Tile Shop Stock: Short-Term Headwinds Are Inevitable (NASDAQ:TTSH)

Elevator Pitch

I reduce my investment rating for Tile Shop Holdings, Inc.’s (NASDAQ:TTSH) stock from a Buy to a Hold. My earlier update for TTSH focused on the potential of the stock garnering greater investor interest and the company’s Q3 2021 financial results. In this current article, I evaluate how Tile Shop has performed in the recent quarter, and examine the key factors that could influence TTSH’s future business and share price performance.

Tile Shop warrants a Hold rating. The short-term outlook for TTSH is poor, considering the weak economic environment and cost pressures. In the intermediate to long term, new products and the initiation of share repurchases might help to re-rate TTSH’s shares. Taking into account both the positives and negatives for the stock, I determine that a Hold rating for Tile Shop is justified.

Tile Shop’s Q2 2022 Earnings Results Send Warning Signals

On August 4, 2022 before trading hours, Tile Shop released its earnings for the second quarter of this year. TTSH’s share price increased by +2% from $3.31 as of August 3, 2022 to $3.37 as of August 4, 2022, before rising by an additional +17% to close at $3.93 at the end of the August 10, 2022 trading day. In my opinion, the sharp +19% jump in Tile Shop’s stock price in the one week following its Q2 2022 results is unjustified.

On the surface, it appears that TTSH’s Q2 2022 financial performance was fine. Tile Shop’s revenue expanded by +11.9% YoY from $96 million in the quarter a year ago to $108 million in the most recent quarter. This is the highest quarterly revenue that TTSH has ever registered in its history. The company also delivered a reasonably good +12.0% comparable same store sales growth in Q2 2022. In terms of the bottom line, TTSH’s earnings per share or EPS grew by +18.2% YoY from $0.11 in Q2 2021 to $0.13 in Q2 2022.

However, there are a number of warning signs that investors should take note of.

Firstly, Tile Shop’s top line growth has slowed considerably in Q2 2022 as compared to what the company achieved a year ago. TTSH’s YoY top line growth went from +42.0% in Q2 2021 to +11.9% in Q2 2021. Similarly, the company’s comparable same store sales growth moderated from +41.6% to +12.0% over the same period.

Secondly, TTSH’s revenue and comparable same store sales growth for the most recent quarter weren’t supported by increase in sales volumes. Tile Shop noted at its Q2 2022 results call on August 4, 2022 that the company suffered from “a modest decrease in unit volumes” in the second quarter of this year. In addition, the company explained that “an increase in average ticket, driven by our pricing actions” was what really drove Tile Shop’s top line expansion in the recent quarter.

Thirdly, Tile Shop’s gross profit margin contracted on a YoY basis in Q2 2022, and the company’s gross margin could continue to trend downwards in the quarters ahead. TTSH’s gross profit margin declined by -310 basis points YoY from 69.1% in Q2 2021 to 66.0% in Q2 2022. More importantly, Tile Shop guided at its most recent quarterly investor briefing that there will be “continued pressure on gross margin rates” for 2H 2022, as the company has decided that it won’t “raise prices to the levels required to maintain our current gross margin rates” going forward. In other words, TTSH is implicitly acknowledging that it is challenging to pass on rising costs without hurting product demand.

Short-Term And Long-Term Revenue Growth Prospects

The near-term revenue growth prospects for Tile Shop are poor, but new products could be a key top line expansion driver for TTSH in the intermediate-to-long term.

Taking into account weak economic conditions and concerns about the health of the housing market, it is reasonable to assume that Tile Shop’s top line growth will be much slower in the next few quarters. At its recent Q2 investor call, TTSH highlighted that it has observed various signs indicating that “the macro environment” is “impacting our customers.”

Separately, Tile Shop also acknowledged that there is a strong correlation between the state of the housing market and its growth, mentioning at the Q2 2022 results briefing that “typically, we’re a few points better than existing home sales.” According to the Wall Street analysts’ consensus financial estimates taken from S&P Capital IQ, TTSH’s revenue growth will go from +8.5% in FY 2022 to +2.7% in FY 2023.

On the flip side, new products could be a key source of growth for Tile Shop in the intermediate to long term. Specifically, TTSH also started to introduce luxury vinyl tiles to the market for approximately one year with a limited set of stock keeping units or SKUs. Tile Shop signaled its ambitions to expand the number of SKUs for its luxury vinyl tiles and grow this specific product segment, by commenting at its recent Q2 call that “we’re getting everything ready on our end to carry more to make mega splash in that arena.”

In quantifying the long-term revenue growth potential for luxury vinyl tiles, this market segment was referred to as “multibillion-dollar opportunity in terms of market or TAM (Total Addressable Market)” by David Kanen from Kanen Wealth Management LLC at the company’s Q2 2022 earnings briefing. In comparison, Tile Shop’s trailing twelve months’ revenue was below $400 million.

Spotlight On TTSH’s Cash Flow And Capital Allocation

Looking forward, Tile Shop’s future cash flow and capital allocation are key factors that have a big impact on the stock’s share price trajectory in the short term.

TTSH’s operating cash flow contracted substantially from $42 million in 1H 2021 to $9 million in 1H 2022. This is mainly the result of the company building up its inventories in anticipation of an increase in the prices of its supplies.

Lower operating cash flow means there is less capital to be allocated to growth investments and shareholder capital return.

Tile Shop had noted at its recent quarterly earnings call that “the response has been great” for stores which have been remodeled, and emphasized that “we’re still not out of remodels.” It remains to be seen if TTSH will slow its pace of store remodels due to increasing working capital needs.

Separately, there are certainly investors who hope that Tile Shop will initiate share repurchases as a means of returning capital to shareholders, especially since its shares have pulled back -44% in 2022 year-to-date. However, there is no clear indication from TTSH with respect to its potential shareholder capital return plans.

Tile Shop clarified at the Q2 2022 investor briefing that “our credit agreement does provide for the ability to repurchase shares as long as our leverage ratio sees below a certain point.” But Tile Shop didn’t commit to any future actions, and it will only say at the recent quarterly call that it has “a good history here of really considering various options in front of us and trying to make the right decision for the company and shareholders.”

In a nutshell, a share buyback catalyst in the very short term doesn’t seem likely, considering TTSH’s 1H 2022 cash flow and its management comments.

Concluding Thoughts

Tile Shop is rated as a Hold. It isn’t a Buy because of short-term headwinds relating to weak economic growth and inflationary cost pressures. But TTSH isn’t a Sell either as there are levers to re-rate its shares in the future, like share buybacks and new product growth. This makes Tile Shop a Hold, rather than a Buy or a Sell.