Should You Bet on the Action at Tile Shop Holdings?

Should You Bet on the Action at Tile Shop Holdings?

Tile Shop Holdings has taken a page from Lumber Liquidators' playbook, proving that small and specialized works as well in tiles as it does in lumber. Like the rest of the home-improvement industry, the company has benefited from a rebounding housing market, with the National Association of Realtors' October report showing continued year-over-year gains in sales volumes and prices for the existing home market.

However, Tile Shop's shares were hit hard this week by a short-seller's allegations of accounting improprieties on the part of management, specifically with regard to related party transactions. So, is it a good time for investors to get in?

What's the value?
In just 10 years, Tile Shop has built a considerable presence in the tile business, currently operating 80 locations that are spread across the Eastern and Midwestern portions of the U.S. The company enjoys a strong gross margin, greater than 70%, which allows it to spend liberally on store overhead, offering "high-touch" showrooms that have an average of 60 room mockups and 1,400 product display presentations.

Tile Shop's solid operating profitability has also allowed it to build a growing operating footprint, recently opening its fourth distribution center that will allow it to push as far west as Colorado.

In fiscal year 2013, Tile Shop posted solid top-line growth, up 25.9%, aided by a double-digit comparable-store sales increase and an expansion of its store network. It has benefited from rising home prices and improved disposable incomes, both of which have led consumers to pursue value-enhancing tiling projects and to increasingly choose higher-priced stone materials, accounting for more than half of Tile Shop's total sales.

While profitability has slipped in the current period, due to rising material costs and sales promotions, the company's operating margin in the high-teens range has given it room to expand its marketing beyond a traditional word-of-mouth network.

Where there's smoke
In the midst of the storm, management tried to quell investor nerves this week by reiterating its guidance for 2013 sales of between $227 million and $237 million, as well as its plans to deliver on its goal of opening 20 new stores in the current year.

Despite the reassurance, investors might want to avoid this fast-growing housing play, given what seems to be weakness in its internal control processes. A more conservative play would be the home-improvement duopoly, Home Depot and Lowe's , which are the primary beneficiaries of the government's programs to push housing prices higher.

Home Depot, the world's largest home-improvement retailer, has been getting back to basics through its Customer First program, which aims to devote 60% of each store's labor hours to customer servicing duties. The company is also trying to solidify its relationships with customers by offering more installation and project management capabilities, including its MyInstall website, which provides real-time updates on project schedules and to-do lists.

While the company's store concept doesn't work everywhere, as evidenced by its decision to close its China stores in 2012, it is gaining traction in Mexico, where it surpassed 100 stores last year.

In fiscal year 2013, Home Depot has enjoyed a solid operating performance, with a top-line gain of 8.2% that benefited from strong comparable-store sales. The company's profitability has increased at an even faster clip, up 23.1%, due to both rising average product prices and the positive effects of its store productivity initiatives. The net result has been significant operating cash flow, $6.0 billion in the current period, which has provided Home Depot with excess capital that it is returning to shareholders through large repurchases.

Meanwhile, Lowe's has generated a performance that is a virtual carbon copy of its larger competitor, reporting a top-line gain of 5.8% in fiscal year 2013 that was a function of higher comparable-store sales. Like Home Depot, Lowe's is trying to form tighter bonds with its customers in all sales channels, as highlighted by its MyLowes website, which allows customers to build home profiles and have easy access to their purchasing history.

The company is similarly producing prodigious operating cash flow, $3.9 billion in the current period, which it is also returning to shareholders through share repurchases.

The bottom line
Tile Shop is well-positioned in a highly profitable niche of the home-improvement business, but it shot itself in the foot with its internal control issues. The old adage "Where there's smoke, there's fire" seems to apply here, meaning that investors should steer clear of this small-cap story until the smoke clears. Home Depot and Lowe's aren't growth stories, as evidenced by their return of capital activities, but they are generating high returns on capital and enjoy solid business moats with their unrivaled store networks.

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Fool contributor Robert Hanley has no position in any stocks mentioned. The Motley Fool recommends Home Depot and Tile Shop Holdings. The Motley Fool owns shares of Tile Shop Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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