Should We Invest in Tile Shop After its Significant Drop?

Tile Shop Holdingshas experienced some volatility in the past few days. First it got smashed on the market, falling from more than $21 per share to only $10.40 per share, then it went back up to $14.50 per share at the time of writing. The main reason for this drop was a recent report from Gotham City Research which stated that Tile Shop overstated its earnings by as much as 200%. Should investors stay away from Tile Shop, or consider this drop a buying opportunity?

Highest EBITDA margin in the industry 
Tile Shop currently operates 83 stores in 28 states and has four distribution centers in the Midwest and Mid-Atlantic U.S. The company has around 4,500 stock keeping units, or SKUs, of ceramic tile, stone tile, and other related accessories. Stone products are the biggest revenue contributor and account for 53% of the company's total sales. Ceramic products represent around 30% of sales, while setting and maintenance products represent around 17% of total sales. 

Investors had been quite impressed with the company's high margins. In the past four years, Tile Shop delivered the highest EBITDA, or earnings before interest, taxes, depreciation, and amortization, margin in the industry, much higher than Home Depot and Lowe's. According to the company's November presentation, its EBITDA margin was 26% for the past twelve months. With trailing EBITDA of more than $5.54 billion, Lowe's EBITDA margin was much lower at only 10.70%. Home Depot's EBITDA margin was in-between these at around 13.20%.

Sales were overstated by 200%
However, Gotham City Research released a report which argues that Tile Shop's margin will deteriorate through 2014 because the company will have to restate several years of historical financial statements. The report claims that Tile Shop's earnings have been overstated by more than 200% because of huge related party transactions with its largest supplier, Beijing Pingxiu. According to Gotham City Research, Beijing Pingxiu, which accounted for 20%-30% of the company's cost of goods sold, was controlled by the CEO's brother-in-law and another Tile Shop employee. 

Indeed, there are several red flags regarding the cash generating ability of Tile Shop. In the past four quarters, Tile Shop reported negative free cash flow of -$31 million, while the free cash flows of Home Depot and Lowe's were $6 billion and $3.36 billion, respectively. Moreover, Tile Shop's inventory grew at a much faster rate than its sales. In the third quarter, while Tile Shop's revenue increased by 28.2%, inventory rose by 53.3%.

Looking deeper, the main growth in inventory was the rise in finished goods, from $39.4 million in December 2012 to $59.5 million in September 2013. The higher level of finished goods indicates a slowdown in sales and weakened cash generating ability. Better scenarios occurred at Home Depot and Lowe's. Home Depot reported 9.5% revenue growth, but its inventory increased by only 1.6%. Lowe's revenue soared more than 10%, but inventory climbed up only 4.7%.

My Foolish take
Whenever inventory grows much faster than sales, there will be a much higher probability that the company will have to write down its inventory soon. I am not sure about Tile Shop's relationship with one of its largest suppliers in China, but the high growth in the level of finished goods in the recent quarter is definitely not a good sign. 

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Anh HOANG 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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