Earnings Call Transcript - TTSH Q3 2022

Mark Davis, Vice President Investor Relations and Chief Accounting Officer

Thank you. Good morning to everyone and welcome to The Tile Shop's third quarter earnings call. Joining me today are Cab Lolmaugh, our Chief Executive Officer; and Karla Lunan, our Chief Financial Officer. Certain statements made during the call today constitute forward-looking statements made pursuant to and within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 as amended. Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from such statements. Those risks and uncertainties are described in our earnings press release issued earlier and in our filings with the SEC. The forward-looking statements made today are as of the date of this call and we do not undertake any obligation to update these forward-looking statements. Today's call will also include certain non-GAAP measurements. Please see our earnings release for a reconciliation of those non-GAAP financial measures, which has also been posted on our company website. With that, let me now turn the call over to Cab.

Cab Lolmaugh, CEO

Thanks, Mark. Good morning, everyone, and thank you for joining us today for an update on our business and a review of our third quarter financial results. Our team is pleased with the quarterly results we announced earlier this morning. While the macro environment remains volatile, we continue to grow sales at comparable stores and ended the quarter with $97.2 million of revenue. This represents our sixth consecutive quarterly sales record for the respective quarter. We also delivered good flow-through to the bottom line. Our sales strength combined with disciplined expense management practices and share repurchases resulted in earnings per share that doubled what we reported in the third quarter last year. These results have been made possible by focusing on our team, refining our processes, and investing in technology. We've made significant progress over the last year and I'm proud of what we've been able to accomplish. I'm also pleased to announce that we completed our share repurchase program. Karla will discuss the details of the repurchases in just a few minutes. At the same time, I see new challenges on the horizon. We've enjoyed a period of very strong demand for home improvement products over the last two years. Rising interest rates and decreases in housing turnover signal that a slowdown in remodeling activity may be coming. Now I've been with The Tile Shop for over 20 years and I know this is a resilient organization. In fact, we've shown that we can grow even when the macro environment is challenging. We are focused on staying proactive with the goal of sustaining our current level of success. As we look ahead to 2023, I believe we can position the company to grow even in a challenging environment by executing the following objectives. First, we're expanding our line of luxury vinyl tile products. For several years, LVT has been one of the fastest growing product categories in hard surface flooring. Initially, we were hesitant to enter this market given product quality concerns, a lower margin profile, and the question of whether our customer base would accept it as a viable option. Over time, product innovations have led to a number of higher-quality LVT products and consumer demand has increased. Several quarters ago, we initiated a test to pilot a small line of LVT products in our stores. This test showed us that LVT lines have broad appeal with both professional and retail customers. We've also learned that many customers who buy LVT from us also buy tile from us, and often on the same order. Over the summer, we actively worked with our suppliers to expand our assortment of LVT products that launched at the end of October. We've added over 40 products to our assortment at a range of price points that we believe will resonate with our customers. While the margin profile of LVT sales is lower than the margin profile of a tile sale, we believe that the additional volume will help us leverage our investments in store and distribution assets and improve overall profitability. Second, we're planning to open new stores in 2023. New store openings have been on pause since our Wayne, New Jersey store opened in the first quarter of 2021. We felt it was prudent to focus on our existing store base until the vast majority of our stores were operating with historical norms. We have made significant progress over the last two years and believe we have a path for continued improvements within our existing store base. Given the volatile macro environment, we're planning to take a conservative approach to store growth. At this time, we anticipate opening two new stores and relocating a third store in 2023. Over the last year, we've added to our construction and design teams to help position the company for growth. We've invested in talent initiatives to establish a bench of managers ready to take on new stores. We're currently refining our new store opening process and I'm excited for the opportunity for measured growth in 2023. Third, we'll continue to invest in initiatives to expand our digital capabilities and reach. We've made some nice progress over the last year in this area, but believe there is still significant untapped potential. We've recently added to our e-commerce team and look forward to accelerating the pace of change and effectiveness of our digital strategies. Last, and perhaps most importantly, we will continue to focus on developing our team and improving execution in our existing stores. We've seen some nice improvements in pro growth, conversion rates, discretionary discounting practices, and shrink losses across many of our stores. This has helped drive improvement in store-level financial measures such as sales per store and store-level EBITDA. As we look ahead to 2023, I believe continued focus on talent development and sales excellence will be a key catalyst to propel the company's performance to the next level. With that, I'll now hand the call over to Karla to walk us through the third quarter results.

