Tile Shop Holdings Looks Solid as a Rock

Almost two months ago, I singled out Tile Shop Holdings  (NASDAQ: TTS  ) as one of three great small-cap stocks with which many investors might not be familiar. After all, the high-end stone and tile specialist still had a market capitalization under $800 million at the time, and only just went public late last year.

Even so, the underlying business had grown from a single store in Minnesota nearly 30 years ago to 68 locations in 22 states. Better yet, the company was generating enough cash at the time to fund its accelerating expansion with free cash flow to spare.

In addition, Tile Shop's business is able to offer consumers low prices without sacrificing margin thanks to its ability to source products directly from quarries around the world, thus eliminating the middleman. Tile Shop also benefits from manufacturing its own line of adhesives, grouts, and other products required for the installation of its wares.

If that sounds familiar, it's because Tile Shop's hardwood counterpart in Lumber Liquidators (NYSE: LL  ) follows nearly the exact same business model by negotiating directly with the lumber mills which produce its products. Of course, this is also the same Lumber Liquidators that recently taught me a humbling lesson after I doubted its seemingly rich valuation.

In any case, as luck would have it, that also turned out to be a great time to buy shares of Tile Shop:

TTS Total Return Price Chart

TTS Total Return Price data by YCharts.

Despite the stock's 45% rise over the past two months, however, Tile Shop's rock-solid first-quarter results have me convinced now is not the time to take profits.

The numbers
When all was said and done in the first three months of the year, Tile Shop's net sales rose 23.9% from the year-ago period to $56.8 million, thanks to a combination of impressive comparable-store sales growth of 10.4% (or $4.8 million), and $6.2 million in new revenue from new locations. Adjusted EBITDA also grew 17.9% to $16.4 million from the same period last year, representing 28.8% of total sales, and income from operations came in at $12 million, or 21.1% of total sales.

On the expansion front, and thanks to strong operating cash flow of $18.3 million during the quarter, Tile Shop opened three new stores in the first quarter and one more so far in April. All told, that brings the company's total count to 72 locations in 23 states. Going forward, Tile Shop remains on track with its plans to operate 85 total stores by the end of 2013.

If that weren't good enough, management also stated the average cost of the new stores it's building is running around $1.35 million, which is less than the already-low $1.4 million the company projected last quarter. Better yet, each new location's average payback period -- or the time it takes for them to completely recoup their original investment -- has remained steady at just 2.5 years.

The downside?
As fellow Fool Jim Royal pointed out a few months ago, future shareholder dilution remains inevitable as Tile Shop still has in-the-money warrants outstanding. In fact, during this quarter's earnings conference call, management clarified that those warrants will ultimately be converted into 10.3 million new shares of Tile Shop common stock.

Even so, the company received a total of $86.4 million in cash to convert those warrants into shares, of which it used $30.1 million to repurchase some of the warrants in March. Of the remaining cash, $10 million will be used in operations and to reduce the company's current $67.2 million in debt, leaving $46.3 million available for... well... whatever the company's board decides is in the best interest of shareholders.

That said, considering the company's founding CEO Robert Rucker owns around 17% of all outstanding shares, you can rest assured Tile Shop will put that money to good use.

Foolish final thoughts
In the end, Tile Shop's business model is nice and simple, very profitable, and growing quickly. Combine that with a shareholder-friendly attitude and managers' interests that are aligned with our own, and this stock increasingly looks more Foolish (with a capital "f") by the day.

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