Friday, November 15, 2013

Tile Shop Holdings and the Gotham hit-piece

Tile Shop Holdings (NASDAQ:TTS) received an unwelcome piece of anonymous research from Gotham Research - see the original here - or the Seeking Alpha summary here.

This is the most convincing "hit piece" put out by any short-seller (Muddy Waters included) this year.

However convincing does not mean it is right. I found Bill Ackman's original 300 page presentation on Herbalife to be utterly convincing. I then did my own work and my view is that Ackman is both convincing and wrong.

It is entirely possible that Gotham is convincing and wrong.

At Bronte we have been short Tile Shop Holdings for about a year but in small quantity, the small quantity reflecting both our lack of conviction (our research was not extensive) and the lack of any catalyst we could identify.

Given the stock dropped almost 40 percent on the Gotham report I can't be displeased. Gotham has provided my catalyst.

That said, until relatively recently being short this was not particularly pleasant.

The reason we were short

The reasons we were short only tangentially overlap the argument covered in the Gotham report. This was not an entirely original short either. I have heard the name suggested by several skilled short sellers (as well as some short sellers whose judgement I do not trust).

The main reason we were attracted to the short was that we simply could not envisage an economic case for the business.

The business, bluntly, is super-stores selling very little other than tiles.

We have super-stores for building products - they are called Lowes and Home Depot. And in Australia, and for that matter everywhere else, they have busily put specialist building materials shops out of business. Killed them stone dead.

I could not imagine "destination shopping" for tiles - and hence the shop did not make sense to me.

Businesses that don't make sense eventually get eaten by the competition. That was (and remains) my expectation for the end-game here. I would rather wrestle gorillas than compete with Lowes and Home Depot.

The public short thesis

As I said, this was a short that was discussed from time to time. The widely discussed short case was that Tile Shop Holdings had very large inventory numbers.

Gotham reports them in days sales of inventory - and here I reproduce their table.

Approximately 400 days of inventory in a retail store seems very odd. It seems double-odd in a big-box retailer. The formula for most retailers is to turn the product over very fast (the faster the better) and earn a small margin lots of times over the space. This is the model that emphasizes sales per square foot, asset turns, low pricing.

The conventional model is clearly not the model of Tile Shop Holdings which has a huge amount of inventory, low turns and very fat margins.

We thought very little of the business model (destination stores for something you might buy once a decade). Therefore we were short. We did not think the fat margins were sustainable.


The publicly discussed short-thesis is not entirely convincing. There are models which have very large amounts of inventory with very low turnover but where it all works because the margin is fat.

Plumbing supplies is a good example.

Our house has all matching taps (faucets in America).

Suppose one faucet breaks and I need to replace it.

I would very much like it to match all the other faucets or I may have to change them all.

A plumbing supplier who can sell me a matching faucet, not fashionable for fifteen years and out of production, is a very welcome supplier.

I would happily give him a 300 percent gross margin.

And to get his gross margin he has to stock a huge range of plumbing supplies, and so winds up large inventory and low turns.

It was possible that Tile Shop Holdings was like that. It had a huge range of tiles and relied on people falling in love with particular tiles and the range would allow them an increase in gross margin. Other than looking at shops and querying customers I had no real way of knowing whether the inventory numbers were sensible or not.


The inventory numbers however are worrying. There are several frauds in retailing that have depended on large and faked inventory numbers. One of the most famous of these - famous at least in part because one of the perpetrators talks to short-sellers - is Crazy Eddie. Sam Antar is more than happy to tell short-sellers how he pulled off the Crazy Eddie fraud.


Then along comes the Gotham Report. Here is the show-stopper allegation:

TTS's largest supplier, Beijing Pingxiu, is an undisclosed related company, and accounts for 20-30+% of TTS's cost of goods sold.
Beijing Pingxiu is secretly controlled by Fumitake Nishi. Mr. Nishi is the CEO's brother-in-law and a TTS employee. 
Beijing Pingxiu invoices sent to the Tile Shop are directed to Fumitake Nishi. Beijing Pingxiu has no presence in one of its listed addresses, and a minimal presence in another. 
Days sales' inventory for FY2011 & LTM 2013 exceed 365 days, at 396 & 414 days respectively.
This is a show-stopper allegation because it provides a mechanism to fake the inventory numbers. Before the Gotham Report you might guess that they had faked their numbers but you had no mechanism for explaining how they might have done it. You had nothing auditable. Indeed all you had was a guess.

After the Gotham Report you had a mechanism. That certainly increases the chance that the "fraud thesis" is right.


The company issued a press release denying most allegations but confirming some allegations in the Gotham Report.

