Your Next Big Winner in Home Improvement

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I bought my initial position in Tile Shop Holdings (NASDAQ: TTS) in February of this year.  Tile Shop is a retailer of flooring tile and accessories, selling to both contractors and home owners.  It boasts large, beautifully laid-out stores (stores average 23,000 square feet), and couples compelling products with in-store education for do-it-yourself types.  It was a recommendation by the one of my favorite Motley Fool newsletters, Hidden Gems, in 2012, but I didn't bite.  But when David Gardner and David Meier teamed up to recommend it in the Motley Fool's Rule Breakers service, I was convinced.  Bowled over, in fact.  I staked my initial claim the day after the recommendation was made (a rarity for me!).

My initial research had indicated that Tile Shop possessed several attributes that I value in a growth company:  Seasoned leadership, great store financials, vertical integration, and a compelling market opportunity indicated this was a solid company to invest in, and the company's market capitalization is small, with plenty of room for growth.  But, most importantly, Tile Shop has a clear expansion plan for the future.

Let's take a look at each of these attributes.

Seasoned Leadership

Bob Rucker is the CEO and founder of the company.  He has guided the ship from the original store in Rochester, MN (which opened in 1985) til now.  The success of the company under his guidance has been spectacular, and he remains active beyond the C-suite and boardroom by being personally involved in sourcing products and materials.  The senior management beyond Mr. Rucker have also been on-board for the long-haul.  The two senior VPs each have 20 years with the company, and the CFO has been with Mr. Rucker for 30 years. 

Great store financials

Each new store that opens costs the company roughly $1.4 million, and is expected to generate $1.9 million in sales the first year of operation.  Margins are high (EBITDA margins average over 27%, the highest in this industry), and cash-on-cash return is 40%.  The cash payback time is two-and-a-half years, and same-store sales have been increasing at over 10% per year.  The employees are well-compensated (managers earn over $100K per year, and sales associates average over $50).  This leads to low employee and manager turnover, further improving store performance.

Vertical integration

The high margins are greatly helped by the fact that all of the setting materials are 'house brands', manufactured in Tile Shop's two manufacturing facilities.  Setting materials comprise 17% of total sales, and the margins on these sales are very high.  Couple that with the 'unique sourcing model' that Tile Shop has developed, and the company has tremendous control over the entire supply chain.  Tile Shop directs the sourcing of the raw materials, consults closely with local manufacturers to obtain premium finished products, and controls the transportation of those finished products from the source country to the distribution centers.  This 'top to bottom' control gives them a pricing advantage over their competitors, resulting in better margins across the board.

A compelling market opportunity

There are plenty of companies that sell tile, but none have the scale of the Tile Shop.  Several regional chains exist, but the six chains that target both contractors and the home-owner have a total of 52 stores among them, compared to Tile Shop's 73 stores.  Tile Shop is well on its way to becoming the sole national retail tile chain. 

Tile Shop has thrived even as the flooring industry as a whole has suffered along with the entire housing market.  Industry-wide sales in 2012 were just over $18 billion, 28% less than the peak years of 2005 and 2006.  But, during that time, the market was shifting, and hard-surface flooring gained as a percentage of sales, going from 36% to 43%. Tile Shop should benefit from this trend.

Certainly, Lumber Liquidators (NYSE: LL), which sells hard-wood flooring, has benefited from the shift to hard surfaces, seeing its revenue nearly double, and its stock price quadruple since the dark days of 2008.  Conversely, Interface (NASDAQ: TILE), which sells carpeting primarily to commercial clients, has seen its sales decline from over $1 billion to just over $900 million since 2008.  This reflects the general shift from soft-surface materials to hard-surface flooring. 

What Lumber Liquidators has done for hard-wood flooring, Tile Shop can do for floor tiles.   But, Lumber Liquidators already has 266 stores, many more than The Tile Shop, so we are catching the Tile Shop early in its expansion life-cycle.

A clear expansion plan

The company currently has two manufacturing centers and four distribution centers supporting 73 stores spread over 22 states. This current infrastructure can support an additional 100 stores, with the new Durant, OK facility ready to supply planned stores in the lower plains states (Texas, Oklahoma, Arkansas, Louisiana, New Mexico and Colorado).  Tile Shop sees opportunity for doubling the number of stores over the next several years, with an ultimate target of over 400 stores. Two more planned distribution centers are going up in the mountain west, providing coverage for the entire lower 48 states.

A picture is worth...

This month I was doing my three-month review, and decided that this story had even more to it than initially met the eye.  Looking at a map of their current stores, one thing jumps out at me:

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There are almost no stores in the traditional 'tile belt' -- the hot, often sandy states in the deep south and southwest, where tile is the choice for flooring.  Tile feels cooler in hot weather, and it is easy to sweep up the sand tracked in from the beach, or the back yard. In other words, the Tile Shop has yet to enter what I would consider its prime markets!  A significant growth catalyst is hidden (in plain sight) in their expansion plans.  When they begin building distribution centers and retail stores westward and southward, I would expect per-store revenue to be even greater than their already uber-profitable stores in the midwest and northeast. 

The chain is expecting to grow from the current 70 stores to between 400 - 600 (depending on who you ask!).  All other things being equal, that should lead to a nice price multiple.  But, it appears that all other things are not equal.  The planned expansion is into 'tile territory', which should boost the company's same-store stellar results even more.  This potential catalyst was enough to convince me to triple my holding in the Tile Shop.

Perhaps you are intrigued enough to do your own homework on this company, and maybe even invest in it.  I expect that the experienced management team will succeed in leading this company to be a nation-wide chain of highly-profitable stores, and in the process, reward those of us who invest in the shares handsomely. 

James Kirtley owns shares of Tile Shop Holdings. The Motley Fool recommends Tile Shop Holdings. The Motley Fool owns shares of Tile Shop Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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