Karla Lunan, CFO

Thanks, Cab. Good morning, everyone. Third quarter sales at comparable stores increased by 5.3%. The increase in sales was largely driven by an increase in our average ticket, partially offset by a decrease in sales volumes. The gross margin rate during the third quarter was 66.5%. We were pleased to see this result, which was primarily due to a decrease in discretionary pricing adjustments. We continue to see elevated levels of inventory receipts at higher price points throughout the third quarter and as we started the fourth quarter. Given the softening macro environment, we are maintaining a more conservative approach to adjusting prices in the near term. Accordingly, we anticipate modest decreases in gross margin rates during the fourth quarter. Further, as we move into 2023, we anticipate that the expansion into LVT will drive incremental gross profit dollars. However, we anticipate the gross margin rate will decrease as our sales mix changes. SG&A expenses decreased by $700,000 during the third quarter of 2022 when compared to the third quarter of 2021. This variance was related to a one-time $700,000 asset impairment, which was recorded last year and not repeated this year. Also during the third quarter, we entered into an agreement to terminate one of our store leases with a landlord who plans to redevelop their center. Under the terms of this agreement, we will vacate this space during the fourth quarter. In exchange for this concession, the landlord has agreed to pay us a $1.4 million lease termination fee. We recognized an $800,000 benefit in SG&A associated with this transaction during the third quarter and plan to recognize the remaining $600,000 benefit during the fourth quarter. We anticipate relocating the business from the store to another nearby store within the same market. The benefit recognized in connection with the lease incentives during the third quarter of 2022 was offset by a $700,000 increase in pay and benefits expenses during the third quarter of 2022 when compared to the third quarter of 2021. Net income was $3.8 million during the third quarter of 2022 and adjusted EBITDA was $12.2 million. Our adjusted EBITDA margin rate improved by 130 basis points to 12.6% largely due to the increase in sales and favorable SG&A expense leverage. Earnings per share during the third quarter doubled from $0.04 during the third quarter of 2021 to $0.08 during the third quarter of 2022. During the third quarter of 2022, our Board of Directors approved a $30 million share repurchase plan. As of September 30, 2022, we had repurchased 4.1 million shares under the plan for $15.5 million inclusive of brokerage commissions or an average share price of $3.80 per share. Following the end of the third quarter, we completed the share repurchase program. In total, we repurchased 7.8 million shares for $30.2 million inclusive of brokerage commissions or an average share price of $3.87 per share. Turning our attention to the balance sheet, we closed the quarter with $121.5 million of inventory. This represents a sequential increase in inventory from the second quarter of $11.5 million. The increase in inventory was largely driven by our decision to accelerate purchases ahead of expected price increases, particularly from our European suppliers in response to inflationary cost pressure due to rising energy, raw material, and labor costs. We anticipate that inventory will remain at elevated levels through the end of the year and begin to decline in 2023. As of the end of the quarter, we had $30.4 million of debt outstanding on our line of credit. The $25.4 million sequential increase in debt from the second quarter of 2022 was largely due to the increase in inventory and share repurchase activity that took place during the quarter. On September 30, we entered into a new credit agreement led by JPMorgan Chase. This was a straightforward deal compared to our prior facility, which was fully paid off and terminated. The new credit agreement provides the company with access to a $75 million line of credit for the next five years, provided the company remains in compliance with certain financial and non-financial covenants. We believe this facility will provide the company with sufficient capital to sustain operations and fund growth initiatives. In closing, we're incredibly pleased with the strong results. With that, Cab and I are happy to take any questions.

Connor Jensen, Analyst

Hi, guys. This is Connor Jensen from Lake Street for Mark Smith. Thanks for taking my call today.

Cab Lolmaugh, CEO

Good morning, Connor. Thanks for being on.

Connor Jensen, Analyst

So gross profit margin looked pretty good on a sequential basis. Can you talk about your outlook for the margin, kind of where you're seeing pressures on your cost and your ability to continue to pass through price increases?

Karla Lunan, CFO

Yes, definitely, Connor. This is Karla. Good morning. As I mentioned in my earlier comments, we do expect to see some ongoing pressure on the gross margin. There are positive developments such as improvements in freight rates and benefits from the price increases we implemented earlier in the year. We are maintaining strong inventory controls and keeping our reserves relatively low concerning inventory. However, inflationary cost pressures are still a concern. We're working on diversifying our supplier base, and we are aware of the need to manage price increases and control our costs to avoid further price hikes. We are also very optimistic about LVT, acknowledging that it has a different margin profile that will impact us going forward. Nonetheless, we believe we will continue to grow and are committed to increasing our gross profit dollars for the company.

