Since reporting fourth-quarter financial results before market open on Feb. 21, shares of Tile Shop Holdings, Inc. (NASDAQ:TTS) have taken a beating. As of this writing they've fallen more than 34%, after a terrible quarter that included the abrupt resignation of the CEO. The company reported only 2.6% sales growth (despite increasing its store count by more than 10%) with a 5% drop in same-store sales contributing to a $7.4 million loss in the quarter.

At the same time, the company is making a major change in its market strategy -- essentially an about-face from the strategy the company said it was taking as recently as the third quarter.

Blocks with black arrows aimed right, with one block with a red arrow aimed left.

Tile Shop is making a big turn. Image source: Getty Images.

A closer look at the results

Here's a breakdown of some key metrics for Tile Shop's fourth quarter:

Metric Q4 2017 Q4 2016 Year-Over-Year Change
Revenue $78.580 million $76.614 million 2.6%
Net income ($7.351 million) $273,000 N/A
Earnings per share ($0.14) $0.01 N/A
Gross margin 66.8% 69.6% (2.8 percentage points)
Comparable sales (5%) 3% N/A

Data source: Tile Shop. 

While it's not a good idea to get too caught up in analyst estimates, it can offer some context. Wall Street was looking for $83.8 million in sales and a profit of $0.05 per share, both of which were wildly different from the company's results. But it wasn't just Wall Street's estimates that were missed: Tile Shop also significantly underperformed its own guidance, released prior to the third-quarter earnings release last October. Tile Shop's full-year guidance had been for 7% sales growth and comps growth of 1%. The company finished 2017 with sales growth of 6.3% and comps growth of 0.5%. 

For added context, Tile Shop's comps decline isn't the product of weak overall demand. Big-box home improvement giant Home Depot reported its comps grew a remarkable 6.8% in 2017, and is guiding for 5% comps growth in 2018. Tile Shop and Home Depot aren't perfect comparisons, but the point is that home improvement spending continues to be healthy. 

Big changes in its market focus

Tile Shop seemed to be making significant improvements under former CEO Chris Homeister. During his three years as CEO, the company prioritized training, retaining, and promoting its best store employees, developing better programs for professional customers, and improving its product selection. And while some of the foundation established under Homeister, such as store training, compensation, staffing, and an emphasis on pro customers, will remain, it seems there was a breakdown between Homeister's market strategy and what the board wanted.

Interim CEO and founder Bob Rucker opened the earnings call with this statement: 

During the third and fourth quarters of 2017, the board and management initiated a comprehensive review of our business strategy. We had become concerned about some of the weaknesses in our business that we reported to you in previous quarters, and we were concerned that the strategy we were following was not producing the results we wanted. As a result of this review, the board decided to initiate a significant change in our business strategy. In late October, I was asked to return as interim CEO to spearhead the implementation of a new strategy.

Rucker went on to describe that Tile Shop's core focus, going back to his founding of the company in 1985, had been higher-end tile, such as stone and other materials that are harder to replicate, and not so much focus on entry-level products. The board decided the company should refocus on this strategy, and Homeister was out. 

Expect more pain before the gain

Tile Shop also announced that longtime employee Cabby Lolmaugh had been promoted to chief operating officer, and would play a major role in the company's strategic shift. On the call, Lolmaugh acknowledged this shift would have an impact on business:

These are all quite substantial changes, and in the short-term we expect to experience some volatility in store traffic. That is what we're experiencing at this time, and we can't say with certainty when our new initiative will gain traction. What we do know is that average selling prices and our gross margin percentages are moving up, which will drive an increase in gross margin dollars. Now, we are not where we need to be yet, but we hope to show some progress in the second quarter this year, and especially in the second half of the year when we should have fully implemented the new plan.

Management has also made the decision to substantially slow expansion this year, instead investing in inventory and remodeling stores. The company said it will open only three new stores in 2018, versus 15 new locations in 2017. Tile Shop will remodel 30 existing locations, and spend 25% to 35% more on inventory than in 2017. 

The company will also spend $5 million to $7 million more on sales, general, and administrative expenses in 2018 related to adding new regional sales management, increasing compensation for store sales and warehouse personnel, and enhancing technology for customer relationship management.

Looking ahead

Beyond the items listed above, Tile Shop management wouldn't offer any additional guidance -- a smart move considering that it is planning to spend a lot of money on its strategy change without having a clear picture of how this shift will affect near-term sales. Furthermore, the company continues to operate without a permanent CEO (though some think Lolmaugh may be under consideration), creating more uncertainty. 

The bottom line is this: Tile Shop is making a big change in the customers it is targeting, eschewing people looking for inexpensive tile for a small project in order to focus upmarket. This will likely cause a lot of disruption to its business in the short term, while also taking time to prove out. Rucker says this was Tile Shop's focus when he founded it, and the board is aiming to return the company to what had made it successful.

Whether this shift works or not will take time to see. Shareholders may want to fasten their seatbelts. It's almost certain to be a bumpy ride.

Jason Hall owns shares of Tile Shop Holdings. The Motley Fool has the following options: short May 2018 $175 calls and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Home Depot and Tile Shop Holdings. The Motley Fool has a disclosure policy.