Here is the main part of that release:

Tile Shop Holdings, Inc. (TTS) (the “Company”), a specialty retailer of manufactured and natural stone tiles, setting and maintenance materials, and related accessories, announced that earlier today, the Company was made aware of a report which alleges that its historical financial statements may require restatement along with other accounting irregularities. 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. As a result of this disclosure, The Company has suspended its relationship with this entity. 
The Company intends to thoroughly investigate this relationship. The Company believes that any issues associated with the ownership of Beijing Pingxiu, or the utilization of other export trading companies, have had no material impact on the economics of inventory purchases. 
Further, the report alleges that the Company’s vendors are compensated in some form through stock transfers. The Company can confirm that there have been no issuances or transfers of stock from the Company or inside shareholders to any vendors or to Beijing Pingxiu.

In it the company denies accounting irregularities and confirms that they use intermediate export trading companies to buy their tiles.

Then they sort-of-confirm the show-stopper allegation. They confirm that there is an "ownership" issue with Beijing Pingxiu that were not previously disclosed to the company. It sounds like a related party, but they do not confirm that the related party is the CEO's brother in law (as per the Gotham allegation).

That said, having confirmed an undisclosed "ownership" issue they state that they do not believe this has had a material impact on the economics of inventory purchases. [In the Crazy Eddie case it may not have had an impact on the economics of purchases - but it sure had an impact on the accounting of purchases - but that is a digression.]

Still we now know that someone failed to disclose a material relationship ("ownership") in a major (maybe the major) supplier.

We know there is at least one cockroach. It looks to me to be a very big cockroach.

Actions for the board of Tile Shop Holdings

Gotham allege that the related party to Beijing Pingxiu is the CEO (or at least his family).

If this was not disclosed the board has a problem - they cannot be sure the CEO is trustworthy.

For a board that is a very difficult situation - one I would not envy.

The board should stand the CEO aside - at least temporarily whilst outside lawyers do an investigation.

The company has announced an intention to "thoroughly investigate". There are processes for doing this. And this board has reputable people on it who have reputations to defend - so I expect it to be done.



Black Sambo said...

Interesting. So I understand better - in what way is the "fake inventory" said to have helped the company? From memory, in the Crazy Eddies case they received the inventory pre-financial year end but didn't have to pay for it or, were billed for it post-financial year end, - hence inflating their profits by the value of that inventory. Is that the allegation here, John? Or is it that the inventory doesn't exist at all and there are fake profits as a result (which the audit should catch due to lack of cash etc).

Thanks in advance.

On a similar note, your post reminded me of Sino Forest. One of the MW allegations, which sounded very convincing, was that the forests didn't exist (or that SF didn't have title to the forests). I think that is how it has been portrayed in the popular media. However, the reality is a bit different. The forests certainly existed (very poor quality wood however), and often SF did not in fact have title (as MW pointed out). But, SF did have contractual rights to the timber. I never knew if MW didn't know this or were a bit cute as to how they reported it. Obviously, the structure was a different matter and the bigger issue. I think the bond holders will struggle to recover much now in any event. Whomever is paying 30-35 cents is dreaming if they think they will recover anything in China (and good luck getting the $600m tax refund owed to SF!).


Black Sambo

ps good to see you back bloggin'

Ed said...

Some thoughts from someone with no position but who has refitted many bathrooms in his time.

In the UK, we also have big box DIY/building stores (principally B&Q and Homebase, with Wickes being aimed at trade but open to the public too). We also have specialist tile stores (Topps Tiles is one) and some of those are superstore sized.

I'm not sure I agree that tiles are comparable directly with other building materials. There will be some landlords who just want the cheapest ceramic tile that's not going to give him any cracking or recoating issues, and will be happy to go with something from the economy selection at Wickes. These are probably the cheapest tiles it's possible to get.

But tiles can easily be 30% of the cost of a bathroom renovation, and that's without getting into marble or other fancy materials. If you have a large bathroom and a wife who fell in love with the floor-to-ceiling bathroom tiles she saw in that five star hotel it can easily reach 50% or more. Tiles done wrong can detract from a $10-15k remodel, as can the 'wrong' tiles. You can't just paint over them like you can the wrong paint.

If you care at all about the final product (and given how much a decent remodel can add to the value of the house, people will), it is not enough to a) rely on the small selection carried by a general building material store. UK stores often supplement their small stocks with catalogues, but this is inconvenient and catalogues lie (and people know this). For the same reason, online tile stores, which should be eating the lunch of tile specialists AND general stores, face an uphill battle in convincing anyone to pay £1-3k, sight unseen. Tiles, unlike say wooden flooring, don't lend themselves as well to the free sample game either that some websites have adopted. The best they can hope for is someone going into Topps et al and then ordering online, but can you trust that they're going to be exactly the same? Topps brand most of their tiles themselves, so you can't tell the underlying manufacturer.

