Tile Shop Holdings Largely Exonerates Itself

With allegations of fraud swirling around it, the tile company gives itself a clean bill of health.

Jan 29, 2014 at 9:22AM

Well, all's well that ends well, right? The consumer tile seller that was accused of fraud late last year has conducted an investigation into the allegations and not surprisingly said this week that although there were some problems, it's largely the other guy's fault and it's back to business as usual.

But maybe Tile Shop (NASDAQ:TTS) is a little too willing to pin the blame on others and dodge any responsibility.

As investors probably know by now, noted short-seller Gotham City Research issued an explosive report last November alleging (among other things) that Tile Shop inflated its inventory, exaggerated earnings, and failed to disclose that the brother-in-law of its CEO was its biggest supplier, an individual who then also received kickbacks -- er, "consulting fees" -- from Tile Shop vendors. The combined result was vastly overstated profits and margins that, now uncovered, would lead to financial restatements and a substantial reset of the stock's price.

The effect of the report was twofold: Tile Shop's stock did lose roughly 30% of its value, and the company launched an internal investigation of the allegations.

As the Fool's Jeremy Bowman detailed, though, Gotham may have engaged in fuzzy math to arrive at some of its conclusions, while inflated margins and some other key points of contention are at least partially defensible. For example, because Tile Shop salespeople work on commission, many of the costs associated with sales drop down a line or two on the balance sheet from the cost of goods sold to SG&A, so gross margin would appear higher than rivals'. But Jeremy acknowledged that the claim of ignorance about the relationship between the supplier and Tile Shop's CEO is sketchy, and when it comes to these kinds of situations, investors are willing to believe where there's smoke there's fire.

Internal reviews are de rigeuer for companies accused of fraud, and by and large they end up clearing the company of any misdeeds. So you have to give Tile Shop some credit for admitting an undisclosed third-party relationship, then firing the brother-in-law and severing business ties with his company. But that was the easy outcome; management couldn't much hide the relationship at this point, so it had to be jettisoned. It's the rest of the report that is concerning because it essentially absolves Tile Shop of any fault. Heck, it even blamed the brother-in-law of failing to disclose his ownership of the supplier business, as if the CEO was shocked, shocked! to learn of it as well.

The mea culpa also provided preliminary financial results that showed sales, which had been growing at a strong 16% annual clip over the past three years and were up 25% over the last 12 months, suddenly ran into a wall of resistance mid-November. While it expects fourth-quarter revenue to come in 26% higher than last year, the company noted that revenue tailed off sharply in the last two months -- to the point that Tile Shop was barely able to make the low end of guidance. Gross margin is also an anomaly, since despite being reliably above 70% for the past few years -- this was what attracted Gotham's notice in the first place -- it will now come in at some undisclosed lower level.

Although much of the broad retail market also encountered a difficult Christmas selling season, it has actually faced these headwinds for several years running, which is part of the reason retailers pulled out all the stops this past year, by starting promotions earlier than ever, opening up on Thanksgiving Day itself, and running 'round-the-clock shopping marathons right up till Christmas Day -- all to little effect. Tile Shop, though, has been remarkably resilient in fending off those buffeting currents, except this past year at the exact time its shady dealings became publicized. Maybe it's coincidence, but the timing of the problems are curious.

Sometimes companies accused of malfeasance receive a measure of vindication in their claims of innocence. Silvercorp Metals, for instance, has survived long enough to see its accuser pursued for false statements and misrepresentations in an effort to profit at the miner's expense. Whether Tile Shop Holdings can similarly use this report to plaster over investor distrust connected to the allegations remains to be seen, but with trial attorneys pursuing class action lawsuits against the tile company, the fallout from the misdeeds -- whether it admits to them or not -- will be felt for some time to come.

A straight shooter
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Fool contributor Rich Duprey has no position in any stocks mentioned. The Motley Fool recommends 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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