Is Tile Shop Holdings Damaged Goods?

Shares of Tile Shop (TTSH -2.26%) fell more than 50% last week on fraud accusations by short-selling investing firm Gotham City Research. Gotham City's report focused on inflated inventory and an undisclosed family relationship with Tile Shop's largest supplier, Beijing Pingxiu. In addition, Gotham City has also accused Tile Shop of the following:

1. It has used shady auditing practices. It has used three different auditing firms in two years, and no one on its audit committee has a CPA or an accounting background. The company also did not have a CFO at the time of its IPO.
2. A major shareholder was on Enron's board.
3. Another short seller, Infitialis Research Collective, found in its investigations that some of Tile Shop's tile contained an unsafe level of lead contamination.
4. CEO Bob Rucker misrepresented Tile Shop's financial projection during his 2001 divorce proceedings.
5. The company entered public markets through a SPAC, or special-purpose acquisition company, a method some fraudulent companies have used.

Through its findings, Gotham City has asserted that the fair value of Tile Shop shares is about $3, its earnings over the last 12 months were overstated by 200%, and that the company will be forced to restate several years of financial results.

Here are the details investors need to understand in the report.

Excessive inventory
Gotham City's central argument is that Tile Shop is overstating its inventory so it can understate its cost of goods sold expense. As evidence, Gotham City points out that the retailer's days sales of inventory (DSI) -- or the number of days its average inventory sits in its possession -- has reached 414 as of its last quarterly report. This is unusually high, and as a current asset, inventory must be converted to cash within a year according to generally accepted accounting principles.

However, Gotham City's methodology is incorrect, as it does not take the average inventory held over the last year, instead using ending inventory. When applying the average inventory, DSI falls to 325 and has declined over the past three years. While that figure is still high, it is not nearly as much of a concern, considering that Tile Shop is a rapidly expanding business, growing sales by about 30% a year. Naturally, the chain needs to stock up on inventory before it can open new stores.

Gotham City believes Tile Shop has overstated its TTM inventory and therefore its earnings by $19 million, meaning its actual earnings over the last year are $9 million instead of $28 million. However, this claim seems spurious, considering that, proportionally, inventory levels are falling.

In addition to the excessive inventory levels on Tile Shop's books, Gotham City notes that its gross margins seem abnormally high, a logical result of understating cost of goods sold, as its gross margin hovers above 70%.

The chart below shows how that figure compares with some of Tile Shop's home-improvement retailing peers.

Source: Yahoo! Finance, Gotham City Report.

Notably, Tile Shop's current competitors all have gross margins within the same tight range at less than half of Tile Shop's rate. In retail, margins above 50% are rare, as the majority of expenses are generally products and labor. Even luxury retailer Tiffany, with the added benefit of its brand, has a gross margin of just 55.2%.

However, once again, there seems to be an explanation for this that Gotham City overlooked, either deliberately or accidentally.

Topp's Tiles, a U.K.-based tile retailer, has gross margins near 60%. Both it and Tile Shop pay sales associates by commission, meaning their expenses fall into the selling, general, and administrative category rather than COGS, where labor expenses are typically found. As it explains in its 10-K report, payroll costs at Tile Shop account for about half of SG&A, or a quarter of revenue.

Undisclosed related third party
Perhaps the biggest red flag in Gotham City's report was the revelation that Tile Shop's biggest supplier, Beijing Pingxiu (BP), is owned by CEO Rucker's brother-in-law, Fumitake Nishi. In its report, Gotham City suggests that Beijing Pingxiu has sold goods to Tile Shop at near cost, and that its special relationship with BP has allowed it to manipulate its inventory levels. Finally, it alleges that BP is compensated through gains in Tile Shop's stock price, a claim that Tile Shop flatly denied. Tile Shop makes no reference to this relationship in its SEC filings. Gotham City also visited addresses that Beijing Pingxiu claimed and said there was no presence of the company there.

While the large inventory seems possible for a company growing at Tile Shop's rate -- analysts expect sales growth of 30% next year -- the undisclosed familial relationship seems suspicious.

Tile Shop's defense
After Gotham City released its findings last Thursday morning, Tile Shop responded that afternoon, saying it "adamantly denies these allegations and believes that the financial statements are properly stated and its business practices are appropriate." The retailer went on to explain that it negotiates all inventory directly with each vendor and that Chinese vendors often use an export trading company, such as Beijing Pingxiu.

Beijing Pingxiu is not a direct supplier, but simply an export licensee.

However, regarding the supposed familial ownership, Tile Shop's statements were more cryptic. The retailer said, "The Company has been made aware of the ownership of Beijing Pingxiu, which were not previously disclosed to the Company. As a result of this disclosure, The Company has suspended its relationship with this entity." It added that it would investigate that relationship, and said it doesn't believe those issues have had any "material impact on the economics of inventory purchases." Tile Shop also maintained its full-year guidance.

On the key question of Rucker and Nishi's relationship, Tile Shop ducked. It's hard to believe that the CEO would be unaware that his own brother-in-law owned a partner business. Tile Shop needs to clear up this discrepancy before investors can be fully confident in management again. Expect more clarification on that as it seems hard to trust Tile Shop's management until that issue is cleared up.

Foolish bottom line
While Gotham City's report seems to be overzealous on some fronts, the relationship between Beijing Pingxiu and Tile Shop needs further explanation. As long as that relationship remains a question mark, Gotham City's other questions will resonate within the market as one unscrupulous thing leads to others. Tile Shop does not seem to be manipulating its inventory, but if it has purposefully neglected to disclose the relationship between Rucker and Nishi, investors may be justified in thinking that there is more information the company is hiding from them. Hopefully, Tile Shop will act quickly to confront these concerns directly and offer an adequate response to Gotham City's accusations. If not, the share price is likely to continue to be depressed.