Weak Shorts, Weak Longs – My Mistakes of 2013

Preface

“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” – Charlie Munger

A lot of things went right in 2013. My portfolio handily beat the S&P’s stellar performance. But I don’t want to focus on that. This post is about the mistakes I made, and the lessons I’ve tried to learn. For those who don’t want to read the whole post, I’ve summarized the take always below:

1. Be careful not to let an edge turn into an ego trip. ONLY take a position when you have an edge.

2. Learn to do nothing. Never be afraid to walk away from an investment. As WB puts it, wait for the fat pitch!

3. Once you get what you were looking for from a catalyst, cover your ass!

4. Short selling is very hard.  Be very picky and never bet too much.

Meta Analysis Disclaimer

There is a lot of noise in any given year or even years investing results, so much so that even with the benefit of hindsight it can be difficult to say what was a mistake and what was correct. Acknowledging that, let’s just say I’m going to go over mistakes that fall into the known mistakes category, and ignore the unknown mistakes category – and even more troubling – I’ll ignore the possibility of these trades I label mistakes actually were correct ex-ante.

Debt Ceiling – Distinguishing Edge From Ego

This first mistake is a very clear example of how to behave when you have an edge and how not to behave when you don’t. When the S&P sold off in the fall of 2013 due to concerns about the government’s ability to pass the debt ceiling, (again) I was closely monitoring the situation. At one point it was 11pm EST and news stories began to appear on Twitter and the Wall St. Journal stating that the house was very close to reaching some sort of compromise. One look at the level of S&P futures told me that the market either hadn’t incorporated the information or chose to disbelieve it. Though I believed in congress’ ineptitude, the deadline for a deal was fast approaching and I judged it likely that there was some truth to the news reports. Realizing that a breaking story happening outside of regular trading hours actually offered a small investor such as myself an advantage, I felt I had enough of an edge to merit backing up the proverbial truck, and so I did. I bought as many S&P mini-futures as a safely could. Over the course of the next day the market rallied nearly 20 points and I made profits worth about 20% of my equity.

This entire rally happened on the back of no concrete deal. Merely the hint that something was close to being agreed upon. Now this is where I made my big mistake. Somehow, someway I got it into my head that this yet to be seen agreement would disintegrate due to the usual partisan squabbles. Now it’s one thing to conjecture something, but it’s another to make trade out of it. Honestly, and embarrassingly, I think that instead of attributing the money I had just made to a well timed play on shaky information, I started to believe that I was George Soros re-incarnate. So of course, I gave back all the money I had just made when the market continued to rally and I was stopped out.

What I’m trying to take away from this mistake is how easily edge can lead to ego and how dangerous that is. George Soros says the market is always wrong but that he’s always fallible too. To me those two statements are like an equation that has to balanced because if it doesn’t you wont be in the game for long. Taking a big position when you believe you have an edge is justified so long as the security is liquid and you can cap your downside. Taking a big position when you have no edge is just a road to ruin. In short, I need to be careful that I don’t let luck or even a brief edge creep into ego. Hopefully getting burned once will be enough.

HLF – Weak Shorts, Weak Longs

“ Cause it’s so hard to do and so easy to say, but sometimes, sometimes you just have to walk away.” – Ben Harper

Herbalife, oh herbalife, how many hours have fallen by thy name? They should use this stock as a case study at Harvard business school because I think everyone involved is crazy, myself included. I became interested in this stock like everyone else because of the controversy surrounding it. So I took the time to watch Mr. Ackmann’s presentations, read long and short opinions on the interweb, and looked at the financials. Net, net I came to the erroneous conclusions that it made sense to be short the stock going into the end of the year, and the firm’s audit report deadline. I lost money shorting the stock because of horrible position management. That said, I believe there is a broader lesson to be drawn from Herbalife, a lesson that is more about choosing the proverbial table you play at then how a given hand goes while your there.

I said I was intrigued by the controversy surrounding the stock, and what I’ve come to conclude is that the controversy was legitimate. The longs were vulnerable to the possibility of the marketing schemes collapse and increased government regulation (of whatever form), and the shorts were vulnerable to continuing profitability and squeeze pressure from both opportunistic investors and the company. The shorts also lacked both proof of fraud and a precedent of real government intervention. Of course anything can be an attractive at the right price but HLF was (hardly) ever there.

