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.