ITE
M 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31,
2018
and our consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. In some cases, you can identify these statements by words such as, but not limited to, “anticipate,” “believe,” “can,” “continue,” “could,” “depend,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “project,” “seek,” “should,” “target,” “will,” “will likely result,” “would,” and similar expressions or variations, although some forward-looking statements are expressed differently. All statements other than statements of historical fact are statements that could be deemed forward-looking statements. The forward-looking statements in this Quarterly Report on Form 10-Q relate to, among other things, our anticipated new store openings, remodeling plans, and growth opportunities; our business strengths, marketing strategies, competitive advantages and role in our industry and markets; our expectations regarding financing arrangements; our expectations with respect to dividend payments; our expectations with respect to ongoing compliance with the terms of our credit facility; and our expectations with respect to remediation of our identified material weaknesses.
These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause our actual results, performance, or achievements to differ materially from any expected future results, performance, or achievements expressed or implied by such forward-looking statements. These risks and uncertainties include, but are not limited to, the level of demand for our products and our ability to introduce new products that satisfy market demand; our ability to grow and remain profitable in the highly competitive retail tile industry, our ability to access additional capital; our ability to attract and retain qualified personnel; unexpected delays or expenses related to opening new stores and maintaining or renovating existing stores; changes to economic or market conditions and customer preferences; disruptions in our supply chain or inventory management; unanticipated issues with respect to remediation of our identified material weaknesses; and those factors set forth in the section captioned “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2018 and the additional Risk Factors set forth in Part II, Item 1A of this Quarterly Report on Form 10-Q.
There is no assurance that our expectations will be realized. If one or more of these risks or uncertainties materialize, or if our underlying assumptions prove incorrect, actual results may vary materially from those expected, estimated, or projected. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Furthermore, such forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
Overview and Recent Trends
We are a specialty retailer of natural stone and man-made tiles, setting and maintenance materials, and related accessories in the United States. We offer a wide selection of products, attractive prices, and exceptional customer service in an extensive showroom setting. As of
March 31, 2019
, we operated
140
stores in
31
states and the District of Columbia, with an average size of
approximately
20,200
square feet.
We purchase our tile products and accessories directly from suppliers and manufacture our own setting and maintenance materials, such as thinset, grout, and sealers. We believe that our long-term supplier relationships, together with our design, manufacturing and distribution capabilities, enable us to offer a broad assortment of high-quality products to our customers, who are primarily homeowners and professionals, at competitive prices. We have invested significant resources to develop our proprietary brands and product sources, and we believe that we are a leading retailer of
natural stone and man-made
tiles, accessories, and related materials in the United States.
We believe that the highly-fragmented United States retail tile market provides us with a significant opportunity to expand our store base. We opened
one
new store
and closed one store at the end of its lease
in the first three months of
2019
, and opened
two
new stores during
2018
. Between April 1,
2018
and
March 31, 2019
, we opened
one
new store and closed one store
. We plan to open an additional
five
stores in
2019
, of which one is a relocation.
We believe that there will continue to be additional expansion opportunities in the United States and Canada. We expect store base growth will drive productivity and operational efficiencies. Our growth plans also require us to maintain significant inventory on-hand in order to fulfill transactions at these new locations.
For the
three months ended March 31, 2019 and 2018
, we reported net sales of
$86.9
million and
$91.1
million, respectively. The decrease in sales for the
three months ended March 31, 2019
compared to the
three months ended March 31, 2018
was primarily due
to a decline in comparable stores sales of 4.2%, or
$3.8
millio
n.
In addition, we had one less store in the comparable base during the three months ended March 31, 2019, which resulted in a
$0.4
million
decrease in net sales
. The decrease in sales at comparable stores for the
three months ended March 31, 2019
was
due to
weaker store traffic
and customer experience issues
following the implementation of a new enterprise
resource planning system
and the launch of our new website. Poor weather in the Midwes
t and Northeast as well as a $
0
.8
million reduction in advertising spend also contributed to the decrease in traffic during the three months ended March 31, 2019.