Herbalife is a case of weak shorts and weak longs. Everyone, both sides, are choosing to play a hard game, when the reality is I don’t have to. I think making things harder than they have to be is probably one more the most pervasive errors in investing. We, me, people, spend a lot of time, do a lot of research and as a result feel like we need to have a conclusion to show for it. So we make wagers that we don’t have to because we feel like we deserve to have an opinion based on all the work we’ve done.

People talk a lot about being unemotional about investments but not nearly as much about remaining unemotional about our investment candidates. Likewise, people often say investing is hard, but sometimes it’s the not investing that’s difficult. Stepping away from something you’ve put your time and energy into is hard. There is a huge psychological barrier against it.  To combat this tendency I’m going to start making a list of all the things I’ve learned while researching the stock. Then I’m going to look at that list and say to myself, even if I don’t invest now, these are all the new things I know that can help me with future investments. That way I’ll be able to feel like I haven’t wasted my time, and more importantly, stop myself from wasting my money.

JCP – Know Your Business

JC Penny was a situation where I didn’t understand the business well enough. My thesis was that with Ron Johnson out and Mike Ullman in, the company had enough cash and assets to get it through the turn around 2.0 without diluting current equity holders.  I believed I had done my research, I read financial statements, created an elaborate financial model of the capital structure and checked to see how others opinions compared with my own. I ended up being wrong about the capital structure, and the company had to raise equity because their business (suppliers) demanded it. This mistake was a result of not sufficiently understanding the stock and/or business. It was a small comfort to see that Kyle Bass and Hayman Capital were in the same boat I was. Sometimes even smart people with better access to experts get things wrong.

MUSA  – Using Leverage With Catalysts

“Bulls and Bears make money, but Pigs get slaughtered.” – Anonymous

“Experience is what you get when you didn’t get what you wanted.”  – Howard Marks

MUSA which has been previously profiled on this site was a recent spinoff trading at a significant discount to its peers. In addition, it had ethanol assets worth more than their carrying value that it was going to dispose of, and windfall income from the sale of RIN credits. My thesis was that the first earnings call would bring the Wall St’s attention and lead to the stock trading higher. Since I thought knew the timing of an event which would be the catalyst for a higher valuation, I decided to use options to increase my leverage. Lo and behold the stock did climb nearly ~20% to $45 in the run-up to and following the first earnings release. And of course, instead of congratulating myself on the windfall I had just made I decided to try and avoid paying taxes in 2013, and see if the stock could get to my price target of $51 per share. Now I did sell some options but not nearly enough and soon after J.P. Morgan put a price target of $45 on the stock, and a slight sell-off crushed the stock back down to ~40 per share turning my formerly spectacular profit into an abysmal loss.

I may have been wrong to buy those options in the first place. Spinoffs can take a long time to develop a following. Joel Greenblatt says you should give the market 2-3 years to correct a mis-pricing.  Assuming I was correct to have the position in the first place, I should have sold much more of it as we moved away from the “catalyst event” in question. Another lesson I’ve learned is that while options are great when they work for you, when you own illiquid options in a stock you believe in it is extremely painful to start caring about daily price fluctuations.

So two take always; one, only use options (or lots of leverage) when you are sure about a catalyst event, and two, once that catalysts delivers the juice you were hoping for, start selling down the position, cover your ass – don’t wait.

 The Wages of Sin – Pandora, Tesla, TTS, Et al.

“We don’t short stocks because we don’t like trading misery for money.” – Charlie Munger

2013 taught me that shorting stocks is very hard.  I think the most important lesson was to never short a company whose product you would actually use or want. I don’t care how overvalued, unless there is fraud, it’s probably not going to be a strong short. Whatever your conditions for being long a stock they should be doubly stringent for going short, and the position size greatly reduced because of the negative convexity shorts exhibit.

Timing is another important element of short selling that I can improve upon. As a small investor, it is fairly easy for me to get in and out of positions, and because shorting is so difficult (especially in a bull market), I think it would be wise to use that to my advantage.  This goes especially for weaker shorts where I believe I’ve identified a catalyst/trigger event. Using technical factors to try and position oneself into an event could very much help limit losses associated with a rising market or single name. Of course if the stock were pure scum with no discernable trigger you probably don’t want to play games jobbing around the position. But with more “event driven” short opportunities, I think this kind of positioning game could help performance. On the other hand, I’m sure it would also be a lot of work to implement.

In Sum

All in all, 2013 was a great year, and I can’t complain but I can try to improve.

