It's Time to Put Real Money on Tile Shop

The latest buy for my Special Situations portfolio is Tile Shop (NASDAQ: TTS  ) . 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.

The business
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 (NYSE: HD  ) and Lowe's (NYSE: LOW  ) 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 (NYSE: LL  ) , 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.

Risks
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.

Interested in Tile Shop or have another stock to share? Join me on my discussion board and follow me on Twitter (@TMFRoyal).


Read/Post Comments (5) | Recommend This Article (13)

Comments from our Foolish Readers

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  • Report this Comment On December 27, 2012, at 5:51 PM, MazonCreekRich wrote:

    I have enjoyed your investment thoughts, and appreciate your willingness to share them.

    In the sense of appreciation and an effort to give something back, let me point out that I see a constellation of facts here (for TTS) that gives me pause and is probably sufficient to cause me to eschew this potential investment. The relevant facts are:

    A1. TTS went public through the SPAC procedure – back door IPO techniques have been revealed in recent times to be a breeding ground for bad behavior and the avoidance of scrutiny (see numerous Chinese small cap companies listing in the US through this back-door method. See also, e.g., http://money.msn.com/top-stocks/post.aspx?post=eb2ab25b-4959... ;

    A2. Large owner Nabron International, a key participant in the back door IPO, is a Bahamas corporation about which nothing is known – this kind of privacy may well signal an unsavory foreign partner (or it may not, but I am leery of foreign owners seeking to avoid the spotlight, since they could well be people with whom I do not want to associate – I am willing to tell my partners who I am; why aren’t they?).

    A3 Finally, Rucker (the CEO) has a history of fraud and misrepresentation, albeit in a domestic dispute scenario, as evidence by the following excerpt from a court opinion:

    <i>Respondent Katherine M. Rucker successfully sued her ex-husband, Robert Rucker, for fraud on the court committed during a dissolution of marriage action. The trial court found that in the dissolution action Robert Rucker engaged in an intentional course of material misrepresentation and non-disclosure concerning the value of his business interest in The Tile Shop that resulted in a grossly unfair‖ property settlement.</i>

    http://lawyersusaonline.com/wp-files/pdfs-3/rucker-v-schmidt...

    To sum it up, we are looking at a company run by a guy who has been held by a court to have committed economic fraud and misrepresentation, who teamed up with a mysterious foreign corporation with undisclosed owners to go public through a back door technique that avoids scrutiny, in a way similar to techniques that have frequently been used by fraudulent Chinese companies in recent years.

    I think I prefer to take other types of risk. But of course YOMD.

    Best regards,

    Rich

    Mazon Creek Rich

  • Report this Comment On December 27, 2012, at 6:29 PM, buylowersellhigh wrote:

    Thanks for the information Rich. Insightful.

  • Report this Comment On December 27, 2012, at 7:44 PM, TMFRoyal wrote:

    Thanks, Rich. And thanks for letting me know on the message board.

    I appreciate the point about the SPAC. I'm less concerned about that, however, because as you point out, it's a favored method for Chinese companies to go public. While it's still a bit of an unusual IPO situation in the U.S., otherwise reputable companies have used SPACs to go public or recapitalize (Talbot's, for example). If this were a Chinese company, this type of IPO would be a dealbreaker. In addition, while a backdoor technique, the SPAC had to undertake its diligence. This is not your typical reverse merger into a Nevada shell company.

    I've just learned more about Nabron. I'm not that concerned about their Bahamas/Monaco registry, since many reputable hedge funds are located offshore (plenty of shady ones, too!). But I do know now that Nabron is related to Morningside Private Investors and Peter Jacullo, a TTS board member. Jacullo and one of the wealthiest Hong Kong families (the Chans) co-founded Morningside in 1987. (That may add more fuel to your fire, Rich). They appear to have gotten in TTS back in 2011.

    Thanks for the info on the CEO. While in a different context, as you admit, it doesn't look much better. I'm always unsure how to factor this type of information into my evaluation. It just ends up being a qualitative factor that I try to keep in the back of my mind as I judge subsequent events.

    Thanks again for your post.

    Jim

  • Report this Comment On December 27, 2012, at 8:22 PM, MazonCreekRich wrote:

    Thanks Jim!

    Congratulations on your research skills; I was unable to dig up much of anything on Nabron. I actually think you have uncovered some very important information, because the Chan family is IMO reputable, competent and likely to be ethical, although not necessarily shareholder-oriented in the Jim Sinegal sense (which is, let’s face it, sort of an impossibly high standard). So this really addresses a significant chunk of my concerns.

    Now I need to ponder for a while . . . .

    Best regards,

    Rich

  • Report this Comment On June 06, 2013, at 12:47 AM, MartinSamuelson wrote:

    I realize it's 6 months later, but here is more info on that divorce fraud case: http://caselaw.findlaw.com/mn-supreme-court/1551603.html

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