The latest buy for my Special Situations portfolio is Tile Shop . The business recently went public through a special purpose acquisition company, or SPAC, backdooring into the public market. The company is rapidly growing and is largely undiscovered by investors. The valuation doesn't exactly sit in traditional value territory, but I think the market still undervalues its prospects based on a few technical factors, which I'll explain below. So tomorrow I'll put $1,500 to work in the Tile Shop.
Tile Shop runs a chain of 66 eponymously named stores in the Midwest, Northeast, and Mid-Atlantic. The company sells over 4,000 types of tile and stone flooring in its retail locations, which average about 23,000 square feet. Tile Shop sources materials directly from a wide array of producers across the world, providing a range of choice that mass-market rivals such as Home Depot and Lowe's can't offer.
Of course, that doesn't mean the big-box stores aren't key competitors. But where they take a shotgun approach to inventory -- wide range and little depth -- Tile Shop does the reverse: focus on one niche of flooring and then acres of selection. And they complement it with high levels of customer service. In its focus, Tile Shop takes a similar approach to Lumber Liquidators , which is profitably exploiting its niche of wood flooring in the face of big-box rivals. The growth profile of Lumber Liquidators offers a reasonable proxy for what Tile Shop could do.
Tile Shop is expanding quickly. The company added 13 locations this year, for a total of 66 stores, and aims for at least 15 more next year. That unit growth of 23% should add to earnings rapidly, because the store economics are fantastic. On average, a store costs $1.4 million to set up, but it returns an average 40% for the first three years, and the initial investment is repaid in about 2.5 years. The per-store adjusted EBITDA comes in at a very high 28%. In fact, these stores generate so much cash, that this company can fund its growth internally and still have free cash flow left over. Same-store sales have been phenomenal, with more than 10 straight quarters of gains.
In a few years, the company should be able to double store count, and that's a huge tailwind. It's led by founder Robert Rucker, who has grown the store from its original location over 20 years ago.
What's the special situation?
Tile Shop's entrance into the public market via SPAC was efficient, but it means the company is underfollowed by Wall Street analysts. And that's a critical point here. With few Street analysts following every move -- just three right now! -- it means that the stock can be mispriced. This is a key advantage. Wall Street just doesn't have the incentive yet to pump this stock, and so the lowdown is still on the down low. We want to be in this stock before every investment bank is issuing strong buys on this growth opportunity. This informational advantage is exactly the type of thing I try to exploit in my other, more traditional special situations, such as spinoffs.
One of my concerns here is the concentrated share ownership in Tile Shop. Nabron International holds 35% of the shares, and it's unclear what their objective or strategy is. In fact, it's unclear who Nabron is at all, since no information is available. In this regard, I'm pleased to see another insider owning a huge chunk of shares, founder and CEO Robert Rucker at 17%, which gives me confidence in the company's non-traditional IPO route. Earlier this month, we saw these shareholders and another director unload 4.6 million shares at $15 per share in a secondary offering. Any significant sales could put pressure on the share price, but each still maintains a sizable stake in the company.
Tile Shop also has warrants for 17.8 million shares available at an exercise price of $11.50. These are in the money currently, so we should expect dilution. But that would raise more money for the company to expand. If the stock trades above $18 for 20 or more consecutive days, the company could force warrantholders to redeem their shares. This could be a source of downward pressure.
My final concern here is also short-term in nature. I do not expect Tile Shop to grow its profit at all in 2013. That's a function of the costs of being public, but more importantly the emergence of Tile Shop as a full-income-tax-paying corporation. Where its tax rate was around 5% as a private company, it will approach 35% in 2013, eating up any profit growth that the company will see. After that we should see rapid earnings growth. The market may not like this when it becomes more widely known. But this is a short-term issue, and we need to think three to five years out. Any price weakness could offer an excellent buying opportunity, and I would be interested in buying more.
Foolish bottom line
Tile Shop is not your traditional special situation, though I think it has some of the key features that make a great investment -- small size, significant room to ramp operations, and underfollowed by Wall Street. With all these interesting features, my Special Situations portfolio will buy $1,500 of Tile Shop shares tomorrow.
The article It's Time to Put Real Money on Tile Shop originally appeared on Fool.com.
Jim Royal does not own shares of any company mentioned. Motley Fool newsletter services have recommended buying shares of Home Depot and Lumber Liquidators Holdings. Motley Fool newsletter services have recommended writing covered calls on Lowe's. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.