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Nike Free 4.0 Tile Shop Holdings, (TTS) is a tile retailer that went public in September of 2012. Since then, it has benefited form the markets re infatuation with anything housing related and currently trades at a ridiculous 26x EV/EBITDA. In the past month the share price has declined 29% due to an earnings miss and allegations by short seller, Infitialis, research that the company's products contain hazardous amounts of lead. After reading Infitialis' otherwise excellent report, and hearing the company's response on the most recent earnings call; I deem it unlikely that any action by regulators will be forthcoming. With that in mind, I wrote this article to demonstrate that, even without the threat sadaknkj10 of poisoning its customers, Tile Shop has issues that, from an investor perspective, are just as poisonous as lead. The biggest reasons for this are that tile is by and large a commodity product, and retailing it is a business with low barriers to entry. Home Depot (HD), Lowes (LOW) and smaller competitors can just as easily buy it from vendors, and sell it for cheaper. But even if it wasn't a commodity product, the company's margins are way higher than those of other national retailers that sell highly differentiated goods. For instance, Apple sports a gross margin of around 40%, and remember, they invented the iPhone! Other premium brands with lower gross margins include Coach 72%, Lulu Lemon 50%, and Abercrombie Fitch 62%. TTS isn't selling Gucci loafers or Louis Vuitton bags, and its margins will come to reflect that as it tries to become a national franchise. based Top Tiles (TPT), and achieve a 60% gross, a margin that would leave TTS firmly on the wrong side of profitability.The other problem at TTS is the SG spend. As a percentage of revenue it was 56% in the most recent quarter. And while management is hopeful they can bring that down to the historical 50%, they give no indication of having the ability or even the intention to lower it any further (despite helpful hints by sell side analysts to suggest otherwise). With only $3.85 million of cash on hand as of September 30th and $85.4 million in debt, the company is taking a big risk attempting such an aggressive expansion. Simply put, the company is overleveraged and any bump in the road may be detrimental not only to equity holders but also to lenders willingness to extend credit.In addition to the daredevil capital structure, investors should be concerned with the speed of the undertaking. Difficult as growing a business is under any conditions, it becomes exponentially more difficult when you try and do it quickly. Issues such as inventory management, location selection, employee quality and supervision, to name just a few, don't get any easier to manage when you have Wall Street eying you with a stopwatch. As of November 2012 Nabron International, a trust controlled by the Chan brothers (one of which is a former Enron board member), was the largest single stakeholder with an interest in 36% of the outstanding shares. As of June 18th 2013, Nabron had reduced its interest in the company to 20%, a near 56% reduction in a little over six months. Similarly JWTS, a private equity firm, has reduced its stake from 13% in November 2012, to 8.4% as of June 10th. Finally, despite receiving share based compensation, CEO and founder Robert A. Rucker has also reduced his stake from 19.9% in November 2012, to 15% as of June 2013.All of these investors obviously have better places to put their money than TTS equity why don't you?As short sellers Infitialis mention in their report, the CEO of TTS was convicted of fraud in civil court related to divorce proceedings from his now ex wife. For me, this isn't a good thing but it's not necessarily the end of the world.The other management issue brought to light by Infitialis is the fact that the former Senior Vice President of Operations, Mr. Joseph Andrew Kinder is on probation due to his involvement in a domestic dispute another bad sign. Since then, it appears Mr. Kinder has been demoted in favor of the recently hired Chris Homeister. Mr. Homeister was previously Senior VP at Best Buy (BBY), a company with a poor record of competing on the national stage.Last but not least, in 2012 the company was found to have a material weakness in its disclosure controls and procedures. As I understand it, the company didn't have enough people in place at headquarters that were financially competent, nor did they have a sound process for closing the books at the end of year.In and of themselves none of the aforementioned issues is detrimental to the company's future. However, when taken together, the picture sure isn't pretty. Let's put on our optimist hats, and see if we can make the current valuation make sense. Historically the company has earned about 27.5%. Therefore this assumption extremely generous, especially given that its peers are earning EBITDA margins around 12%. This would correspond to a 23% compound annual growth rate for stores. To achieve such a rapid expansion without any margin contraction is highly unlikely, but hey we're looking on the bright side here. That's a higher than what Home Depot currently commands, and it's a national franchise with a honed operating model, experienced and competent management. I also assume debt will increase to $150 million to finance this growth, while cash moves up to $20 million.What's the result of all this future gazing? Despite our psychedelic concessions to the gods of delusion the company still stands 17% overvalued based on Friday's closing price.
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