Connor Jensen, Analyst

Yes, definitely makes sense there. And then another question. What's kind of your appetite for store growth? I know you said one in 2023, but maybe some additional color on how you guys are thinking about allocating capital between the store growth and the share buybacks?

Cab Lolmaugh, CEO

You bet, Connor. Actually, we said two, and that's very conservative. Not happy with two but that's the right and prudent thing to do for the business at this time. As we said in the comments, refining new store process. So we're looking at things a little different when it comes to real estate, when it comes to size, when it comes to how we can operate more efficiently. And so, we've identified a few spots that we want to be in and we'll watch the macro. We'll do our analysis. But we do it by store, by market and make sure it's the right decision. Now, would I love to grow more? Absolutely. But let's get it started with two and see where we go from there.

Connor Jensen, Analyst

Got you. It makes sense. And then, you're still looking to kind of do those buybacks you've been doing in the past?

Cab Lolmaugh, CEO

Not at this point. I think, right now, we were able to execute at a very efficient time frame. We're happy with the results, but let's make sure we're doing what's right for the business in a tough macro environment.

Connor Jensen, Analyst

Yes. Definitely makes sense. So, I’ll turn it over. Thanks, guys.

Cab Lolmaugh, CEO

Thanks, Connor.

Dave Kanen, Analyst

Good morning. Can you hear me?

Cab Lolmaugh, CEO

Yes. Got you, Charles.

Dave Kanen, Analyst

Okay. This is Dave Kanen. My apologies for the confusion. So, yes, first question is in regards to gross margins. Given the Nord Stream pipeline issues and energy prices, especially natural gas surging in Europe, how much of your sourcing comes from there and then in terms of percentage? And then, what are you hearing from your sourcing partners in terms of cost increases and effect on pricing?

Cab Lolmaugh, CEO

Thank you for the question, Dave. It's an important one because The Tile Shop is closely monitoring global economics and the challenges faced by our vendor partners. The percentage of our assortment that comes from Europe varies by segment and is typically not disclosed, but it ranges from 30 to 50 percent and can change each quarter. We have been aware of these issues for some time, especially with the tariffs and antidumping measures from China. We've adjusted our sourcing globally, and while some vendor partners are experiencing significant challenges, others are coping better. There is a noticeable shift towards South America and some movement back to Asia. This situation encourages us to seek new partners and opportunities, which I believe ultimately strengthens our company. While we recognize the difficulties our partners are facing, freight rates are decreasing, and some raw material costs are stabilizing, although natural gas prices remain a significant concern. We're adapting to these changes.

Dave Kanen, Analyst

So is the answer that you've been able to diversify some of your sourcing away from Europe where there's the natural gas impact? Is that what you're saying?

Cab Lolmaugh, CEO

Yes. Yes, absolutely.

Dave Kanen, Analyst

Okay. Great. For the quarter, what percentage was LVT? And looking ahead, what do you expect that percentage to increase to?

Cab Lolmaugh, CEO

Yes. For the quarter, it was still our pilot SKUs, so it was less than 10%. And it's something that we're going to look to grow. I don't want to throw a percentage of where it's going to go. We just launched it at the end of October. So we all have our hopes, but we figured it should grow at least to that, if not further.

Dave Kanen, Analyst

What was the early read cap in the stores where you ran pilot? How was it accepted? What could you share with us, kind of qualitatively?

Cab Lolmaugh, CEO

We were excited to see how the products performed on the sales tickets. We observed that both retail and professional customers were purchasing items without negatively affecting existing products. Customers continued to buy tile for bathrooms, backsplashes, fireplaces, and mudrooms. Instead of seeking LVT elsewhere, they chose to add it to their purchases for basements, living rooms, and bedrooms. As the year progressed, we recognized a larger opportunity. Initially, we only had a limited selection for the pilot, but now we have a robust assortment with new boards, merchandising, and marketing strategies. We believe this will significantly enhance our growth moving forward.

Dave Kanen, Analyst

Okay. Thanks, guys. Good luck in the coming year. Appreciate it.

Cab Lolmaugh, CEO

Thanks. Thanks, Dave.

Mark Davis, Vice President Investor Relations and Chief Accounting Officer

Thank you for listening to our earnings conference call. We anticipate filing our Form 10-Q later today. Thank you for your interest in The Tile Shop and have a great day.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.