Coattailing Sears Canada – $SCC

You don’t have to think of everything, you know. It was Isaac Newton who said I’ve seen a little more of the world than others because I stand on the shoulders of giants. There’s nothing wrong with standing on other people’s shoulders. – Warren Buffett

TickSCCshot

Sears Canada is an example of what Warren Buffett calls coattailing.  That is, putting other peoples ideas into your own portfolio. I came across this stock when reading the Horizon Kinetics Q4 investor letter.  You can and should read their excellent letter here - but essentially – their thesis is that based on recent transactions, the company has leases that could be monetized to the tune of  ~3.00 billion. Given that the company currently has a  ~ 1.3 billion market capitalization this represents a significant asset cushion, and a potentially attractive investment.

That said, intelligent investors will want to know, what are the assumptions going into that ~3 billion of asset? Here’s what the folks at Horizon said:

“So, if the company agreed to vacate six stores for $644 million, how much might the rest be worth? The annual report provides information that the average size of the full-line department stores is a bit over 128,000 square feet. In that case, the $644 million, for those 11 stores amounts to about $450 per square foot. Now some would say, and they’re probably right, that these were among the best-located, most valuable Sears Canada stores, and that the remaining 111 full-line stores are worth far less.

Ok. Our investigations suggest that merely to construct a mall store costs well above $100 per square foot. If we assume that the remaining full-line stores are worth only that much, then 111 stores x $100/sq ft x 128,800 sq ft/store = $3.03 billion, or $29.78 per share. That was over twice the market value of Sears Canada at the time.  Nor does that calculation include the 300-plus other properties. Nor does it include the top four full floors of the Toronto Easton Centre, the premier shopping center/office tower/hotel complex in Toronto, which the company did not vacate as part of the October transaction.”

Cynics might assume that any company selling so cheap must be up to its eyeballs in debt. That’s not the case here. With about ~230 million in cash on the books,  ~700 million in net current assets, ~50 million in debt, and ~412 million in retirement obligations – the company is well capitalized.

As for the operating business, it was cash flow positive for eight years up until 2013. Now however, the business, (like most other big box retailers) is under pressure. Cash from operations over the trailing twelve months has been -33 million. These losses are not devastating to the investment thesis so long as they are constrained to the present level but it is a risk. A mitigating factor is that Sears Canada has Sears Holdings and thereby Edward Lampert as a controlling owner. Bearing in mind that a considerable portion of Mr. Lamperts net worth is invested in Sears Holdings, it seems reasonable to assume he will take steps to maximize shareholder value should the losses mount.

Other Risks

Anything times zero is zero, Buffett said. A total loss is a “zero.” No matter how small the likelihood of a total loss on any given day, if you kept betting and betting, the risk kept stacking up and multiplying. If you kept betting long enough, sooner or later, as long as a zero was not impossible, someday a zero was one hundred percent certain to show up. Long-Term, however, had not even tried to estimate the risk of a loss greater than twenty percent—much less a zero. – Alice Schroder, The Snowball

At first glance SCC seems like a homerun; a well known brand with backed by significant asset coverage and an incentivized owner-operator is probably as much as an investor could wish for. What gives me pause is that this bet has aspects, which to me, make it a derivative of the Canadian real-estate market.

As some may be aware, there has been hypothesizing of a Canadian housing bubble for some time now.  Though skeptics have largely pointed at the residential market, I feel it’s safe to assume that a credit bubble lifts more than one boat.  The most obvious and important being the commercial being real-estate market. Any decline in said market would likely have negative impact on the realizable value of the real estate assets held be SCC. In addition, a declining housing market would likely have a profound impact on an already leveraged consumer base.  Considered together, these vulnerabilities conjure the vision of a declining real-estate market and weakened consumer eroding both the asset coverage and core business at Sears.

Of course, the question is not merely whether the scenario is possible, but rather how likely? The answer is unknowable, at least to me. Nonetheless, it seems likely enough to give any investor second thoughts about about loading up on Sears Canada.

Disclosure: Long SCC

Rationally Considered – Handicapping The Odds of Fraud at $TTS

Croachapple

Intro

On November 14th, Gotham City Research published a report alleging that the Tile Shop (TTS) was using an undisclosed related party to fraudulently inflate its earnings. Later that day the company responded with a statement denying every allegation except that they do business with an export trading company owned by one of their own employees. The next day a number of banks put out research notes recommending the stock, stating that they believe the company’s financials are accurate and the core business sound. After all this, the company is trading at an enterprise value of about ~ 920 million, a generous valuation that for me begs the question, is this a fraud or not?