The table below sets forth information about our comparable store sales
decline
for the
three months ended March 31, 2019 and 2018
.
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For the three months ended
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March 31,
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2019
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2018
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Comparable store sales decline
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(4.2)
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%
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(6.8)
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%
|
For the
three months ended March 31, 2019 and 2018
, we reported gross profit of
$61.8
million and
$64.0
million, respectively. The gross margin rate was
71.2%
and
70.3%
for the three months ended March 31,
2019
and
2018
, respectively. The increase in gross margin rate was primarily driven by higher pricing on new products
added to our assortment over the last twelve months
.
For the
three months ended March 31, 2019 and 2018
, we reported income from operations of
$2.9
million and
$6.1
million, respectively. The decrease in income from operations was primarily driven by a
decrease in
net
sales
and increased selling, general and administrative expenses
.
Net cash provided by operating activities was
$19.7
million and
$9.9
million for the
three months ended March 31, 2019 and 2018
, respectively, which was used to fund operations, new store construction activities, store remodels,
merchandising and information technology investment,
dividends and debt repayments. We expect to continue to fund our capital expenditures and daily operations from our operating cash flows.
On April 29, 2019,
our
Board of Directors authorized a
share repurchase program (the
“Program”), pursuant to which
we
may, from time to time, purchase shares of
our
common stock for an aggregate repurchase price not to excee
d $15,000,000. The Program began
on May 2, 2019 and will continue indefinitely until the full repurchase amount has been utilized or
our
Board of Directors terminates the Program
.
Key Components of our Consolidated Statements of Income
Net Sales
–
Net sales represents total charges to customers, net of returns, and includes freight charged to customers. We recognize sales at the time that the customer takes
control
of the merchandise or final delivery of the product has occurred. We are required to charge and collect sales and other taxes on sales to our customers and remit these taxes back to government authorities. Total revenues do not include sales tax because we are a pass-through conduit for collecting and remitting sales tax.
Sales are reduced by
a reserve
for anticipated sales returns that we estimate based on historical returns.
Comparable store sales growth is a percentage change in sales of comparable stores period-over-period. A store is considered comparable on the first day of the 13th full month of operation. When a store is relocated, it is excluded from the comparable stores sales growth calculation. Comparable store sales growth amounts include total charges to customers less any actual returns. We include the change in allowance for anticipated sales returns applicable to comparable stores in the comparable store sales calculation.
Cost of Sales
–
Cost of sales consists primarily of material costs, freight, customs and duties fees, and storage and delivery of product to the customers, as well as physical inventory losses and costs associated with manufacturing of setting and maintenance materials.
Selling, General, and Administrative Expenses
–
Selling, general, and administrative expenses consists primarily of compensation costs, occupancy, utilities, maintenance costs, advertising costs, shipping and transportation expenses to move inventory from our distribution centers to our stores, depreciation and amortization.
Pre-opening Costs
–
Our pre-opening costs are those typically associated with the opening of a new store and generally include rent expense, compensation costs and promotional costs. We expense pre-opening costs as incurred and include these costs in selling, general, and administrative expenses.
Income Taxes
–
We are subject to income tax in the United States as well as other tax jurisdictions in which we conduct business.
Non-GAAP Measure
We calculate Adjusted EBITDA by taking net income calculated in accordance with accounting principles generally accepted in the United States (“GAAP”), and adjusting for interest expense, income taxes, depreciation and amortization,
and
stock based compensation expense
.
Adjusted EBITDA margin is equal to Adjusted EBITDA divided by net sales.
We believe that
this non-GAAP
financial
measure
provide
s
useful information to management and investors regarding certain financial and business trends relating to our financial condition and results of operations. Our management uses
this non-GAAP
financial
measure
to compare our performance to that of prior periods for trend analyses, for purposes of determining management incentive compensation, and for budgeting and planning purposes.
This
non-GAAP financial
measure
is
used in monthly financial reports prepared for management and our Board of Directors. We believe that the use of
this non-GAAP financial measure
provides an additional
tool for investors to use in evaluating ongoing operating results and trends and in comparing our financial
performance
with other specialty retailers, many of which present
a
similar non-GAAP financial measure to investors.
The reconciliation of Adjusted EBITDA to net income for the
three months ended March 31, 2019 and 2018
is as follows:
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(in thousands)
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Three Months Ended
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March 31,
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2019
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% of sales
(1)
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2018
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% of sales
|
Net income
|
|
$
|
1,320
|
|
1.5
|
%
|
|
|
$
|
4,011
|
|
4.4
|
%
|
Interest expense
|
|
|
978
|
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1.1
|
%
|
|
|
|
554
|
|
0.6
|
%
|
Income taxes
|
|
|
611
|
|
0.7
|
%
|
|
|
|
1,581
|
|
1.7
|
%
|
Depreciation & amortization
|
|
|
7,964
|
|
9.2
|
%
|
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|
|
7,000
|
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7.7
|
%
|
Stock based compensation
|
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|
739
|
|
0.8
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%
|
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|
|
617
|
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0.7
|
%
|
Adjusted EBITDA
|
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$
|
11,612
|
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13.4
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%
|
|
|
$
|
13,763
|
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15.1
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%
|
(1)
Amounts do not
foot
due to
rounding
.
We calculate pretax return on capital employed by taking income from operations divided by capital employed. Capital employed equals total assets less accounts payable, income taxes payable, other accrued liabilities,
lease liability,
deferred rent and other long-term liabilities. We believe this non-GAAP
financial
measure is useful in assessing the effectiveness of our capital allocation over time. Other companies may calculate pretax return on capital employed differently, which limits the usefulness of the measure for comparative purposes.
The calculation of pretax return on capital employed is as follows:
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($ in thousands)
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March 31,
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2019
(1)
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2018
(1)
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Income from Operations (trailing twelve months)
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$
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13,347
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$
|
16,324
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Total Assets
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328,030
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266,994
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Less: Accounts payable
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(29,242)
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(22,020)
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Less: Income tax payable
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(116)
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(150)
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Less: Other accrued liabilities
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(27,035)
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(24,713)
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Less: Lease liability
(2)
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(67,122)
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(40,670)
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Less: Other long-term liabilities
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(3,937)
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(4,895)
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Capital Employed
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$
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200,578
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$
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174,546
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Pretax Return on Capital Employed
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6.7
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%
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9.4
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%
|
(1)
Income statement accounts represent the activity for the trailing twelve months ended as of each of the balance sheet dates. Balance sheet accounts represent the average account balance for the four quarters ended as of each of the balance sheet dates.
(2)
Represents the average lease liability and deferred rent account balances for the four quarters ended as of each of the balance sheet dates.
Our management does not consider
these
non-GAAP
financial
measure
s
in isolation or as an alternative to financial measures determined in accordance with GAAP. The principal limitation of
these
non-GAAP financial measure
s
is
that
they
exclude
significant expenses and income that are required by GAAP to be recognized in our consolidated financial statements. In addition,
they are
subject to inherent limitations as they reflect the exercise of judgments by management about which expenses and income are excluded or included in determining
these
non-GAAP financial measure
s
. In order to compensate for these limitations, management presents
its
non-GAAP financial measure
s
in connection with GAAP results. We urge investors to review the reconciliation of our non-GAAP financial measure
s
to the comparable GAAP financial measure
s
and not to rely on any single financial measure to evaluate our business.
Results of Operations
Comparison of the
three months ended March 31, 2019
to the
three months ended March 31, 2018
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(in thousands)
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2019
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% of sales
(1)
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2018
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% of sales
|
Net sales
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$
|
86,908
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$
|
91,134
|
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Cost of sales
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25,066
|
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28.8
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%
|
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|
27,096
|
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29.7
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%
|
Gross profit
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61,842
|
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71.2
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%
|
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64,038
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70.3
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%
|
Selling, general and administrative expenses
|
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58,948
|
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67.8
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%
|
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57,927
|
|
63.6
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%
|
Income from operations
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2,894
|
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3.3
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%
|
|
|
6,111
|
|
6.7
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%
|
Interest expense
|
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(978)
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(1.1)
|
%
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(554)
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(0.6)
|
%
|
Other income
|
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15
|
|
0.0
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%
|
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35
|
|
0.0
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%
|
Income before income taxes
|
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1,931
|
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2.2
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%
|
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|
5,592
|
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6.1
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%
|
Provision for income taxes
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(611)
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(0.7)
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%
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(1,581)
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(1.7)
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%
|
Net income
|
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$
|
1,320
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1.5
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%
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$
|
4,011
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4.4
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%
|
(1)
Amounts do not foot due to rounding.
Net Sales
Net sales for the
first
quarter of
2019
decreased
$4.2
million, or
4.6%
, compared with the
first
quarter of
2018
, primarily due to a
$3.8
million decrease in net sales generated by comparable stores. The decrease in sales at comparable stores for the
three months ended March 31, 2019
was due to weaker store traffic and customer experience issues following the implementation of a new enterprise resource planning system and the launch of our new website. Poor weather in the Midwest and Northeast as well as a $0.8 million reduction in advertising spend also contributed to the decrease in traffic during the three months ended March 31, 2019. In addition, we had one less store in the comparable store base during the
first
quarter of
2019
, which resulted in a
$0.4
million decrease in net sales.
Gross Profit
Gross profit for the
first
quarter of
2019
decreased
$2.2
million, or
3.4%
, compared with the
first
quarter of
2018
primarily due to a decrease in net sales. The gross margin rate was
71.2%
and
70.3%
for the three months ended March 31,
2019
and
2018
, respectively. The increase in gross margin rate was primarily driven by higher pricing on new products added to our assortment over the last twelve months.
Selling, General, and Administrative Expenses
Selling, general, and administrative expenses for the
first
quarter of
2019
increased
$1.0
million, or
1.8%
, compared with the
first
quarter of
2018
.
Depreciation expense increased $1.0 million in the first quarter of 2019 compared to the first quarter of 2018. First quarter selling, general and administrative expenses also included approximately $2.5 million of expense related to the implementation of our new enterpris
e resource planning system. The
increases in expenses were partially offset by lower variable expenses of approximately $1.0 million, a $0.8 million decrease in advertising expenses and a $0.6 million decrease in transportation expenses.
Pre-opening Costs
During both the
first
quarter of
2019
and
2018
, we incurred pre-opening costs of
$0.1
million.
Interest Expense
Interest expense was
$1.0
million and
$0.6
million for the
first
quarter of
2019
and
2018
, respectively. The increase was due to higher average debt balances and higher interest rates during the
first
quarter of
2019
.
Provision for Income Taxes
Income tax provision decreased
$1.0
million for the
first
quarter of
2019
compared with the
first
quarter of
2018
due to a decrease in income before income taxes. Our effective tax rate for the three months ended
March 31, 2019
and
2018
was
31.6%
and
28.3%
, respectively.
Liquidity and Capital Resources
Our principal liquidity requirements have been for working capital and capital expenditures. Our principal sources of liquidity are
$7.9
million of cash and cash equivalents at
March 31, 2019
, our cash flow from operations, and borrowings available under our credit facility. We expect to use this liquidity for opening new stores, purchasing additional merchandise inventory, maintaining our existing stores,
executing share repurchases,
reducing outstanding debt, and general corporate purposes. We intend to continue our regular quarterly dividend, which will enable us to return excess cash to stockholders. Future dividend payments are subject to the approval of the Board of Directors each quarter.
On September 18, 2018, we and our operating subsidiary, The Tile Shop, LLC, entered into a credit agreement with Bank of America, N.A., Fifth Third Bank and Citizens Bank (the “Credit Agreement”). The Credit Agreement provides us with a senior credit facility consisting of a $100 million revolving line of credit through September 18, 2023. Borrowings pursuant to the Credit Agreement
initially bear interest at a rate of adjusted LIBOR plus 1.75% and may bear interest in a range between adjusted LIBOR plus 1.50% to adjusted LIBOR plus 2.25%, depending on The Tile Shop’s consolidated total rent adjusted leverage ratio. At
March 31, 2019
, the base interest rate was
6.50%
and the LIBOR-based interest rate was
4.49%
.
Borrowings outstanding consisted
of
$50.0
million on the revolving line of credit as of
March 31, 2019
. We also have standby letters of credit outstanding related to our workers compensation and medical insurance policies. As of
March
31,
2019
and
2018
, the standby letters of credit totaled
$1.2
million
and
$1.1
million, respectively
. There was
$48.8
million available for borrowing on the revolving line of credit as of
March 31, 2019
, which may be used to support our growth and for working capital purposes.
The Credit Agreement is secured by virtually all of our assets, including but not limited to, inventory, receivables, equipment and real property. The Credit Agreement contains customary events of default, conditions to borrowings, and restrictive covenants, including restrictions on our ability to dispose of assets, make acquisitions, incur additional debt, incur liens, or make investments. The Credit Agreement also includes financial and other covenants, including covenants to maintain certain fixed charge coverage ratios and consolidated total rent adjusted leverage ratios. We were in compliance with the covenants as of
March 31, 2019
.
We believe that our cash flow from operations, together with our existing cash and cash equivalents, and borrowings available under our credit facility, will be sufficient to fund our operations and anticipated capital expenditures over at least the next
twelve
months.
Capital Expenditures
Capital expenditures were
$12.2
million and
$4.8
million for the
three months ended March 31, 2019 and 2018
, respectively. The
increase
in capital expend
itures is primarily due
to
increased investments in store remodels, merchandising, and information technology investments.
Cash flows
The following table summarizes our cash flow data for the
three months ended March 31, 2019 and 2018
.
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(in thousands)
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Three Months Ended
|
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March 31,
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2019
|
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2018
|
Net cash provided by operating activities
|
|
$
|
19,679
|
|
$
|
9,858
|
Net cash used in investing activities
|
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|
(11,588)
|
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|
(4,846)
|
Net cash used in financing activities
|
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|
(5,742)
|
|
|
(4,504)
|
Operating activities
Net cash provided by operating activities during the
three months ended March 31, 2019
was
$19.7
million compared with
$9.9
million during the
three months ended March 31, 2018
. The
in
crease is attributable to
improved working capital management
.
Investing activities
Net cash used in investing activities totaled
$11.6
million for the
three months ended March 31, 2019
compared with
$4.8
million for the
three months ended March 31, 2018
. Net cash used in investing activities in each period was primarily for capital purchases of store fixtures, equipment, building improvements and leasehold improvements for stores opened or remodeled, asset additions in our distribution and manufacturing facilities, information technology infrastructure, and general corporate information technology assets.
Financing activities
Net cash used in
financing activities was
$5.7
million for the
three months ended March 31, 2019
compared
with
$4.5
million for the
three months ended March 31, 2018
.
Net c
ash
used in financing activities during the
three months ended March 31, 2019
was primarily
$
18.1
million
for the payments of long-term debt and
financing
lease obligations and $
2.6
million in dividends paid to stockholders, offset by advances on the
revolving
line of credit of $
15
.0 million.
Cash and cash equivalents totaled
$7.9
million at
March 31, 2019
compared with
$5.6
million at
December 31, 2018
. Working capital was
$50.7
million at
March 31, 2019
compared with
$79.8
million at
December 31, 2018
.
The decrease in working capital during the first quarter of 2019 was due to the new accounting standard for leases, which added a current portion of lease liability to the Consolidated Balance Sheet.
Off-
B
alance
S
heet
A
rrangements
As of
March 31, 2019
and
December 31, 2018
, we did not have any “off-balance sheet arrangements” (as such term is defined in Item 303 of Regulation S-K) that could have a current or future effect on our financial condition, changes in financial condition, net sales or expenses, results of operations, liquidity, capital expenditures or capital resources.
Contractual Arrangements
As of
March 31, 2019
, there were no material changes to our contractual obligations outside the ordinary course of business.
Recently Adopted Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board (“FASB”) issued a
final
standard that primarily requires organizations that lease assets to recognize the rights and obligations created by those leases on the
c
onsolidated
b
alance
sheet. This standard
also requires expanded disclosures to help financial statement users better understand the amount, timing and uncertainty of cash flows arising from leases.
We
adopted
this
standard effective January 1, 2019 using a modified retrospective approach through a cumulative effect adjustment to retained earnings as of the beginning of the period of adoption.
We determine
if an arrangement is a lease at inception. Operating leases are included in right of use assets and
lease liabilities on the c
onsolidated
b
alance
s
heets. The right of use asset
s
and lease liabilities are recognized as the present value of the future minimum lease payments over the lease term at commencement date. As most of the leases do not provide an implicit rate,
we use
the
incremental borrowing rate based on the information available at commencement date in determining the present value of future payments. The right of use asset is also adjusted for any lease payments made and excludes lease incentives and initial direct costs incurred.
Our
lease terms may include options to extend or terminate the lease typically at
our
own discretion.
We regularly evaluate
the renewal options and when they are reasonably certain of exercise,
we
include the renewal period in its lease term.
Th
is
standard provides a number of optional practical expedients in transition.
We
elected the package of three practical expedients permitted under th
e transition guidance within this
standard, which among other things, allows
us
to carryforward the historical lease classification.
We
did not separate non-lease components from lease components by class of underlying assets
and
we
did not apply the recognition requirements of the standard to short-term leases, as allowed by the standard.
We
also elected to apply the hindsight practical expedient.
Our
election of the hindsight practical expedient resulted in the shortening of lease terms for certain existing leases and the useful lives of corresponding leasehold improvements. In
our
application of
the
hindsight
practical expedient
,
we
considered recent investments in leased properties and
our
overall real estate strategy, which resulted in the determination that most renewal options would not be reasonably certain in determining the expected lease term.
Upon adopting
this
standard,
we
established a right of use asset of
$147.
2
million
and
lease liabilities of
$169.
9
million, reduced deferred rent by
$44.6
million, and recorded a cumulative effect adjustment to retained earnings of
$2
2.0
million.
This retained earnings impact was due to the election of the hindsight practical expedient which resulted in a decrease in the cumulative difference between the straight-line rent expense and rental payments that had been made between the inception of each lease and January 1, 2019.
We also adjusted the
useful life assigned to certain leasehold improvements
, which
resulted in a
$15.3
million reduction in fixed assets and retaine
d earnings. The adoption of this
standard did not have a material impact on net income or cash flow
s during the three months ended
March 31, 2019.
Accounting Pronouncements Not Yet Adopted
In June 2016, the FASB issued a final standard on accounting for credit losses. Th
is
standard is effective for
us
in fiscal 2020 and requires a change in credit loss calculations using the expected loss method.
We are
evaluating the effect of
this
standard on
our
consolidated financial statements and related disclosures
.
In August 2018, the FASB issued
a final standard
which provides guidance on the accounting for costs of implementation activities performed in a cloud computing arrangement that is a service contract
.
The
standard requires customers of cloud computing services to recognize an intangible asset for the software license and, to the extent that payments attributable to the software license are made over time, a liability is also recognized. The standard also allows customers of cloud computing services to capitalize certain implementation costs. The
standard is
effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019.
The
standard will become effective for
us
at the beginning of its 2020 fiscal year, although early adoption is
permitted for all entities. We are evaluating the effect of the standard on our consolidated financial statements