When specialty tile retailer Tile Shop Holdings, Inc. (NASDAQ:TTS) surprised the market with preliminary third-quarter earnings on Oct. 2, investors responded by aggressively selling. Shares finished that day down about 36%, with nearly 12 times as many shares trading hands as a typical trading day for the company's stock.

The company announced its final results for the third quarter on Oct. 17, and they were in line with the preliminary numbers management said to expect a couple weeks back. The earnings provided a deeper look at the financials and operating performance, as well as what management has done and intends to do to improve sales and profits.

A person using a rubber mallet to install floor tile.

Image source: Getty Images.

Sales grew, but product mix and competition kept profits flat

Tile Shop reported $84.4 million in sales, a 7.5% increase year over year. Comparable sales -- that is, sales at stores open more than one year -- increased 1.1%, about $900,000, while sales from new stores increased $5 million. Net earnings of $0.05 per share was 45% lower than last year's third quarter.

There were two things that kept earnings from growing, despite a nearly 8% growth in revenues.

First, Tile Shop reported gross margin percent fell from 70.2% last year to 67.1% in the quarter. This was discussed in detail in the Oct. 2 preliminary release, with management saying that a combination of product mix and increased competitive pricing was behind the big drop. With regards to product mix, management said it was seeing an increase in focus for more entry-level products at competitors, and apparently didn't have similar products in its mix. This double-whammy resulted in the company losing sales and having to make markdowns to keep from losing even more business.

Second, Tile Shop spent $5 million more to cover sales, general, and administrative expenses, a roughly 10% increase. Operating income was $4.4 million, down 44% from last year.

What management is doing about it

The good news is the company is working quickly to address the mix issue, saying sales and profitability will both improve as a result. On the earnings call, CEO Chris Homeister said Tile Shop is adding 400-plus new products including many at lower price points. But it's not just about price.

"While we desire to be relevant on price, especially on certain comparable SKUs, our primary focus for growing our business will continue to be providing our customers the broadest product assortment, delivering unmatched service levels and offering unique and exclusive products," Homeister said.

Unfortunately, it sounds like the company's efforts to prepare for the product transition also affected sales in many locations in the quarter, as the company worked to reset its merchandising in advance of new products coming in.

SG&A growth is a little trickier. When Homeister took over as CEO a few years ago, one of his first moves was to slow the pace of store expansion in order to address a bloated balance sheet and focus on improving store operations. Fast-forward to this year, and the company's debt load is the lowest it's been in five years, store employee turnover has been cut steadily with every passing quarter, and cash flows have also improved.

This year the company will open 15 new locations, the most in a single year since Homeister took the helm. This higher rate of new stores has caused SG&A to grow faster than sales for the time being, and that could remain the reality until the company's product transition starts to pay off in accelerated sales growth. However, part of the company's decision to accelerate its store count growth is that Tile Shop is opening stores for around $1 million each, roughly 40% less than the company's historical average.

A surprising statistic and what it could mean

On the earnings call, CFO Kirk Geadelmann made an interesting observation. He said that while existing home sales growth has stalled in recent months, "industry data suggest that first-time homebuyers are increasing their spending on home renovation projects at a faster rate." On the surface that sounds like a net positive for Tile Shop. Unfortunately, Geadelmann said first-time homebuyers haven't "historically represented our core customer."

On the housing front, the National Association of Realtors has steadily said the biggest challenge with existing home sales has been inventory -- specifically too little of it in most markets -- while buyer interest has remained steadily high.

Going back a few years, Tile Shop last struggled with comp sales when existing home sales tightened, and saw its comps rebound strongly when existing home sales recovered. It would appear that management is focusing on what's within its control right now: improving its product mix to better compete, while also staying the course on a responsible expansion that it can pay for with cash flows.

The good news is Homebuyers are still active. It's just a matter of sufficient inventory to support demand (and create more opportunities for Tile Shop).

Looking ahead

It's been a painful 2017 for Tile Shop investors, who have seen the stock fall 62% from the high. The good news for long-term investors is the business is healthy, with a vastly improved balance sheet, a more affordable expansion plan, better-trained, longer-tenured store staff, and relatively healthy demand for its products.

The big question is whether -- and if so, how quickly -- the product transition will result in higher sales and margins. It has every appearance of being a short-term problem that may have created a buying opportunity for patient investors. Only time will tell if that's the case or not.

Jason Hall owns shares of Tile Shop Holdings. The Motley Fool recommends Tile Shop Holdings. The Motley Fool has a disclosure policy.