TTS V.S. Topps Tiles U.K.

I’m not going to cover 90% of what Gotham did in its report, so you should go read it if you want the whole story. What I’m going briefly discuss is, after know everything Gotham has said, what does a “normal” tile retailer look like, and what can that help is infer about TTS? Gotham used the long bankrupt Color Tile Inc. as an example of what tile economics should look like. I think that’s a decent comparison, but using a now bankrupt company seems a touch rocky to me. So instead I went and looked at Topps Tiles; a specialty tile retailer in the U.K., that I think makes for an equal or better comparison. Topps Tiles has 320 store locations in the U.K., $275 (USD) of revenue in 2012, is publicly traded and has a market capitalization of approximately 175 million GBP or 262 million USD.

First up, what are gross and EBITDA margin? TTS sports some of the badest (best) in the business, at 70% gross and ~27.5% EBITDA. The more mature Topps Tiles has a gross of 59% and an EBITDA of around 11% between 2010 and 2012.  Many people, myself included, have doubted whether TTS can maintain such outstanding margins as it becomes a national retailer, and Gotham wen’t so far as to deny that the gross margin is even real. The reality is that no one but the company knows the truth about gross margin. For now, all that we can say is that a gross margin of 70% doesn’t seem to be the norm for large flooring retailers.

Margins are very important but the inventory levels are what I find really interesting. This was a major focus of Gotham’s report, and something I missed completely when I looked at the company earlier this year (shame on me). In its report Gotham cited a metric called Days Sales Inventory, which is calculated as ((Inventory / COGS) *365). And indeed, TTS has some very high days sales inventory. Since 2007 DSI has been at or above 250, and currently stands at a striking 411 on a trailing twelve-month basis.

DSI Delta

However, I feel i must mention that when looking at both companies one thing I noticed though is that because of how DSI is calculated, a company with a higher gross margin will tend to exhibit a higher DSI.  This puts TTS at a comparative disadvantage for no reason other than it supposedly buys cheaper. (See exhibit above) Therefore I took the step of adjusting Topps Tiles gross DSI for the difference in margin between the companies. The result, even with this adjustment TTS exhibits much higher DSI than Topps Tiles in every period.

TTS DSI CALC

Forgetting DSI for a moment, comparing the two companies in more absolute terms provides an even better sense of the profound amount of inventory that TTS is carrying on its books. Topps Tiles has 320 stores and $275 million in sales in 2012. It carries $41 million (USD) of inventory to support its operations. TTS has 80 stores and $ 218 million of sales in the TTM period, and carries $71.8 million of inventory as of Q3 2013 or 75% more than Topps Tiles.

Why and how can a company that is supposed to have better gross and EBITDA margins be carrying so much inventory?

Cockroach Theory

I ended the last section with a question because that’s all I have. As far as I can see there is no direct proof that TTS has done anything illegal – only circumstantial evidence (the exception being not disclosing a related party.) This brings me to what short sellers sometimes call cockroach theory. The analogy is that just as if you’ve seen one cockroach the likelihood is that there are others, if you see one instance of misconduct, the likelihood is that there is more. TTS has already showed us at least one cockroach by admitting to the non-disclosure of the related party. Taken together with the massive inventory levels and the other issues brought up by multiple reports, I’ve come conclude it is more likely than not that something rotten at The Tile Shop.

Invert

As Mr. Munger would do lets leave off by examining the counterfactual; what if TTS is not a fraud? In that case what we’re left with is an incompetent management team, an unproven business model, a highly leveraged capital structure, plenty of shareholder lawsuits, material weakness in financial reporting, and a shit-load of tile.

Disclosure: Short TTS 

Memo Attention Apple: A Map to Pandora’s Jugular

Memo Attention Apple: A Map to Pandora’s Jugular

Background

I am disgusted with myself for not seeing what was right in front of me, and I am disgusted with iTunes Radio for the same thing. Since September, I have been short Pandora (P), believing that iTunes Radio would be a powerful competitor, powerful enough to knock the luster off P’s Tech-bubble 2.0 valuation. Essentially, I was betting that Apple would continue its legacy of creating products that offer a superior user experience. Instead, what they released was a half-baked add-on whose only purpose seems to be demonstrating that Apple (AAPL) has forgotten its roots. Unlike other Apple products, iTunes Radio seems to be based on the thesis that people will value features over depth of experience. This is a shocking and disturbing outcome for Apple shareholders, since the entire Apple Empire has been built on delivering products that are the antitheses of such geeky reasoning. The good news is that iTunes radio is highly fixable. Here’s how to do it.

