Specialty home-improvement retailer Tile Shop Holdings (NASDAQ:TTS) reported second-quarter results Thursday, and investors were rewarded with a big day for the stock, which surged almost 13%. For many who watch the company closely, the market's positive reaction was a bit of a surprise, considering that the company reported another quarterly decline in earnings, which fell by one-third on weaker traffic and higher expenses. 

So why the positive attitude from Mister Market? In short, it was a combination of low expectations as the company pivots its strategy, and optimism that the new focus on higher-end products should pay off with bigger profits down the road, similar to what happened after the company's first-quarter earnings release. Let's take a closer look at Tile Shop's results and what management had to say about the company's progress. 

Young man and woman shopping in a tile store.

Image source: Getty Images.

A closer look at what drove the numbers

Tile Shop reported sales of $92.9 million, up a modest 3.9% from last year. However, comparable sales -- sales at stores open more than one year -- declined 1.8% in the quarter. This marks the third consecutive quarter of comps declines. At the same time, the company is spending more on its operations. Selling, general, and administrative expenses were 14% higher in the quarter, mainly due to increased compensation for store and warehouse employees, the additional expense of the new "regional sales leader" and additional "professional market manager" positions, and increased shipping costs. This higher spending was the biggest driver behind Tile Shop's 33% decline in earnings per share, which fell from $0.15 last year to $0.10. 

The company says that this increased spending was intentional, as management continues to prioritize retention of its best employees, and to provide them with more support to boost sales and profits as the company refocuses its product mix, marketing, and store displays on higher-end products. 

There's some evidence that this is starting to pay off. Comps fell year over year, but improved from the 6.8% decline the company saw in the first quarter of 2018. On the earnings call, management said that this was expected. And it's expected to continue since the shift away from aggressive promotion of lower-cost tile will result in lower traffic counts. But the expectation is that by selling more high-end product to fewer customers, Tile Shop's bottom line will get a boost.

TTS Gross Profit Margin (Quarterly) Chart

TTS gross profit margin (quarterly) data by YCharts.

It's seeing some improvement already. Gross margin percent was 70.3% in the quarter, identical to the first-quarter result and up 0.6 percentage points year over year. With the higher revenue in the quarter, Tile Shop's gross profit increased by $3 million versus last year, helping to offset the additional expenses, though falling well short of covering them. 

However, management expects that the drag of higher expenses will ease in the second half of the year, in large part due to expectations that sales productivity should increase as more high-end customers -- driven in large part by the company's efforts to grow repeat sales from kitchen and bath professionals -- buy at Tile Shop. 

Looking ahead

Tile Shop continues to invest relatively aggressively on realigning its inventory and refreshing its existing stores to reflect its upscale product focus. The company has slowed the pace of new store development in the near term to do this. On the earnings call, CFO Kirk Geadelmann said that the company was reducing the number of full remodels it would perform in the second half of the year in order to roll out certain merchandising improvements to all of its stores. And as a result, it expects close to $32 million in capital expenditures this year.

The company won't open any more new stores this year, and that is likely to result in steadily slowing sales growth, as traffic continues to lag against last year's levels. But management continues to expect that the growth of more-profitable sales should eventually more than offset this, and its reimaged stores should eventually start driving better traffic from affluent customers. 

Lastly, the company does face some potential impact from tariffs. About half its tile is sourced from Asia, with a substantial portion of that made in China. If the 10% tariff that is currently on the table is implemented, it's not clear how much of that cost it would be able to pass along to customers. 

The good news is Tile Shop's balance sheet is in relatively good shape. Its working capital has increased since the start of the year, even as the company has significantly increased the value of its inventory. Long-term debt has also increased slightly, but much of that increase is offset by a similar increase in its cash on hand. It also continues to generate steady cash flows, with cash from operations of $19.2 million in the quarter. 

That's good, because it gives the company some margin of safety to continue its pivot away from high-traffic and low-price, toward more-profitable sales to more-affluent shoppers. Eventually, the market is going to expect all those investments to pay off with bigger earnings. It's still not clear how long before that happens.

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