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The Market Saw Weakness in Tile Shop's Earnings But May Have Missed Something Important

By the way the market reacted after Tile Shop Holdings, Inc. (NASDAQ: TTS) reported second-quarter earnings on July 18, one would think the company reported awful, bad, horrible news: maybe a big quarterly loss, an unexpected drop in sales, or even more of the problems which plagued the business under founder and former CEO Bob Rucker.

Yet none of these things happened: no scandal, and sales were up 6.2%, while earnings per share increased 15%. So what exactly led to the huge sell-off?

Tile Shop's sales were improved, but they fell short of the expectations set by Wall Street analysts. Furthermore, Tile Shop management also reduced parts of its full-year guidance. This likely produced a compounding effect, leading to the big drop in the stock price post-earnings, particularly if short sellers took the earnings results as a cue to short the stock even further post-announcement; with short interest up in recent weeks, this is a real possibility.

Factor in a big decline in comps -- an important measure of sales health for retail operators that's plagued Starbucks' stock results in recent quarters -- and there are a few reasons why investors may have sold.

Image source: Getty Images.

But instead of analyzing the market's reaction to Tile Shop's results, long-term investors are better off understanding how the company actually performed, as well as what management intends to do going forward. Keep reading to learn about Tile Shop's results, and what to expect looking ahead.

How a single month affected Tile Shop's comps

Tile Shop's key financial results for the second quarter:

Metric Q2 2017 Q2 2016 Year-Over-Year Change
Revenue $89.5 million $84.3 million 6.2%
Net income $7.7 million $6.8 million 13.2%
Earnings per share $0.15 $0.13

15.4%

Comparable-store sales growth 0.5% 8.2%

N/A

Data source: Tile Shop Holdings.

The good news is that sales and profits did grow, but as with coffee giant Starbucks' recent quarterly results, the market is focusing very closely on comps -- that is, sales at stores open for more than one year. This is important for several reasons; comps help measure whether a company's business is able to attract new (or repeat) customers regularly, the general health of the industry it serves, and to some extent, its ability to raise prices to both offset higher expenses and drive higher profits.

And after more than two years of regularly delivering quarterly comps growth of more than 3%, Tile Shop's near-flat comps create some uncertainty about both the health of the home-improvement spending cycle and whether the company will be able to continue generating increased sales leverage to drive higher profits. This second concern proved true in the quarter, with adjusted EBITDA margin (which essentially measures cash flow margins from operations and excludes non-recurring, non-cash, and tax and interest expenses) down 115 basis points to 21.4%.

There's potentially good news with comps, however. On the earnings call, CFO Kirk Geadelmann said that a "meaningful shortfall" to the company's sales plan in April -- in part due to the timing of the Easter holiday, which cost the company a Sunday of sales -- was responsible for nearly all of the company's poor comps result. Geadelmann said sales recovered in May and June, and the company delivered its typical "mid-single-digit comparable-store sales growth."

Furthermore, management provided some indication that they see the April result as an aberration, and not a shift in the trend, when they left their comps guidance for the full year unchanged at low- to mid-single-digit growth.

Balance sheet deleveraging continues, even as store expansion ramps up

Even with sales growth underwhelming, Tile Shop continued to chip away at its debt and improve the quality of the balance sheet. Working capital -- current assets minus current liabilities -- increased $2 million. The company ended the quarter with $12 million in cash, down $1.6 million sequentially but doubled year over year -- and $19 million in long-term debt, down $9 million from the first quarter and the lowest level in over five years. Furthermore, Geadelmann said that management still expects to reduce debt to $10 million by year-end, and expects to have a cash balance similar to its current position.

One of the ways the company has been able to pay down its debt over the past couple of years is by slowing its rate of expansion, freeing up cash flows it had been investing in capital expansion to pay off a debt that had ballooned to over $90 million in 2014. This has cut interest expense in half over that time, freeing up more cash that management can use to further deleverage or reinvest in growth.

There's some indication that management plans to ramp up expansion, too. The company opened four new stores in the quarter, and said that it would open 15 total stores this year, the high end of the range of 10 to 15 management set at the start of the year.

Another reason Tile Shop has been able to increase its rate of store openings is a "significant decline" in the cost of opening new stores. On the earnings call, CEO Chris Homeister said that the company is able "to build our new stores for less than $1 million on average, for the significant decline from our prior historical average of approximately $1.4 million."

Looking ahead: Management keeps working on what they can control

The reality for any company that sells a product at retail to consumers is that the market will ebb and flow with the economy. The good news is that in general terms, the U.S. economy remains relatively healthy, and consumers have continued to spend on big-ticket items like home-improvement projects. And despite the hiccup in April, it appears that Tile Shop has been able to capitalize on this, with steady sales growth and store expansion.

But at the same time, the music will eventually stop; the economy will take a breather for a quarter or two, or unfortunately even longer every decade or so, with little indication when it will happen until it's already started. Tile Shop's management, under the leadership of Homeister, have steadily taken steps to make sure the company is best positioned for any environment; they have reduced the debt by 80% over the past several years, reduced how much inventory the company carries while focusing on its best-selling SKUs, and invested in retaining and providing career opportunities for its best store employees. According to Homeister, store turnover fell yet again last quarter, while manager tenure increased.

It's never comfortable to see a stock in your portfolio fall more than 20% in a single day. But the good thing about Tile Shop is that, even with this painful drop in price for the stock, there's a lot of evidence that the business is probably in better shape than the market's reaction would indicate, and management is still taking steps to build a stronger business for the long term.

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Jason Hall owns shares of, and The Motley Fool owns shares of and recommends, SBUX and Tile Shop Holdings. The Motley Fool has a disclosure policy.