On November 14th, Gotham City Research published a report alleging that the Tile Shop (TTS) was using an undisclosed related party to fraudulently inflate its earnings. Later that day the company responded with a statement denying every allegation except that they do business with an export trading company owned by one of their own employees. The next day a number of banks put out research notes recommending the stock, stating that they believe the company’s financials are accurate and the core business sound. After all this, the company is trading at an enterprise value of about ~ 920 million, a generous valuation that for me begs the question, is this a fraud or not?
TTS V.S. Topps Tiles U.K.
I’m not going to cover 90% of what Gotham did in its report, so you should go read it if you want the whole story. What I’m going briefly discuss is, after know everything Gotham has said, what does a “normal” tile retailer look like, and what can that help is infer about TTS? Gotham used the long bankrupt Color Tile Inc. as an example of what tile economics should look like. I think that’s a decent comparison, but using a now bankrupt company seems a touch rocky to me. So instead I went and looked at Topps Tiles; a specialty tile retailer in the U.K., that I think makes for an equal or better comparison. Topps Tiles has 320 store locations in the U.K., $275 (USD) of revenue in 2012, is publicly traded and has a market capitalization of approximately 175 million GBP or 262 million USD.
First up, what are gross and EBITDA margin? TTS sports some of the badest (best) in the business, at 70% gross and ~27.5% EBITDA. The more mature Topps Tiles has a gross of 59% and an EBITDA of around 11% between 2010 and 2012. Many people, myself included, have doubted whether TTS can maintain such outstanding margins as it becomes a national retailer, and Gotham wen’t so far as to deny that the gross margin is even real. The reality is that no one but the company knows the truth about gross margin. For now, all that we can say is that a gross margin of 70% doesn’t seem to be the norm for large flooring retailers.
Margins are very important but the inventory levels are what I find really interesting. This was a major focus of Gotham’s report, and something I missed completely when I looked at the company earlier this year (shame on me). In its report Gotham cited a metric called Days Sales Inventory, which is calculated as ((Inventory / COGS) *365). And indeed, TTS has some very high days sales inventory. Since 2007 DSI has been at or above 250, and currently stands at a striking 411 on a trailing twelve-month basis.
However, I feel i must mention that when looking at both companies one thing I noticed though is that because of how DSI is calculated, a company with a higher gross margin will tend to exhibit a higher DSI. This puts TTS at a comparative disadvantage for no reason other than it supposedly buys cheaper. (See exhibit above) Therefore I took the step of adjusting Topps Tiles gross DSI for the difference in margin between the companies. The result, even with this adjustment TTS exhibits much higher DSI than Topps Tiles in every period.
Forgetting DSI for a moment, comparing the two companies in more absolute terms provides an even better sense of the profound amount of inventory that TTS is carrying on its books. Topps Tiles has 320 stores and $275 million in sales in 2012. It carries $41 million (USD) of inventory to support its operations. TTS has 80 stores and $ 218 million of sales in the TTM period, and carries $71.8 million of inventory as of Q3 2013 or 75% more than Topps Tiles.
Why and how can a company that is supposed to have better gross and EBITDA margins be carrying so much inventory?
I ended the last section with a question because that’s all I have. As far as I can see there is no direct proof that TTS has done anything illegal – only circumstantial evidence (the exception being not disclosing a related party.) This brings me to what short sellers sometimes call cockroach theory. The analogy is that just as if you’ve seen one cockroach the likelihood is that there are others, if you see one instance of misconduct, the likelihood is that there is more. TTS has already showed us at least one cockroach by admitting to the non-disclosure of the related party. Taken together with the massive inventory levels and the other issues brought up by multiple reports, I’ve come conclude it is more likely than not that something rotten at The Tile Shop.
As Mr. Munger would do lets leave off by examining the counterfactual; what if TTS is not a fraud? In that case what we’re left with is an incompetent management team, an unproven business model, a highly leveraged capital structure, plenty of shareholder lawsuits, material weakness in financial reporting, and a shit-load of tile.
Disclosure: Short TTSFULL POST