotham City Research LLC they made public on November 14. The Tile Shop currently trades around $14 down from a high of $31 in July 2013. The IPO was in the summer of 2012 done through a SPAC -- a shell company listed on an exchange that transfers its listing to the merged private company. It’s made up of cash from investors with a mandate to get a deal done. Going with a SPAC eliminates the usual IPO headaches including roadshows and other IPO expenses. It’s something like a reverse merger. The Tile Shop has been doing business as a public company for a bit more than a year and had been going hell bent for leather until the Gotham hit piece. The aftermath was a bloodbath for Tile Shop shareholders and shares are down 55% from the 52-week highs.
The Gotham research is not easily verifiable or necessarily accurate and shorts who release research to the public are suspect for a very unhidden agenda -- to create panic and profit from a fast appreciating short position. Other recent examples are Linn Energy and Ackman’s famous three hour-long presentation on Herbalife. Gotham has a total of two available reports – EBIX and the Tile Shop. They may have scored on EBIX that is currently being probed for false earnings statements falling hard on the news in June. This does tend to give Gotham some street creds for a negative report they put out in February that resulted in SEC action.
The Short Case
In short Gotham is accusing the Tile Shop of manipulating gross income through a related party supplier -- Beijing Pingxiu (BP). According to Gotham, TTS gets at least 30% of its inventory from this shady Chinese supplier that sells at cost or even a loss raising gross margins for TTS. BP has no long term assets like property or plants (according to documents provided by Gotham). Beijing Pingxiu allegedly makes it possible for the Tile Shop’s gross margins to exceed those of its peers by providing inventory at or below cost. Since BP has no property or warehouses, they would be merely a pass through vendor for TTS never handling the product itself. Because it’s Chinese, it will be extraordinarily difficult to confirm Gotham’s documents and numbers – they provide some invoices and filings.
The Tile Shop Responds
The Company adamantly denies these allegations and believes that the financial statements are properly stated and its business practices are appropriate. The Company negotiates all inventory purchases directly with each vendor. As is common practice, certain vendors utilize an export trading company, such as Beijing Pingxiu, for sales to U.S. based companies. Other Chinese vendors maintain their own export licensing authority. The Company has been made aware of changes of the ownership of Beijing Pingxiu, which were not previously disclosed, to the Company.
A Trip Through the Margins
One of the few things we can verify is TTS margins and compare them to similar companies. There are multitudes of privately held tile stores – Tile America, Arizona Tile, Riteway—and big boxes that sell tile like Home Depot and Lowes. None are either available or appropriate for comps. Gotham uses the long bankrupt Color Tile for a comp.
I found a UK tile store that looks like a better fit and also use Lumber Liquidators. LL is strictly wood but otherwise has a similar business model with retail stores and reliance on vendors for product.
[See Post for Tables]
The following is UK based Topps’ margins. The two companies are not far apart. If Gotham had used Topps, the case would be weaker. Color Tile sold wood flooring, carpet and window shades – all much lower margin products and was not a good comp.
The biggest part of cost of sales for both is the tile. Operating income includes employee expenses and occupancy and make both TTS and Topps similar in where the expense of large items is recognized. There was some suggestion from the Fool that TTS was unique in putting employee expense in SG&A making gross potentially larger than competitors – that’s not the case and doesn’t impact gross margins making them higher than peers. Most peers run employee expense in operating expense.
TTS was able to turn in better net margins as a privately held company but in 2013, corporate withholding kicked in and net dropped barely exceeding the competitions’ net. TTS has gross margins around 10% higher than Topps. That would seem to indicate TTS is not grossly understating costs (by 200% according to Gotham) when comparing to another strictly tile business. Color Tile ran gross margins in the 40%-48% range over 5 years from 1990-1995 declining as they expanded into blinds and window treatments after acquiring American Blind. Color Tile also sold carpet and wood flooring with installation that eroded gross margins. They aren’t a great comp for margins.
From LL’s margins we can see that wood flooring costs are much higher creating significantly lower gross margins making them an inadequate comp for margins. What is helpful and slightly concerning is Tile Shop’s inability to control operating costs. Since they became publicly traded with higher tax rates and compliance costs, the net margins are almost equivalent to businesses that start out with lower gross but can compete on net margins.
The Tile Shop’s gross margins don’t seem grossly overstated and that would indicate the earnings are probably not overstated by 200%. I wouldn’t bet against the SEC getting involved like they did with two other short targets—EBIX (Gotham’s research) and Linn Energy from Hedgeye. The SEC may take an interest in the Tile Shop and open an informal investigation. The stock will almost certainly fall even harder if that happens.