Forget the Features! (Know Your Customer)

Apple has put a lot of emphasis on the breadth of its catalogue, and the higher sound quality on offer. This is a mistake. While both of these things are worthwhile, they are only marginally additive to the average user experience, which is the only thing that really counts.

First the catalogue, lets face it; most people listen to the hits. Yes you will find one in a hundred people who want to hear 1950’s French pop music but most of us don’t want to hear much more than we would on traditional radio. Ask any musician, the Pareto Principal in full effect when it comes to the average persons musical tastes. That is to say, 80% of the people only care about 20% of the music, and the real numbers are probably much more like 95% to 5%. This is simply not a differentiating factor for the average streaming radio user, end of story.

Sound quality is the other oft-touted feature that offers only the most marginal improvement to the average users experience. Think about yourself in the car, how bad does the sound quality have to get before you change the station? For me, if it’s a song I like, things have to get pretty awful before I touch the dial. The idea that users are going to flock to iTunes for higher sound quality is ludicrous. Look at how many people use the crappy ear-bud headphones Apple gives out. If quality was really a motivating factor, everyone would be walking around with Sennheiser headphones – they’re not.

Fix the Algorithm! (Quality of Selections)

This is a difficult claim to make. But I’m gonna do it anyway. The iTunes radio song selection algorithm is broken, and needs to be fixed. Reasonable minds will enquire; do you have any data to support that conclusion? And the answer is no. I have only my own experience. Nevertheless, I feel confident in asserting that the iTunes algorithm is at present, far inferior to the one Pandora employs. I’ve reached this conclusion after trying ten of my favorite artists on both stations and comparing the musical selections each platform played. The result; I was blown away at how bad iTunes radio performed at selecting relevant songs. That said, I encourage readers to run a similar experiment for themselves, and come to their own conclusions. Don’t take my word for it – go try it out.

The bright side of this, (if you can all it that) is that the affect of the inferior algorithm on the user experience is so obvious, I honestly cannot imagine that it’s not being worked on as we speak. In addition to the tweaking of the broader algorithm, we can reasonably expect improvements in iTunes performance as data from user input is incorporated into the system. Pandora for instance benefits from years of people plugging away at their thumbs up / down icons, helping to fine-tune what gets presented to users and the algorithm itself. As Apple accumulates more feedback from its users it should be able to improve its algorithm to the point where it is competitive. But it’s vital that this happens ASAP. A critical point is that the algorithm doesn’t have to be as good as Pandora’s but it has to be better than it is or things will never work out.

A second order result of poor song selection is that on iTunes radio you quickly run up against your station song skip limit. This is detrimental to new user conversion, hitting the skip limit on multiple stations makes people much more likely to abandon the platform out of sheer frustration.

PandoraSkipLimit

With regard to the skip limit, it’s worth pointing out that Pandora (pictured above) at least gives you a nice, short explanation of why you can’t keep skipping, and how to listen to more music. iTunes radio on the other hand provides only the somewhat terse message: “You can skip six songs per hour on each station.” Being nice and helpful still counts for something in this world, not to mention it’s cheap. Apple, take note.

iTunesSkip

As my girlfriend was kind enough to point out, one good thing about Apple’s message is that it tells you how many how many songs you are allowed to skip per station. Pandora’s by contrast is ambiguous and can make users nervous about using the skip button.

Pandora Helpful Hints

While we’re on the subject of niceties, another nice thing about Pandora is that they provide suggestions of similar artists you might like to make a station for (pictured above). Something akin to this would be especially helpful for iTunes radio because it would minimize user loss due to the frustration that occurs when you run up against the skip limit. Put another way, I’m already mad when I run out of skips, I don’t want to have to think about what else I might want to hear. Anyone familiar with the paradox of choice will immediately recognize the value of this or any feature that minimizes the users cognitive workload.

