Tile Installing Floor Tiles
More DIYers and professionals alike are choosing Tile Shop lately. Image source: Getty Images.

Specialty retailer Tile Shop Hldgs, Inc. (NASDAQ:TTS) reported another excellent quarter on July 19, delivering double-digit revenue growth, a huge 53% jump in net income, and solid improvements in sales at stores open more than one year. Sure, a lot of the sales growth is related to a rebound in the housing market and a stronger economy, but the company's management, led by CEO Chris Homeister, has done an excellent job of allocating resources to better support the stores, while actually lowering costs overall as a percent of sales. 

But at the same time, there's one lingering question that comes back to me every quarter: Is the company missing out on an excellent opportunity to accelerate growth right now? After all, Tile Shop will only open about half as many new stores this year as it did in 2014, and there's no doubt that demand is measurably better now. 

Frankly, it's not a simple answer. After all, there's a big reason management took its foot off the store count-growth gas pedal, and I'll address that below. Let's take a closer look at the company's second-quarter earnings report. 

The numbers

MetricQ2 2016Q2 2015Change
Revenue  $84.3  $75.7 11%
Net income  $6.8  $4.5 53%
Gross margin %  69.7%  67.8%  +190 BPS
Earnings per share  $0.13  $0.09 44%
Comparable-store sales  8.2%  5.7%  +250 BPS

Revenue and net income in millions. Data source: Tile Shop earnings release.

Keys to the strong quarter

Tile Shop didn't just grow sales and margins solely because it sold more stuff per store. A lot of the progress was a product of strategic focus on key areas, particularly improving the company's operating structure and strengthening the balance sheet. 

  • Sales, general, & administrative expense increased $4.1 million, but they actually fell as a percent of revenue, from 56.6% last year to 55.8%. At the same time, the company has allocated more resources to the stores, adding market manager and senior assistant store manager positions over the past year, helping the company retain top talent and reduce store-level turnover. This has almost certainly benefited sales as well, especially with home improvement professionals. 
  • On the earnings call, CEO Chris Homeister said  sales growth to professionals "soundly outpaced" overall sales growth.
  • Total long-term debt was $24.9 million, down from $36 million at the start of the quarter and $51.2 million at the beginning of 2016. Interest expense was $450,000, down from $795,000 last year. So far in 2016, Tile Shop has saved $580,000 in interest expense. 
  • Cash and equivalents was $13.4 million, down from $16 million at the start of the quarter, but up from $10.3 million at the beginning of 2016. 
  • The company opened three new stores in the quarter, after opening one new store in the first quarter. Management says it will open 10-12 total new stores for the full year. Management said the capital outlay for its last six stores was 20% lower than the $1.4 million historical average cost. 
  • CEO Chris Homeister said the company has generated $29 million in free cash flow this year. After generating $21 million in Q1, that puts the total at $8 million in free cash flow in the second quarter. 

Pay down debt or more aggressively expand? Management has decided the balance sheet is more important for now

The housing and home improvement market is doing incredibly well right now, and Tile Shop isn't the only company benefiting. When home improvement giant Home Depot Inc (NYSE:HD) reported earnings in May, the company increased its guidance for the full year. The company said it expected to grow total revenue 6.3% for the full year, with comparable sales growth of 4.9% driving most of that increase.

Home Depot is a much larger and more mature business than Tile Shop, with thousands of stores selling everything related to home improvement, compared to Tile Shop's 117 stores focusing on a single product category. Considering the company's strong growth expectations, it's clear that now's a great time to be in the home improvement business. 

But since taking charge of the company at the start of 2015, Chris Homeister has taken a more conservative approach to growing Tile Shop, and has instead invested in operations, existing stores and employees, and reducing debt. At the end of 2014, Tile Shop had more than $92 million in long-term debt and had opened 19 stores that year. 

As of this writing, the company has significantly reduced its debt (and the costs associated with it), at least partly by opening fewer new stores than in prior years. But there's more to it from a big-picture perspective.

Yes, there's some missed opportunity to "strike while the iron is hot" and aggressively expand now. But at the same time, housing-related industries can be very cyclical. It appears Homeister has decided it is more important to build a better operating business with a strong balance sheet while business is good than to use debt leverage to expand, and potentially leave the company exposed in a sudden and unexpected downturn in the housing industry. 

Looking ahead

While only history will judge whether or not the slowed rate of expansion was a "missed" opportunity or not, it's hard to argue that building a stronger business is a mistake. It's almost certainly going to put Tile Shop in a better position to ride out the next eventual cyclical downturn -- whether it happens next year or next decade. This much is clear: Tile Shop is a stronger company 18 months into Homeister's tenure than it was when he first took over. 

Looking at the full-year expectations, company guidance was largely unchanged from last quarter, with only minor upticks in bottom-range guidance for revenue, earnings, and store count growth. Management expects $322 million to $329 million in sales, "mid to high single digit" comps growth, $0.41-$0.45 non-GAAP earnings per share, and 10-12 new stores to be opened by the end of 2016. 

Jason Hall owns shares of Tile Shop Holdings. The Motley Fool owns shares of and recommends Tile Shop Holdings. The Motley Fool recommends Home Depot. 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.