Days in Inventory DIO
Inventory levels are another matter and are far more concerning than margins. The Tile Shops continuously runs inventory levels at significantly higher levels than other consumer retail stores. Color Tile, Lumber Liquidators and Topps have far lower levels of inventory consistently than TTS.
Inventory spends nearly one year in the store/distribution centers or put another way, TTS manages to turn their inventory over only once a year. There is no discernible reason they need to hold this much inventory year-over-year courting obsolescence and write-offs. Management argues that their recently opened third (it’s really the 4th) distribution center pushed up inventory levels and in the past, has said slow-down of production in Asia caused them to load up during certain periods. Bottom line is the inventory turnover is always sluggish and DIO is always far higher than retail peers.
The now bankrupt Color Tile had excellent inventory management and DIO was around 80 days so it wasn’t too helpful for them but it’s still an important part of running a retail business.
Concerning the 3rd/really 4th distribution center from the CC
We also recognized that in order to ensure success, we must continue to make investments now in order to be positioned to accomplish our long-term goals, we are focused on infrastructure where we have made major investments in order to stay ahead of our projected store expansions, to that end our third distribution center located in Durant, Oklahoma is up and running and already supplying some of our newest locations with product.
That said it did cause us to incur some additional cost in the quarter but the long term benefits will far outweigh these initial expenses, we also were on time and on budget in getting the center up and running, [indiscernible] will initially serve us 18 stores by the year end.
This distribution center is actually the fourth if the 10Ks and 10Q’s are more accurate than the CEO’s memory and it was purchased as 150,000 SF of warehouse space in the 4th quarter of 2012 and is at least one year old. That seems like an excessive amount of time to get a warehouse, already standing, stocked.
In Q3 2013, DIO increased to 386 days and TTM turns were only 0.84X per year. There was no slow steady build of inventory over the past year to stock the facility as one might expect and it seems unlikely the entire increase was due to the nearly year old fourth distribution center.
Topps turns tile nearly 3x per year and almost three times as fast as Tile Shops.
While Lumber Liquidators isn’t a great comp for margins, it is good for inventory turn comparisons as a consumer home construction product sold at retail stores.
In its recent quarter, Lumber Liquidators inventory did increase by two weeks to 146 days—still far better than TTS.Is too much inventory necessarily bad?
Until Q3 2013, the high inventory levels were not a big drag on net income or cash flow. Cash flow from operations increased over the past 3 years to $47 million in 2012. Operating income has also been on the rise and do not appear to be extraordinarily high. But do they really need a fourth warehouse for only an 80-store base? Or would less inventory have made it easier to go with three? Three distribution centers are located in Wisconsin, Michigan and Virginia. With all the stores located in the south, Deep South, east coast, and Midwest, this Oklahoma property is not much use at present. Management claims it will allow expansion into Texas and to Denver, but the low number of stores involved in these openings makes this distribution center look a little useless. They have one store in Tulsa and one in Oklahoma City. Filling this warehouse for two stores (and there was a huge bump up in inventory) looks suspect or at least like poor judgment. It’s difficult to know exactly what they are doing and why inventory continues to swell without outlets to ship it to. Planning for future expansion is great, but at the pace they open stores, the Durant warehouse may be more expensive than simply shipping from Wisconsin. Consider shipping from Durant OK to Denver is 826 miles and from Spring Valley Wisconsin its only 100 miles further. It does cut shipping distances and costs to local Oklahoma stores, but there are only two. Shipping from Wisconsin would take around 10 hours. The new warehouse looks like an expensive investment soaking up a lot of inventory until they get a substantial number of stores within a few hundred miles to ship efficiently to.
TTS inventory has always been excessive relative to peers (measured by turns and DIO) and is now in even worse shape. It has finally crimped cash flow and compromised growth. For nine months 2013, CFFO was only $13 million and down from $41 million in Q3 2012. Inventory increases were a large part of that with a $25 million increase. It’s a problem because cash flow no longer supports rapid expansion and debt levels were increased. Cash levels are extremely low at only $3.9 million. Reduction in inventory would free up some of the cash that’s now locked away in working capital. They could certainly use some right now.Gotham gets part of it right
The margins are a non-starter for proving fraud and the inventory levels don’t follow a pattern of increasing at the end of every period as would be necessary to deflate cost of goods. Those arguments don’t hold water. The China connection and the no-profit related party business is just stupid. The point to related parties is that they get to overcharge for sales and get rich—not that they go broke doing a favor for their brother-in-law. Where’s the incentive?
The biggest concern is why does the Tile Shop insist on holding nearly 3x the inventory of most peers? It ties up a lot of cash that could be used in more profitable ways. It’s inexplicable and management’s reasoning is full of holes. I don’t suspect them of malfeasance like Gotham does, but I’m not crazy about the way they are running the business in 2013.