Fix The Feedback Interface! (Ease of Feedback)

“What I propose is a road map to modify our man-made systems to let the simple – and natural – take their course. But simplicity is not so simple to attain. Steve Jobs figured out that ‘you have to work hard to get your thinking clean to make it simple.’ The Arabs have an expression for trenchant prose: no skill to understand it, mastery to write it.” – Nassim Taleb, Antifragile

AppleStar

User feedback is not only an important part of tuning the song selection algorithm, it’s an integral part of the user experience as well.  And so the fact that iTunes radio serves up an inferior interface puts it at a disadvantage on both fronts. I call it inferior is because it’s simply more difficult to use. It takes two clicks to perform any preference action aside from skipping the song. First you have click this little star button (pictured above), and then chose one of three menu options (pictured below). Pandora by contrast offers every single preference option just one click away. It’s hard to express how this little difference can be such a big deal. Steve Jobs would get it. The only other way I can think to put it is that people are really, really lazy. I want to feel like I’m in my favorite armchair listening to the radio, not organizing my iTunes library. Easy – get it?

AppleStarMenu

The other problem is that the feedback options aren’t sufficiently granular. The positive feedback options are ok. You can choose between, “Play More Like This” and “Add to iTunes Wish List”. On the negative side however, your only choices are, “Never Play This Song”, and to skip. This dichotomy comes to feel like a nuisance, especially when you run out of skips. Additionally, the “Never Play This Song” button is ambiguous.  Are we never playing this song again on just this station, or on all stations? I suspect it’s the former but the ambiguity will definitely make many users hesitant to use the button at all. The fix for this is that every preference action be only one click away, and non-committal / non-threatening.

This failure, yes the failure of the iTunes radio user interface is surprising for two reasons. One, this is what Apple is supposed to be good at. Two, they have Pandora to copy! And therein lies the solution. I don’t know whether the thumbs up / down interface is patented, but it shouldn’t take hiring Dan Brown to come up with some alternative symbols. This should have been a layup and they blew it.

ThumbsUpDown

Make it an App! (Accessibility)

iTunes radio isn’t easy to find, and thus far maybe that’s a good thing. In fact, I would wager that half of Apple users have never opened the platform, simply because they don’t know where it is. More importantly, even after you figure out where it is, it’s annoying to have to go into iTunes to get it. This could be easily remedied if Apple would make a separate App for the radio. Even if that app were just a shortcut to bring you into the radio part of the Music App, it would go a long way to making the product user friendly. Make it preinstalled, make it easy to see. You’ll be amazed how many new users you get.

Conclusion

Tim Cook should have been draping the bloody carcass of Pandora across his shoulders at the last Apple event, as proof that Apple is still primus inter pares. Instead, iTunes radio is languishing in the depths of OS 7 – a blemish on an otherwise unparalleled legacy of delivering products that recognize the primacy of user experience above everything else.

Before I wrap up, let me be clear about something; Pandora is overvalued. But not because it doesn’t make any money, it’s overvalued because intelligent investors wouldn’t pay $5 billion plus for a startup with a replicable product that’s surrounded by competitors looking to take a bite out of it. Not the least of which (Apple) also happens to be the distribution platform for 1/3rd of its users. Pandora has been granted a stay of execution thanks to Apple’s shoddy implementation of what has the potential to be a far superior product. However, as I have demonstrated, the road to Pandora’s ruin is not complicated.  Apple could implement most of the changes in a weekend. The only question is whether the giant in Cupertino has enough of its former mojo to strike the killing blow sooner than later.

$TTS – The Louis Vuitton of Tile? – I Think Not

Background

Tile Shop Holdings, (TTS) is a tile retailer that went public in September of 2012. Since then, it has benefited form the markets re-infatuation with anything housing related and currently trades at a ridiculous 26x EV/EBITDA. In the past month the share price has declined 29% due to an earnings miss and allegations by short seller Infitialis research that the company’s products contain hazardous amounts of lead.  After reading Infitialis’ otherwise excellent report, and hearing the company’s response on the most recent earnings call; I deem it unlikely that any action by regulators will be forthcoming. With that in mind, I wrote this article to demonstrate that, even without the threat of poisoning its customers, Tile Shop has issues that, from an investor perspective, are just as poisonous as lead. These include, a fundamentally flawed business model, an overleveraged capital structure, aggressive expansion strategy, declining insider ownership, management misconduct, and oversight failures – all packed into a company that is overvalued in even the rosiest scenario imaginable.

