After a Bad Start to 2014, Can Tile Shop Holdings Turn It Around?

Niche home improvement retailer Tile Shop Holdings (NASDAQ: TTS  ) continues to grow rapidly, with its store count increasing by a third over the past year, as it tries to build bulk in order to offset the size advantages of the industry's giants, Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) . Shareholders, though, are still waiting for the company's promise to pay off. Tile Shop's share price is down by more than 40% over the past twelve months, which includes a double-digit loss in 2014.

Unfortunately, Tile Shop's latest financial update didn't inspire much confidence; the company reported negative comparable-store sales growth and a decline in its adjusted operating profitability. However, with management expecting better results over the course of the year, is the company a good bet at current prices?

What's the value?
Tile Shop has found success by focusing on one product line, tiles, and offering a large product assortment that runs the gamut of material types; it has everything from stone and ceramic to stainless steel. The company has also created an interactive store format, complete with mockups and more than 1,000 display boards per store; this recipe has led to significant repeat business which accounts for approximately half of its total sales. The net result for Tile Shop has been a growing customer base and rising sales that have helped fund a more than doubling of its store base over the past five years.

In its latest fiscal year, Tile Shop continued building on its multi-year growth trajectory; this was highlighted by a 25.7% top-line gain that was an equal function of comparable-store sales growth and a double-digit expansion of its store network. While the company's adjusted operating income grew as well, its operating margin contracted sharply because of necessary sales promotions and greater support costs that resulted from its strategic moves into new markets like Texas and Arizona. Not surprisingly, the combination of lower profitability and inventory buildup for new stores led to a reduction in operating cash flow for Tile Shop, which puts into question the company's ability to sustain such a fast pace of store openings going forward.

The industry giants are cash-rich and looking for growth
Of course, Tile Shop is also dealing with a greater drive by the home improvement retail giants to capture more of their customers' project spending plans, of which tiling is undoubtedly a key component. Lowe's, in particular, has been aggressively going after sales in the area through its investments in its digital capabilities; its MyLowes application allows customers to create home profiles, to-do lists, and project timelines.

The company has also been focusing on the professional customer segment through its ProServices unit, likely with the hope of getting in the back door on some of its customers' home improvement projects. Lowe's is relaunching its dedicated website for the professional segment in the second quarter of fiscal 2014, which it expects to have upgraded features like enhanced pricing capabilities and a better interface with mobile devices. The company also has the luxury of being able to offer exclusive product pricing and credit offers to its professional customers thanks to the strength of its balance sheet, a competitive advantage relative to Tile Shop.

Not to be outdone, Home Depot is likewise focusing on the professional segment as it tries to find a higher sales trajectory; its top-line growth slipped to 2.9% in its latest fiscal quarter, roughly half the rate seen in the previous two fiscal years. The company recently unveiled a separate loyalty program for its professional segment, Pro Xtra, which includes order tracking, special pricing, and exclusive product offers. Home Depot has also been investing in its Red Beacon brand, which helps do-it-for-me customers find the right professionals for their individual project needs. Clearly, Home Depot's goal is to keep its customers' project spending within its customer network, thereby increasing the odds that the project materials will be bought at its stores rather than those of a competitor like Tile Shop.

The bottom line
Tile Shop is obviously cheaper than it was at the start of the year, but with a P/E multiple of approximately 61 it could hardly be described as a value play. Given Tile Shop's current negative trends in comparable-store sales and profit growth, prudent investors should wait for another quarter's worth of data prior to considering a position in this niche player.

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