On the surface, there doesn't seem to be much good in Tile Shop Holdings Inc's(TTSH 0.08%) first-quarter earnings report. Sales fell 1% on a big 6.8% decline in comparable-store sales, earnings per share fell 47%, and expenses increased at double-digit rate. Surprisingly, Tile Shop's shares traded up as much as 7% and finished the day of its earnings release up 5%. 

So, what's happening? In short, it's a case of a few positives that -- in some investors' minds -- outweigh the negatives in the quarter, tied to a change in strategy announced last quarter. Let's take a closer look at what Tile Shop reported and what management had to say about the future. 

Installer using a brush on tile in bathroom.

Image source: Getty Images.

The good and bad in Tile Shop's results

Tile Shop reported sales of $91.1 million in the first quarter, net income of $4 million, and adjusted EBITDA -- earnings before interest, tax, depreciation, and amortization -- of $13.8 million. These results were down 1%, 50%, and 34% from last year's first quarter, respectively. Expenses were also up, with SG&A -- sales, general, and administrative -- expenses $6.7 million higher, up 13% year over year. 

On the earnings call, management said the sales decline -- which was driven by a substantial drop in store traffic and comp sales -- was expected as the company shifts its strategy back toward higher-end tile and stone and away from low-cost products and the highly promotional pricing strategy it had taken under former CEO Chris Homeister, who abruptly left the company in late 2017. 

But there's some good news to be found: Gross margin percent was up sharply in the quarter, to 70.3%, at the high end of management's expectation and substantially improved from the 66.8% it reported in the fourth quarter of 2017. Furthermore, the big 13% jump in SG&A was a product of opening and operating 14 new stores over the prior 12 months. Those new stores generated $5.3 million in sales in the quarter, helping offset the $6.3 million comp sales decline. 

The balance sheet remained relatively strong, with cash up $500,000 and total debt down $2 million since the end of 2017. Inventory increased $3 million and is up substantially from year-ago levels, and management says it's going to continue to increase over the next couple of quarters as the company adds more expensive products to its selection. The good news is that Tile Shop's balance sheet and cash flows improved substantially under Homeister's tenure as CEO, and it seems that this has remained a priority for new leadership. 

2018 will be a transitional year

As the company's results in the quarter showed, its shift away from low-cost products and toward upscale tile and stone products is driving higher margins, but at the cost of lost traffic and revenue. Furthermore, management was candid in their expectation that this would continue through at least the first half of 2018. Part of this is the continued impact of weaker sales and traffic as the company reduces its promotional pricing, reduces its low-cost selection, and adds more expensive stone and high-end tile to its stores. 

Tile Shop COO Cabby Lolmaugh

New COO Cabby Lolmaugh could have the inside track to be Tile Shop's next CEO. Image source: Tile Shop.

Management also expects sales at the roughly 30 stores it will remodel this year to be impacted. On the earnings call, Chief Operating Officer Cabby Lolmaugh said most of the work would happen after hours, but some of the larger remodel projects would have a negative impact on sales at those stores. Tile Shop will invest $27 million to $32 million on capital investments, mainly related to the remodeling initiative. 

At the same time, management is doubling down on pro customers. Tile Shop took steps to engage with professional kitchen and bath contractors under its prior leadership, but current leadership says prior aggressive promotional practices with DIY and non-pro customers, as well as reduced selection of more upscale products, had a negative impact on its pro business. To help grow sales to this important group of recurring customers, the company is launching a pro customer loyalty program and creating a new position -- pro market manager -- in its major markets. The pro market manager will train Tile Shop sales staff in how to best serve pro customers and  reach out to pro customers in their market with training and marketing events. Management expects it will spend $5 million to $7 million in additional SG&A expense in 2018 related to its pro customer initiatives and changes to sales and warehouse employee compensation plans, above and beyond higher spending related to new stores it has or will open. 

Looking ahead

For investors who have held Tile Shop over the past handful of years, it's been a very up-and-down (and hopefully back up) investment. Chances are, there will be plenty more of that to come, as the effects of the company's shift in strategy plays out. It's clear that Tile Shop's stores will be negatively affected by remodeling, reduced exposure and traffic from its prior marketing and promotional strategy, and fewer customers buying low-cost products, while it's far less clear how quickly it will see the benefits of higher-margin, more expensive products in its stores, or a bigger emphasis on pro customers. Furthermore, Tile Shop lacks a permanent CEO, with founder and former CEO Bob Rucker holding control on an interim basis for now. 

So, while there's a strategy in place, and it seems to have starting bearing fruit with higher margins, at some point, Tile Shop will need to start stabilizing store traffic and delivering sales and bottom-line earnings growth. Mr. Market gave management a pass in the first quarter, but it's unlikely that will continue in future quarters if the new strategy doesn't deliver.