Margins & Model

Everyone sort of lives with their rulers in the past and doesn’t look at coming changes.” – Stanley Druckenmiller

 TTS exhibits gross margins close to 75% – this is simply not sustainable.  The biggest reasons for this are that tile is by and large a commodity product, and retailing it is a business with low barriers to entry. Home Depot, Lowes and even smaller competitors can just as easily buy it from vendors, and sell it for cheaper. But even if it wasn’t a commodity product, the company’s margins are way higher than those of other national retailers that sell highly differentiated goods. For instance, Apple sports a gross margin of around 40%, and remember, they invented the iPhone! Other premium brands with lower gross margins include Coach 72%, Lulu Lemon 50%, and Abercrombie & Fitch 62%. TTS isn’t selling Gucci loafers or Louis Vuitton bags, and its margins will come to reflect that as it tries to become a national franchise.

The best case a reasonable TTS investors should hope for is that it can replicate the gross margin of U.K. based Top Tiles, and achieve a 60% gross, a margin that would leave TTS firmly on the wrong side of profitability.

The other problem at TTS is the SG&A spend. As a percentage of revenue it was ~ 56% in the most recent quarter. And while management is hopeful they can bring that down to the historical 50%, they give no indication of having the ability or even the intention to lower it any further (despite helpful hints by sell-side analysts to suggest otherwise). This high margin-operating model may have worked for a few specialty stores in Minnesota but as the Tile Shop is soon to learn, what works in the minors doesn’t always cut it in the big leagues.

Capital Structure & Strategy

For FY 2013, the company has plans to expand its store count by 17 stores, and hinted at another 20 in 2014. With only $3.85 million of cash on hand as of September 30th and $85.4 million in debt, the company is taking a big risk attempting such an aggressive expansion. Simply put, the company is overleveraged and any bump in the road may be detrimental not only to equity holders but also to lenders willingness to extend credit.

In addition to the daredevil capital structure, investors should be concerned with the speed of the undertaking. Difficult as growing a business is under any conditions, it becomes exponentially more difficult when you try and do it quickly. Issues such as inventory management, location selection, employee quality and supervision, to name just a few, don’t get any easier to manage when you have Wall Street eying you with a stopwatch. Sprinting ahead at full speed increases the odds of a stumble, a stumble TTS cannot afford.

Ownership

Never underestimate strong ownership is what I like to say, and I can’t say that about TTS.  As of November 2012 Nabron International, a trust controlled by the Chan brothers (one of which is a former Enron board member), was the largest single stakeholder with an interest in  ~36% of the outstanding shares. As of June 18th 2013, Nabron had reduced its interest in the company to ~20%, a near 56% reduction in a little over six months. Similarly JWTS, the private equity firm managing the SPAC, has reduced its stake from 13% in November 2012, to 8.4% as of June 10th. Finally, despite receiving share-based compensation, CEO and founder Robert A. Rucker has also reduced his stake from 19.9% in November 2012, to 15% as of June 2013.

All of these investors obviously have better places to put their money than TTS equity – why don’t you?

Management & Conduct

As short sellers Infitialis mention in their report, the CEO of TTS was convicted of fraud in civil court related to divorce proceedings from his now ex-wife. For me, this isn’t a good thing but it’s not necessarily the end of the world.

The other management issue brought to light by Infitialis is the fact that the former Senior Vice President of Operations, Mr. Joseph Andrew Kinder is on probation due to his involvement in a domestic dispute – another bad sign. Since then, it appears Mr. Kinder has been demoted in favor of the recently hired Chris Homeister. Mr. Homeister was previously Senior VP at Best Buy, a company with a poor record of competing on the national stage.

Last but not least, in 2012 the company was found to have a material weakness in its disclosure controls and procedures. As I understand it, the company didn’t have enough people in place at headquarters that were financially competent, nor did they have a sound process for closing the books at the end of year.

In and of themselves none of the aforementioned issues is detrimental to the company’s future. However, when taken together, the picture sure isn’t pretty. At the very least, it should cause investors to think twice about the business they are buying into, as well as the team that will be managing it.

Valuation

Now, for a moment, lets try and forget about all the things I just mentioned. Let’s put on our optimist hats, and see if we can make the current valuation make sense.

Looking out to FY 2016, I put together the below valuation model that makes the following (heroic) assumptions.

Margins

marginsv3

First and foremost, TTS EBITDA margin goes to 30% of revenue. Historically the company has earned about 27.5%. Therefore this assumption extremely generous, especially given that its peers are earning EBITDA margins around 12%. Gross margin remains at the princely 74%, well above peers, while SG&A reverts back to 50% of revenue.