Tile manufacturers are the only place you can go where you can see 500+ tiles, properly grouted and hanging vertically as they would be on your walls. They have got very good delivery mechanisms, keeping costs down by shipping locally rather than from a central warehouse (tiles are super heavy in any number). They are the only place that offer decent advice on how to maintain your very expensive travertine tiles - the general stores hire work experience kids on minimum wage who can point you in the right direction but aren't tile experts (or wood experts or gardening experts etc.). The tile specialists will let you take some home to hold up against the wall while your wife decides which shade of white is appropriate. This isn't worth the headache for B&Q et al.

In short, tiles are a big and expensive decision and one of the few building materials that need to be seen in situ before purchase. The big box stores and online do not yet come close to competing except for the very design agnostic (read: lowest margin) customers.

Full disclosure: no position, but made a tidy profit in the past on houses remodelled with nice tiles!

DJ said...

John - always interesting to get your thoughts but the last comment on the board having "reputable people...with reputations to defend"...from Enron?

No Mean Sum said...


Very nice summary. Do you have any opinion on the allegations made by Gotham Research that the related party vendors were compensated with some form of equity in TTS?

Thank in advance.

Brian G said...

Having recently done some tiling in a new kitchen renovation, I have to agree wholeheartdly with Ed's comments.

We wanted better tiles and the Tile Shop had a great selection and we could see them deployed in setting.

Given that they have a larger selection and HIGHER prices, one would expect from just price alone that inventory will be valued higher.

That being said, it could still be a fraud for the reasons mentioned but I do not believe that the argument that they should die only because they are specialized is correct in this case.


Brian Grad

Anonymous said...

Very interesting article. But, as a Londoner, I can tell you that you're slightly off message in contemporary bathroom style - nowadays you are supposed to have different taps in each bathroom/toilet.....

So no need to replace them all anyway.....

Anonymous said...

Topps Tiles listed in the UK should be a pretty reasonable comp. Topps is a similar sized specialty tile chain store and ought to have very similar financial characteristics. Topps has inventory days of 135 vs. Tile Shop now over 400.

Zack said...

The issue is the undisclosed related party transaction.

This is a DE company. Delaware Law provides explicit safe harbors for such related-party transactions in section 144

CEO and his brother in law elected not to use them.

Audit Committee of TTS then chose to adopt more restrictive safe-harbors than those provided by the DGCL.

CEO and his brother elected not to use those either.

Read into that what you will. I don't think there's a read that provides much comfort that the activities engaged in were above-board and GAAP-compliant.

PeterBCPA said...

I like your analysis. Superstore for tiles? How many tiles can people buy? It's the same reason I always new Borders would fail. How many books can you sell (read?) with superstores filled with slow turnover books collecting dust.

Nick said...

Ed's right - we destination shop the hell out of tile shops in the UK.
I have happily driven over an hour just to check one place out.

I haven't checked the valuation but I would be happily long Topps owing to the housing situation in the UK (transactions bottoming, government stimulus).

Also Peter, while you might think you clever analysis of Borders gave you a slam dunk short, in reality you should be thanking Jeff Bezos.

Anonymous said...

akwayst278I found Topps with a search and it's about the only publicly traded pure play tile comp. The TTS margins are not way out of whack compd to Topps but the DIO is inexplicable. TTS regularly over years runs in excess of 310 days with the most recent Q at around 386 days. Topps runs around 120-130 days. How can TTS survive in a competitive business with turns like this. Add to that the opening of another distribution center that management said was #3 in the CC but is actually #4 according to filings and we have to wonder why--soak up some extra inventory. It is in Oklahoma and easily serves only 2 stores. it's a crazy expansion with the concentration of their 80 stores in the East, midwest and south. All in all even if the related party thing is irrelevant the way they manage the business is nuts

Topps Tiles

Margins 2012 2011 2010

Gross 60.0% 59.6% 58.8%
Operating 8.7% 10.4% 11.6%
Net 5.5% 3.3% 5.5%

Tile Shop margins


2012 2011 2010 2009 2008

Gross 72.8% 73.6% 73.3% 72.7% 71.4%
Operating 18.8% 21.4% 22.7% 21.0% 19.7%
Net 17.1% 20.5% 22.0% 20.0% 19.1%


09/2013 06/2013 03/2013 12/2012

Gross 70.1% 70.3% 71.1% 72.7%
Operating 13.4% 18.0% 21.1% 16.2%
Net 7.1% 6.2% 12.0% 9.7%

the tables are not formattable but the info is there

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