Thursday, November 21, 2013

A question for Tile Shop's institutional shareholders

The management of Tile Shop Holdings (NASDAQ:TTS) have spent the last few days in New York and Boston talking to institutional investors mainly to reassure them after the "hit piece" published by Gotham Research. That "hit piece" was described in my last post on Tile Shop.

I am sitting in an office in out-of-the-way Sydney Australia. I get glorious sunshine and harbour views and a rather good surf beach down the road but alas I don't get to New York for my privileged access to management.

I have to do my own thinking.

And the thing that I am thinking is that I don't understand tile shop's margins. You see this is - at least on the margins - a truly wonderful business.

I compared Tile Shop Holdings to the fattest margin fast-growth retail business I could think of. As a comparison I used arguably the greatest retailer of our age: Louis Vuitton.

Louis Vuitton sells leather handbags and purses and similar luxury goods for absurd mark ups. There is however a lot of selling expense - they need to maintain expensive stores and maintain the image. So you would expect an ultra-fat gross margin and a lot of selling and administrative expense (SG&A) relative to sales.

Also Louis Vuitton has been in the hottest part of retail - selling super-luxury goods to the world's burgeoning elites - especially the Asian nouveau wealthy.

Here (courtesy of the ever useful CapitalIQ) are the last three full years of LVMH's profit and loss statement. The numbers are in millions of Euro.




Income Statement


For the Fiscal Period Ending12 months
Dec-31-2012
12 months
Dec-31-2011
Reclassified
12 months
Dec-31-2010
CurrencyEUREUREUR



Revenue28,103.023,659.020,320.0
Other Revenue---
Total Revenue28,103.023,659.020,320.0




Cost Of Goods Sold9,917.08,092.07,184.0
Gross Profit18,186.015,567.013,136.0




Selling General & Admin Exp.12,265.010,304.08,815.0
R & D Exp.---
Depreciation & Amort.---
Other Operating Expense/(Income)---




Other Operating Exp., Total12,265.010,304.08,815.0




Operating Income5,921.05,263.04,321.0




Gross margin65%66%65%
Sales growth19%16%



Louis Vuitton has 65 percent gross margins (give or take about a percent) and a 16 to 19 percent growth rate. (These calculations are mine...)

These are astounding numbers for a retailer but they are what you might expect from LVMH given the mega-trend it is riding (along with seriously competent management).

And here are the same numbers - also from CapitalIQ - for Tile Shop Holdings. The numbers in this case are in millions of dollars.


Income Statement


For the Fiscal Period Ending12 months
Dec-31-2012
Restated
12 months
Dec-31-2011
Restated
12 months
Dec-31-2010
CurrencyUSDUSDUSD



Revenue182.7152.7135.3
Other Revenue---
Total Revenue182.7152.7135.3




Cost Of Goods Sold49.640.336.1
Gross Profit133.0112.499.2




Selling General & Admin Exp.94.778.468.1
Stock-Based Compensation--0.5
R & D Exp.---
Depreciation & Amort.---
Other Operating Expense/(Income)---




Other Operating Exp., Total94.778.468.6




Operating Income38.334.030.7




Gross margin73%74%73%
Growth – year on year20%13%


The gross margin here is 73 percent plus or minus a percent or so.

Who could have known that selling tiles in big-box stores in places like Tulsa Oklahoma could have a fatter gross margin than LVMH selling bags that cost pittance to manufacture for thousands of dollars? Note I am talking margin before SG&A.

Tile Shop grows just as fast as LVMH too.

---

I am puzzled about this. And unlike the top institutional shareholders I don't have access to Tile Shop's management so I have to try and work it out for myself.

And frankly this time I can't.

So I am going to pitch this question at the top shareholders - the ones who warrant a management stopover in New York. Dear shareholders (or readers for that matter) finish this sentence:

I believe that Tile Shop's gross margins are stable and sustainably higher than Louis Vuitton's gross margins because...

I have a further sentence too:

Last week Tile Shop admitted that its largest supplier was an undisclosed related party. This however does not change my belief about the margins because...

Thanks in advance for your answers.





John

22 comments:

Anonymous said...

it seems odd but not entirely crazy that gross margins could be that high. prices range widely, but if you look at alibaba.com and see what prices the factories are charging for floor tile, you get a wide range, but it is between 3 and 12 dollars per square meter. in order to have a 73% gross margin, TTS would need to sell Tile at 11 to 44 dollars per square meter. TTS quotes tile per square foot, so lets divide that by 10.76. that is $1.02 to $4.08 psf. Go to the TTS web site and check around, they sell at even higher prices than that. I think they must not capitalize some transport or selling costs in inventory, but it is possible.

Anonymous said...

Not an institutional investor, but why prejudice the audience with a (very loaded) luxury product comparison? If we want some epistemology, let's not stack the deck to start.

Why not compare to Coca-Cola (a fabulous business in its own right), which does 60% gross margins even after taking on some of its bottling operations? It did 66% back in 2006. And you can be sure its most profitable segments are much higher. Sugar water is cheap, an affordable luxury. A coke costs so little that no one in the US would think of foregoing it to save money.

I suspect the pricing is the same with tile, where an additional 25 cents per square foot (for example) is largely immaterial in the cost of a bathroom or kitchen renovation, but it's very material to margins at Tile Shop. And with tile sourced from a ton of low-wage countries, China being one, the poor bargaining position of coolie labor helps keep costs down.

I'd add one final point. In the 2001 financial projections that were revealed in the Gotham report, Rucker was projecting 63% gross margins. This was a period where the company was substantially smaller and would not be spreading its sourcing costs out over volume purchases nor extracting volume discounts. It was also a period when the company was not subject to public oversight by curious and very interested investors and the company's projections came out inadvertently, ostensibly.

But I still do want a good explanation from management on this related-party transaction.

Anonymous said...

It's not unusual for branded retailers to make high gross margins.

Kathmandu, which has a store in Bondi Junction makes >60% gross margin and has been growing at greater that 10%.

There would be at least half a dozen retailers in that shopping center that would generate those numbers despite not being global brands.

Bruschettaboy said...

Aren't a lot of your contestants just going to fill in something like "... because Topps Tiles has done about high fifties to mid sixties in the UK for the last dozen years"?

Basically, intellectually I can see the case here but I had my bathroom remodelled last year and the emotional sting of paying the bill is still great enough to make me more ready to believe than you are that a) retailers of tiles can gouge you just as badly as Louis Vuitton and b) that the basic reason why they can is the same - when the lady wants *that* product, price elasticity goes out the window. (The window has stained glass in it, which was also overpriced).

John Hempton said...

The comparison to Topps is revealing.

Topps has a fair few percent less gross margin and only about 10 percent (slightly less actually) net margin.

And its inventory is a very small fraction of a year's sales.

J

Bruschettaboy said...

Yes - I might be able to yaddayadda the net margin by saying that UK property rents and transportation is probably more expensive, but the inventory thing is really very hard to explain. Quite apart from anything, bathrooms have fashions (I know! Appalled me too!), so if your average age of inventory is more than a year, you're quite likely to end up discounting or scrapping a lot of tiles.

Anonymous said...

John, What did you think of the new Fred Goodwin book? That'd be a good blog post.

Robert in Chicago said...

My guess is you are leading with the wrong argument. In the month leading up to the Gotham piece, TTS had two other competent hit jobs published on it yet fell "only" 12%. The Gotham piece caused a 50% fall. It was only the Gotham piece that caught the fraud occurring with undisclosed Chinese parties. That fact pattern has produced 80-90% eventual stock price falls with almost 100% success over the last 3 years; "suspiciously high margins," not so much.

Anonymous said...

Robert in Chicago – he’s asking the only question that matters. Investors either believe management that The Tile Shop has the world’s best gross margins in the retail industry or the financial statements are fraudulent. The other hit pieces could only question the integrity of management and expressed disbelief that a highly competitive industry could sustain such dramatic pricing power. As John pointed out in his last post for the first time Gotham provided an economic explanation for how TTS’s margins are overstated. Simply put: overstated margins = overstated profits = fraud.

Anonymous said...

Reece-plumbing supplier, makes 50%+ margins so not impossible

John Hempton said...

I specifically covered the plumbing supplier case in the first post... And I was thinking of Reece.

J

Robert in Chicago said...

Of course suspiciously high margins and secret related-party transactions are both evidence of fraud; my issue was which one is the better evidence. As can be seen on this thread, the suspiciousness of the margins is debatable. The secret related-party transactions are not. And the two together are 3x as powerful as either alone.

Anonymous said...

John, I did meet w/ mgmt in NYC and first I think its important to clarify that the BP entity was not a supplier but rather an export company that processed invoices between TTS and 11 of its Chinese vendors. The prices on all purchases are negotiated between TTS and the vendors directly, not thru BP. BP was collecting 25-50bp off the what the vendor got. So while the related party should have been disclosed BP had essentially no impact on margins. To answer your first question, some of your other readers have accurately pointed out other tile shops that generate high margins, but what I believe sets TTS apart and explains why the margins are higher and sustainable is its efficient direct sourcing model, its purchasing and utilization of entire sources of rock, and its accessories & setting sales. To expand, as you know the direct sourcing cuts out the middle men, but as I understand from my research TTS takes it one step further by purchasing entire sources of rock, opposed just the best pieces, and uses those less desired, cheaper materials for pencils and skirts that can be marked up 100% if presented right. So their better yield and scale is one factor. TTS also manufacturers and sells its own adhesives, grouting and setting products (Superior is the brand) which represent ~18%-20% of sales and carry gross margins of 80%+. Finally, unlike other retailers (even Louis Vuitton) TTS does not have material clearance sales or inventory markdowns (only about $150k a yr typically) because consumer tastes in tile & stone don't fluctuate like fashion.

Anonymous said...

You are trying to reframe the discussion as a comparison to Louis Vuitton...does not make sense...a better question would be how does Tile Shop make 10 points more GM than Top Tile in the UK...also that leads to the question...How does Top Tile in the UK have the same gross margins as Louis Vuitton?

Your premise is incorrect. If you take a harder look at the COGS of Louis Vuitton it has all sorts of costs in there including design costs which is far more than the material cost. Tile Shop's business model is far simpler...stone and tile sold at markups..

Oh well...our biases lead us to not just to our opinions but to the questions that we ask as well.

Anonymous said...

The assertion that The Tile Shop has an efficient direct sourcing model is really enlightening. Companies that spend billions of dollars on their supply chain and hire Ivy League MBAs have an efficient sourcing model… not some guy flying around the world to buy rock.

But if this is the case then Bob Rucker must be a revolutionary in the business and retail community. He is no doubt worthy of a Harvard Business School case study. Vanderbilt, Carnegie, Rockefeller, Ford, Walton, Buffett, Gates, and yes Rucker. In fact he’s so prominent there is absolutely nothing that comes up about him by performing a simple internet search… other than the fact that he manipulated his company’s financials to cheat his ex-wife out of money in a divorce. Buy maybe I’m being na├»ve so lets have the facts speak for themselves.

The company admitted there was an undisclosed related party transaction that is responsible for processing invoices for 11 of their Chinese vendors. But don’t worry it doesn’t impact our financial statements; we just chose not to disclose it.

Prior to the SPAC transaction there was no CFO for The Tile Shop. Who was responsible for the financials?

Prior to the SPAC transaction there was no board of directors. Who was responsible for corporate governance?

The CEO was found by a court to have manipulated the financial statements for The Tile Shop for his own benefit. He has committed fraud before.

The CEO and the SPAC shareholders spent 100% of the $125 mln cash in the shell corporation to buy stock from insiders. The company followed that by taking out debt on the company to distribute this cash to insiders by “purchasing a promissory note”.
There have been 2 secondary transactions in the past 11 months with 100% of the proceeds to management and insiders.
The company spent cash to buy back warrants from insiders.
Who had more to benefit by The Tile Shop coming public through a shell corporation?

The Tile Shop might literally have the worst corporate governance for a public company west of China. But it’s ok because they are all in on it.

Those issues aside I have just one burning question… Why are you a seller of your ownership stake at all? If your company has best in class margins, a phenomenal secular growth story and a unique competitive advantage in your direct sourcing model wouldn’t you do a traditional IPO? Why wouldn’t you let every investor in the US to look at your story? Why not get the absolute best valuation for your huge ownership stake… better yet, why would you ever sell?

I’m glad Mr. New York had the pleasure of Bob Rucker & Tim Clayton’s company. They probably have some stock to sell you.

goldengatesings2 said...

This is in response to the post by Anonymous at Nov 23, 2013 at 8:44 AM.

You are essentially following the fallacy of "argumentum ad ignorantium" which attempts to shift the burden of proof to someone defending allegations made against them.

The source of this fallacy is the assumption that something is true unless proven otherwise.

You can ask these questions in hindsight but the fact investors bought those shares being offered in the secondary knowing how those funds would be used is testament to the growth prospects of the company

The question as to why do insiders sell their shares at all can have many reasons - diversification, collecting some cash after years of cash. Note that this is not a 23 year old running Snapchat who turns down billions of dollars from Facebook. It is a well known fact that Kleiner tried to sell Google (when it was still private) which was in their portfolio for $150M and had no takers. Does the fact that they tried to sell Google then have any implication on the value of Google today?

In addition, not having a CFO before a SPAC transaction is indicative of nothing. Of all the small businesses in the US (99% of them do not have a separate individual serving as the CFO). Your problem appears to be that you are used to the Caifornia startup culture that creates a company with the idea of taking it public or sale.

99% of the small businesses in the US are started with the idea of making money for the proprietors. Tile Shop's success is one of those rare circumstances where a small US business made it big. So again your questions sow the seed of doubt but do not do anything else.

As far as the CEO's character is concerned...I would claim that if you lift the covers off all of our public company CEOs you will find skeletons that you do not like. Steve Jobs is a prime example...the fact that he could abandon his child is far worse than trying to make a few bucks in a divorce proceeding...but Steve Jobs beyond his rather black closet...was one of the best CEOs around. In fact, it is well accepted that Steve Jobs screwed a number of his business partners along the way..could you use that character flaw to short Apple?

The fact is that this discussion is only about one dark spot...why was the Beijing Pinxiu relationship not disclosed. Frankly, I think that if disclosed and consolidated into Tile Shop's books their gross margins would be higher by 50bps (the amount that Beijing Pinxiu was getting) not lower.

All the other assertions as to why their gross margins are higher than Louis Vuitton are silly at best...tile, garments, food these businesses can have very high gross margins depending on the way they are marketed and sold. Gross margins are not just supply chain dependent.

Lastly, my source of disappointed is with the rather silly way the company is handling this crisis. They have their hatches battened down. They need to spend some money on a good PR company to get past this crisis.

Advice for the company:
1. Get a PR firm.
2. Consolidate Beijing Pinxiu into your books if they are related party transaction. Restate statements to a higher gross margin.
3. Pay a fine for poor internal controls.
4. FIRE the brother in law.
5. The board should also consider removing Rucker from the CEO role for his poor handling of the crisis. Rucker is not that important anymore. He has done a great job of taking a commodity business and building a growth story out of it. But he is a poor CEO (who has psychological issues dealing with Wall Street) at best.

We will move higher towards $30 in due course. If one of the larger home retailers does not buy them out first.

Good luck to all.

Anonymous said...

Peter Kamin, a founder of ValueAct Capital, now managing his own money, is a director of TTS. While it is not impossible, I think he'd be in a hurry to get off the board if fraud were a concern. The stock may be a perfectly reasonable short for more prosaic reasons but I don't think it is a zero.

dede said...

"Louis Vuitton sells leather handbags and purses and similar luxury goods for absurd mark ups"

As far as I know, these are not leather but some sort of plastic (which does not make it less absurd)...

Gabe said...

Question for Anonymous who met with management (11/23 post at 3:53 a.m.): BP sales went from 800K to 16mm rmb from 2011 to 2012 (Gotham report at p. 11).

1. What explains the 20x increase?
2. If BP is only processing invoices for a 25-50bp commission, how do they get to 16mm rmb (let's call it $2.5mm)? Tile shop's total COGS is $50mm -- 50bp is $250k. And BP itself jumped to 15mm rmb COGS in 2012 (see Gotham's chart)-- what is BP spending that money on, if not as a supplier?

Anonymous said...

@Gabe
Shipping cost

Jamie said...

It does seem odd that the gross margin could be so high. The price fluctuation is simply too wild. Which means, it can potentially become a double edged sword if the price swing negatively against the company. If the Company is using JIT to manage its inventory then it make sense that their gross margin is this high as they are keeping a very tight grip on raw material cost and eliminating wastages both in process and production.

Bruschettaboy said...

If the Company is using JIT to manage its inventory

Over 400 days of inventory doesn't sound very "just in time" does it?

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