Stores

Stores

TTS expands its footprint to an average of 150 fully operational retail locations in FY 2016. This would correspond to a 23% compound annual growth rate for stores. To achieve such a rapid expansion without any margin contraction is highly unlikely, but hey we’re looking on the bright side here. Not only does the store count expand, but also increases revenue per store to $3.00 million per store or 7% more than they did in 2012.

Enterprise Value

EVV3

We’re going to assume an 11.5x EV/EBITDA multiple in 2016. That’s a higher than what Home Depot currently commands, and it’s a national franchise with a honed operating model, experienced and competent management. I also assume debt will increase to $150 million to finance this growth, while cash moves up to $20 million.

Fullmodelv3

What’s the result of all this future gazing? Despite our psychedelic concessions to the gods of delusion the company still stands ~ 17% overvalued based on Friday’s closing price.

Sensitivity Analysis

Stepping away from never, never land for a moment, I’ve put together a set of sensitivity analyses to get a sense of where more realistic assumptions might value TTS. Below are two sensitivity analyses that still assume the generous revenue per store and store growth assumptions included in the first model but employ more reasonable margins and enterprise multiples.

SG&GM

Highlighted in peach are the areas that I consider plausible scenarios. As you can see, even the most optimistic forecasts of this subset still expect the company to be overvalued by around 50%.

EVGMV3

Conclusion

In addition to the all the fundamental problems, from a more technical and/or psychological standpoint, whatever lollapalooza effect was propelling the stock to its previously astronomical levels has clearly broken-down, and when that magic’s gone, it’s hard to get back. In sum, for TTS the party is over, and the hangover is just beginning.

Genius or Meaningless? – Jesse Livermore Quote

“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.” –Edwin Lefevre in Reminiscences of a Stock Operator

My first impression of the above quote is that it’s genius. And then I think about it a little more and decide that it’s absolutely meaningless. And then I think it might be genius again. I still can’t decide.

What do you think?

$BODY – What’s Book Value Got To Do With It?

Value investing is at its core the marriage of a contrarian streak and a calculator.” – Seth Klarman

Body Central Corporation (Ticker: BODY) is a retailer of women’s clothing focusing on the middle market, late-teens to early-twenties customer. Since their IPO in 2010, the stock has been something of a rollercoaster. Its latest turn has been sharply downward after reporting disappointing results in Q2 of this year. Indeed, since August the shares have declined roughly 45% and the stock now trades at ~90% of book value and ~30% of sales.  At first I was very intrigued by the fact that the company was trading at a discount to book value, was cash flow positive and carried no debt. But then I started to wonder, does book value even matter?

I’ve come to believe that as with many things, the relevance of price to book value for a retailer is a matter of degrees – the lower the better, of course. In BODY’s case a price hovering around 1x book value does not imply a margin of safety for several reasons. The most obvious is goodwill that we should almost always assume to be worthless when contemplating a liquidation scenario. Other considerations are the need to write-down inventories, and operating leases – which are effectively off balance sheet liabilities. In sum, for a retailer, an investor shouldn’t expect any margin of safety above 75% of tangible book value.

For prospective BODY investors, the relevant question (at the risk of stating the obvious) is, will this company be profitable?  The answer, I really don’t know. The new CEO is trying to reinvigorate the store format, and based on the Q2 earnings call, seems very enthusiastic about what’s been achieved.  That said, anyone remotely familiar with the retail market will note that the word transformational has taken on more a ominous connotation after the JCP / Ron Johnson debacle – retailer’s grand visions are now trading at a discount on Wall Street.

Another factor that should give investors pause is the company’s expansion plans. As of Q2 they remained committed to expanding the store count by 25 or approximately 10% of the total store count by the end of the year. My two cents is that management should be focusing on their core business and maybe buying back shares if they are REALLY confidant, rather than distracting themselves with an expanding footprint.

Conclusion

As a value investment, BODY rates highly from a contrarian perspective. Retail is an out of favor sector, and BODY can justifiably be characterized as being at the bottom of the retail barrel. The calculator side of the marriage is more mixed. Declining sales comps, an aggressive expansion policy, and unproven management don’t add up to a margin of safety. On the other hand, stripping out the expansion, the firm remains cash flow positive, and management seems to be working to address the issues. Net-net I think this investment offers better than average prospects but not a substantial margin of safety. Therefore I would advocate a small position at most, if any at all.

P.S.

For more information on the most recent quarter check out this article by 501 analysts on SeekingAlpa.com