FND - Tile Shop Holdings: Clear Winner In Home Improvement Space Once Housing Sector Turns Around

2023-11-08 04:14:50 ET

Summary

• Tile Shop's management of seasoned industry professionals is doing a good job in today's weak macro environment.
• Tile Shop has aligned costs to match declining sales, and has a strong balance sheet with little debt.
• Pro-focused business still has untapped potential for more Pro sales.
• The company is testing a smaller store format, lower-priced mid-market products, and has many options for future growth.

Back in 2020, right as COVID hit, I was sure that Tile Shop (TTSH) was a goner: two straight years of negative comps, a disastrous ERP implementation, had delisted and deregistered from NASDAQ, and seen gross margins fall while SG&A remained stubbornly high and comp sales declines were accelerating. Things looked bleak, but management took decisive action as the pandemic began. They cut head count by 30%, slashed debt, stopped opening stores and skillfully managed inventory until the horizons looked brighter. In my opinion, the company today appears well positioned to be the clear winner in the home improvement space once the housing sector turns around.

Pandemic Management and COVID Boom

As we learned that stay-at-home really meant work-from-home and homeowners were spending an outsized portion of their wallets on their homes, launching a once once-in-a-lifetime boom. It didn't matter if you were a small mom and pop or big box, weak industry player or strong, sales were skyrocketing. Heck, you could rename your business and hide from your customers. It didn't matter. Your sales would still go up. TTSH management smartly maneuvered to build up inventory and hire back more associates. Since 2020, a decline in gross margins of a little more than 370bps has been mitigated by a larger decline in SG&A of ~530bps, netting to in an expansion of operating margins, and with revenues up 17% during this same period, the company is in great shape. Last year, TTSH made one of its shrewdest moves yet, adding luxury vinyl tile or LVT, the hottest selling category of flooring

Fast forward to today and we see that all of the surging demand has collapsed. Existing home sales are below 4 million units on an annualized basis and mortgage rates are near 8%. The weaker players that mismanaged their business during COVID are clearly losing share. However, at TTSH things don't look so bad. Sure, sales are down across the industry, but not all declines were created equally. It is not a reach to say that TTSH has the prettiest house in a really ugly neighborhood, especially after seeing how all of the major publicly traded flooring companies have reported. TTSH has materially outperformed all of them.

TTSH reported a comp sale decline of 4.9% for Q3 , vs the leader in the space, Floor & Decor (FND), with a negative 9.3% comp and Mohawk Industries' (MHK) North America Flooring segment with a decline of 11.7% . The latter two companies highlighted continued price declines and lower traffic and volume. However, TTSH was able to maintain its pricing during the most recent quarter as all of its comp sales decline was attributed to a drop in traffic. By itself this would be troubling, but given the macro backdrop it is understandable. TTSH's deep exposure to pros (will say more on this later) and its pricing power gives me confidence that TTSH can weather the storm until housing turns around. If things get really awful TTSH could cut its pricing on some of its newer, lower priced items designed to grow its budget-conscious customer cohort while continuing to dominate the market for high-end remodeling customers with relatively little reduction in pricing.

One highlight I'd like to point out from the FND conference call was that management noted shrinking ticket sizes. This was reasonably explained as the industry weakens and consumers tighten their belts, people generally focus on smaller projects such as kitchens and bathrooms, areas with a high percentage of tile (think tub surrounds and back splashes). FND saw the tile category outperform laminate and vinyl. When you consider that tile, tile installation materials and accessories is 98% of TTSH's sales then this read through is positive for TTSH in the near term.

On the recent TTSH earning call , management stated that it has some further room to trim inventory. TTSH has turned its inventory from 1.1 to 1.6 times per year since 2020 while FND has consistently turned its inventory 2x per year. On a TTM basis, TTSH turned its inventory 1.4x so I agree it can safely cut its inventory size to boost its return on capital. Management also pointed out progress in its digital advertising, improvements in its sampling program and an enhanced online shopping experience, which led to a 25% increase in its e-commerce business. As more and more homeowners begin their search online, these improvements will help TTSH retain and grow its DIY and end-user business. TTSH highlighted an expansion of lower-priced SKUs, both tile and vinyl, to offer their middle market customers and pros. This is another additional reason I fully support as it represents what I feel is an underrepresented portion of TTSH's business. Speaking of pros, one of the strengths of the TTSH model, as management noted, is ~75% of all sales touch a pro customer, either through a referral or a direct sale. This strength in pro will help cushion the business in a downturn and provide TTSH with growth in the future as there are many opportunities to strengthen these relationships, add products for pro market managers to sell, enhance its loyalty program and expand in store training with vendors.

New Store Format and Changes to Existing Showroom

Looking ahead it is helpful to remind the reader that TTSH reported in its most recent 10-K that it operates 143 stores in 31 states and the District of Columbia. It sells over 6,000 SKUs sourced from 197 vendors throughout the world. Earlier this year, TTSH opened a smaller format store in Colorado. While it is still early, management is pleased with results. Opening a smaller format store with lower fixed costs presents shareholders with a road map to future growth. Moreover, there are other ways that TTSH could expand in the future. Generally, TTSH stores comprise 20,000 square feet with around 50 vignettes and a few thousand feet of warehouse space for customer pick up. Most jobs sold need to be shipped from one of five distribution centers to the company store or job site. I have noticed on recent store visits that TTSH is adding cash-and-carry merchandise to its endcaps. Taken to its logical conclusion, a likely option may be to expand the warehouse area and reduce the size of the showroom so that more product, the most popular SKUs, could be kept in job lot quantities in the store. As other retailers in the space have demonstrated, there is a high correlation between comp sale growth and inventory availability at the store.

Trust in Great Management Team

The important point here is TTSH management is taking a rational approach to growth. They have maintained the store count for several years, right sized fixed costs, cleaned up the balance sheet, introduced LVT, and have fine-tuned their core business model for future growth. There are options available to restart store growth after management has dialed in tweaks to its model. Moreover, insiders own ~36.1% of the stock and the board has opportunistically repurchased stock in the past, which may be a future catalyst to share price gains. Unlike some of its weaker competitors, the important roles in the company, CEO, distribution, supply chain and operations, are filled by executives who have spent the majority of their careers in home improvement and specifically right here at TTSH.

Valuation

Since TTSH doesn't provide much in the way of forward guidance, I am taking my cues from the industry leader, FND. FND has arguably the best management in the space, the best overall business model and has shown over a decade of consistent growth. However, even they are struggling in this difficult environment with quarterly sequential declines in comp sales this year and have moved the target for a possible bottom to the first half of 2024. With a forward P/E near 40, and the news that FND will slow its unit growth next year, FND is currently trading at too high a multiple to recommend. However, TTSH is much more compelling. They improved their comp sales by 310bps on a sequential basis in Q3, reduced debt to $10 million, have a forward P/E of less than 18 and have generated almost $100 million in operating cash flows since the beginning of 2021.

Final Thoughts

I believe it is very likely things will get worse in housing before they get better; therefore, I am going to bide my time and pick my spots. However, the current price is not unreasonable to initiate a long term position in TTSH, which is one of my clear home improvement winners.

For further details see: