ITEM 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 intentions regarding delisting from Nasdaq and deregistering our common stock, 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 Risk Factors set forth in Part I, Item IA of 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 September 30, 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 opened one new store and closed one store at the end of its lease in the first nine months of 2019, and opened two new stores during 2018. Between October 1, 2018 and September 30, 2019, we opened one new store and closed one store. We plan to open an additional four 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 September 30, 2019 and 2018, we reported net sales of $85.9 million and $89.3 million, respectively. The decrease in sales for the three months ended September 30, 2019 compared to the three months ended September 30, 2018 was
primarily due to a decline in comparable stores sales of 3.5%, or $3.1 million. In addition, net sales generated by stores not included in the comparable store base decreased by $0.2 million.
For the nine months ended September 30, 2019 and 2018, we reported net sales of $261.8 million and $273.3 million, respectively. The decrease in sales for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 was primarily due to a decline in comparable store sales of 4.0%, or $10.8 million. In addition, net sales generated by stores not included in the comparable store base decreased by $0.8 million.
The decrease in sales at comparable stores for the three months ended September 30, 2019 was due to weaker store traffic. The decrease in sales at comparable stores for the nine months ended September 30, 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.
The table below sets forth information about our comparable store sales (decline) growth for the three and nine months ended September 30, 2019 and 2018.
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For the three months ended
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For the nine months ended
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September 30,
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September 30,
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2019
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2018
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2019
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2018
|
Comparable store sales (decline) growth
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(3.5)
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%
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2.1
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%
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(4.0)
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%
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(2.3)
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%
|
For the three months ended September 30, 2019 and 2018, we reported gross profit of $59.2 million and $63.0 million, respectively. The gross margin rate was 68.8% and 70.6% for the three months ended September 30, 2019 and 2018, respectively. For the nine months ended September 30, 2019 and 2018, we reported gross profit of $182.4 million and $192.4 million, respectively. The gross margin rate was 69.7% and 70.4% for the nine months ended September 30, 2019 and 2018, respectively. The decrease in gross margin rate was primarily due to higher levels of shrink and damaged inventory write-offs combined with a lower freight collection rate.
For the three months ended September 30, 2019 and 2018, we reported loss from operations of $0.6 million and income from operations of $3.9 million, respectively. For the nine months ended September 30, 2019 and 2018, we reported income from operations of $3.1 million and $17.4 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 $33.6 million and $15.7 million for the nine months ended September 30, 2019 and 2018, respectively, which was used to fund operations, new store construction activities, store remodels, merchandising, information technology investment and dividends. Share repurchases were funded by increased debt during the nine months ended September 30, 2019. We expect to continue to fund our capital expenditures and daily operations from our operating cash flows.
We repurchased 2.3 million shares for $10.5 million during the nine months ended September 30, 2019. Our Board of Directors had previously authorized a $15.0 million share repurchase program. The Board of Directors terminated the share repurchase program effective October 18, 2019.
On October 22, 2019, the Company announced its intention to delist from the Nasdaq Stock Market (“Nasdaq”), deregister its common stock, suspend the quarterly cash dividend, and terminate the share repurchase program. The Company intends to file a Form 25 with the Securities and Exchange Commission (the “SEC”) on or about November 1, 2019 in order to delist from Nasdaq. The Company anticipates that the last day of trading on Nasdaq will be on or about November 8, 2019. On or about November 12, 2019, the Company intends to file a Form 15 with the SEC, at which time the Company anticipates that its obligations to file periodic reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including annual, quarterly and current reports on Form 10-K, Form 10-Q and Form 8-K, respectively, will be suspended, and that all requirements associated with being an Exchange Act-registered company, including the requirement to file current and periodic reports, will terminate 90 days thereafter.
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 provides 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 and nine months ended September 30, 2019 and 2018 is as follows:
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(in thousands)
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Three Months Ended
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September 30,
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2019
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% of sales(1)
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2018
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% of sales
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Net (loss) income
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$
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(1,383)
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(1.6)
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%
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|
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$
|
2,553
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2.9
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%
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Interest expense
|
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1,027
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1.2
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|
715
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0.8
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Income taxes
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(274)
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(0.3)
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652
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0.7
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Depreciation & amortization
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8,308
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9.7
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|
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7,202
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8.1
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Stock based compensation
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660
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0.8
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735
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0.8
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Adjusted EBITDA
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$
|
8,338
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9.7
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%
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$
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11,857
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13.3
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%
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(in thousands)
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Nine Months Ended
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September 30,
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2019
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% of sales(1)
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2018
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% of sales
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Net (loss) income
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$
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(217)
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(0.1)
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%
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|
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$
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11,522
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4.2
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%
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Interest expense
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2,948
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|
1.1
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1,866
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0.7
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|
Income taxes
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348
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0.1
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4,157
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1.5
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Depreciation & amortization
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24,508
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9.4
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21,180
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7.7
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Stock based compensation
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2,169
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0.8
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1,950
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0.7
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Adjusted EBITDA
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$
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29,756
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11.4
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%
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|
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$
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40,675
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14.9
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%
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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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September 30,
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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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$
|
3,762
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$
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13,769
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Total Assets
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389,561
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281,996
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Less: Accounts payable
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(25,280)
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|
(29,015)
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Less: Income tax payable
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(72)
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|
(71)
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Less: Other accrued liabilities
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(26,119)
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|
(26,751)
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Less: Lease liability(2)
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(114,490)
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|
(42,401)
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Less: Other long-term liabilities
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|
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(3,669)
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|
|
(4,346)
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Capital Employed
|
|
$
|
219,931
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|
$
|
179,412
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|
|
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|
|
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|
|
Pretax Return on Capital Employed
|
|
|
1.7
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%
|
|
7.7
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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 measures in isolation or as an alternative to financial measures determined in accordance with GAAP. The principal limitation of these non-GAAP financial measures 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 measures. In order to compensate for these limitations, management presents its non-GAAP financial measures in connection with GAAP results. We urge investors to review the reconciliation of our non-GAAP financial measures to the comparable GAAP financial measures and not to rely on any single financial measure to evaluate our business.
Results of Operations
Comparison of the three months ended September 30, 2019 to the three months ended September 30, 2018
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(in thousands)
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2019
|
|
% of sales(1)
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2018
|
|
% of sales(1)
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Net sales
|
|
$
|
85,944
|
|
|
|
|
$
|
89,259
|
|
|
|
Cost of sales
|
|
|
26,775
|
|
31.2
|
%
|
|
|
26,248
|
|
29.4
|
%
|
Gross profit
|
|
|
59,169
|
|
68.8
|
%
|
|
|
63,011
|
|
70.6
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%
|
Selling, general and administrative expenses
|
|
|
59,804
|
|
69.6
|
%
|
|
|
59,131
|
|
66.2
|
%
|
(Loss) income from operations
|
|
|
(635)
|
|
(0.7)
|
%
|
|
|
3,880
|
|
4.3
|
%
|
Interest expense
|
|
|
(1,027)
|
|
(1.2)
|
%
|
|
|
(715)
|
|
(0.8)
|
%
|
Other income
|
|
|
5
|
|
0.0
|
%
|
|
|
40
|
|
0.0
|
%
|
(Loss) income before income taxes
|
|
|
(1,657)
|
|
(1.9)
|
%
|
|
|
3,205
|
|
3.6
|
%
|
Benefit from (provision for) income taxes
|
|
|
274
|
|
0.3
|
%
|
|
|
(652)
|
|
(0.7)
|
%
|
Net (loss) income
|
|
$
|
(1,383)
|
|
(1.6)
|
%
|
|
$
|
2,553
|
|
2.9
|
%
|
(1) Amounts do not foot due to rounding.
Net Sales Net sales for the third quarter of 2019 decreased $3.3 million, or 3.7%, compared with the third quarter of 2018, primarily due to a $3.1 million decrease in net sales generated by comparable stores. The decrease in sales at comparable stores for the three months ended September 30, 2019 was due to weaker store traffic. In addition, net sales generated by stores not included in the comparable store base decreased $0.2 million.
Gross Profit Gross profit for the third quarter of 2019 decreased $3.8 million, or 6.1%, compared with the third quarter of 2018 primarily due to a decrease in net sales. The gross margin rate was 68.8% and 70.6% for the three months ended September 30, 2019 and 2018, respectively. The decrease in gross margin rate was primarily due to higher levels of shrink and damaged inventory write-offs combined with a lower freight collection rate.
Selling, General, and Administrative Expenses Selling, general, and administrative expenses for the third quarter of 2019 increased $0.7 million, or 1.1%, compared with the third quarter of 2018. The increase in selling, general, and administrative expenses was due to an increase in advertising costs, partially offset by a decrease in legal and variable store compensation expense.
Interest Expense Interest expense was $1.0 million and $0.7 million for the third quarter of 2019 and 2018, respectively. The increase was due to higher average debt balances and higher interest rates during the third quarter of 2019.
Provision for Income Taxes Income tax provision decreased $0.9 million for the third quarter of 2019 compared with the third quarter of 2018 due to a decrease in income before income taxes. Our effective tax rate for the three months ended September 30, 2019 and 2018 was 16.5% and 20.3%, respectively.
Comparison of the nine months ended September 30, 2019 to the nine months ended September 30, 2018
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(in thousands)
|
|
|
2019
|
|
% of sales(1)
|
|
2018
|
|
% of sales
|
Net sales
|
|
$
|
261,755
|
|
|
|
|
$
|
273,307
|
|
|
|
Cost of sales
|
|
|
79,384
|
|
30.3
|
%
|
|
|
80,946
|
|
29.6
|
%
|
Gross profit
|
|
|
182,371
|
|
69.7
|
%
|
|
|
192,361
|
|
70.4
|
%
|
Selling, general and administrative expenses
|
|
|
179,314
|
|
68.5
|
%
|
|
|
174,928
|
|
64.0
|
%
|
Income from operations
|
|
|
3,057
|
|
1.2
|
%
|
|
|
17,433
|
|
6.4
|
%
|
Interest expense
|
|
|
(2,948)
|
|
(1.1)
|
%
|
|
|
(1,866)
|
|
(0.7)
|
%
|
Other income
|
|
|
22
|
|
0.0
|
%
|
|
|
112
|
|
0.0
|
%
|
Income before income taxes
|
|
|
131
|
|
0.1
|
%
|
|
|
15,679
|
|
5.7
|
%
|
Provision for income taxes
|
|
|
(348)
|
|
(0.1)
|
%
|
|
|
(4,157)
|
|
(1.5)
|
%
|
Net (loss) income
|
|
$
|
(217)
|
|
(0.1)
|
%
|
|
$
|
11,522
|
|
4.2
|
%
|
Net Sales Net sales for the nine months ended September 30, 2019 decreased $11.6 million, or 4.2%, compared with the nine months ended September 30, 2018, primarily due to a $10.8 million decrease in net sales generated by comparable stores. The decrease in sales at comparable stores for the nine months ended September 30, 2019 was due to weaker store traffic, customer experience issues
following the implementation of a new enterprise resource planning system and the launch of our new website. In addition, net sales generated by stores not included in the comparable store base decreased $0.8 million.
Gross Profit Gross profit for the nine months ended September 30, 2019 decreased $10.0 million, or 5.2%, compared with the nine months ended September 30, 2018. The gross margin rate was 69.7% and 70.4% for the nine months ended September 30, 2019 and 2018, respectively. The decrease in gross margin rate was primarily due to higher levels of shrink and damaged inventory write-offs combined with a lower freight collection rate.
Selling, General, and Administrative Expenses Selling, general, and administrative expenses for the nine months ended September 30, 2019 increased $4.4 million, or 2.5%, compared with the nine months ended September 30, 2018. The increase in selling, general, and administrative expenses was due to a $3.3 million increase in depreciation expense and $1.3 million increase in advertising expense.
Interest Expense Interest expense was $2.9 million and $1.9 million for the nine months ended September 30, 2019 and 2018, respectively. The increase was due to higher average debt balances and higher interest rates during the nine months ended September 30, 2019.
Provision for Income Taxes Income tax provision decreased $3.8 million for the nine months ended September 30, 2019 compared with the nine months ended September 30, 2018 due to a decrease in income before income taxes. The decrease in the tax provision was due to lower net income before tax.
Liquidity and Capital Resources
Our principal liquidity requirements have been for working capital and capital expenditures. Our principal sources of liquidity are $8.4 million of cash and cash equivalents at September 30, 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, reducing outstanding debt, and general corporate purposes.
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 $100.0 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 September 30, 2019, the base interest rate was 6.00% and the LIBOR-based interest rate was 4.02%. Borrowings outstanding consisted of $63.0 million on the revolving line of credit as of September 30, 2019. We also have standby letters of credit outstanding related to our workers compensation and medical insurance policies. As of September 30, 2019 and 2018, the standby letters of credit totaled $1.3 million and $1.1 million, respectively. There was $35.7 million available for borrowing on the revolving line of credit as of September 30, 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 September 30, 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 $22.8 million and $22.9 million for the nine months ended September 30, 2019 and 2018, respectively. Capital expenditures made in 2019 include investments in store merchandising, store remodels, and information technology.
Cash flows
The following table summarizes our cash flow for the nine months ended September 30, 2019 and 2018.
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(in thousands)
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Nine Months Ended
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September 30,
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2019
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2018
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Net cash provided by operating activities
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$
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33,612
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$
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15,721
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Net cash used in investing activities
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(22,229)
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(22,880)
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Net cash (used in) provided by financing activities
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(8,540)
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10,634
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Operating activities
Net cash provided by operating activities during the nine months ended September 30, 2019 was $33.6 million compared with $15.7 million during the nine months ended September 30, 2018. The increase is attributable to improved working capital management, partially offset by lower net income.
Investing activities
Net cash used in investing activities totaled $22.2 million for the nine months ended September 30, 2019 compared with $22.9 million for the nine months ended September 30, 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 $8.5 million for the nine months ended September 30, 2019 compared with net cash provided by financing activities of $10.6 million for the nine months ended September 30, 2018. Net cash used in financing activities during the nine months ended September 30, 2019 was primarily $43.2 million for payments of long-term debt and financing lease obligations, $10.5 million for repurchases of common stock, and $7.7 million in dividends paid to stockholders, offset by advances on the revolving line of credit of $53.0 million.
Cash and cash equivalents totaled $8.4 million at September 30, 2019 compared with $5.6 million at December 31, 2018. Working capital was $52.4 million at September 30, 2019 compared with $79.8 million at December 31, 2018. The decrease in working capital during the third 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-Balance Sheet Arrangements
As of September 30, 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 September 30, 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 consolidated balance 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 consolidated balance sheets. The right of use assets 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.
This standard provides a number of optional practical expedients in transition. We elected the package of three practical expedients permitted under the 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 $22.0 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 retained earnings. The net impact of the cumulative effect adjustments also resulted in a $1.7 million reduction of deferred tax assets and a corresponding adjustment to retained earnings that was recorded during the nine months ended September 30, 2019. The adoption of this standard did not have a material impact on net income or cash flows during the three and nine months ended September 30, 2019.
Accounting Pronouncements Not Yet Adopted
In June 2016, the FASB issued a final standard on accounting for credit losses. This standard is effective for us in fiscal year 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 fiscal year 2020, although early adoption is permitted for all entities. We are evaluating the effect of the standard on our consolidated financial statements and related disclosures.