Good day, and welcome to the Second Quarter 2022 Tile Shop Holdings, Inc. Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Mark Davis, Vice President of Investor Relations and Chief Accounting Officer. Please go ahead..

Thank you. Good morning to everyone, and welcome to the Tile Shop's second quarter earnings call. Joining me today are Cabby Lolmaugh, our Chief Executive Officer; and Karla Lunan, our Chief Financial Officer.

Certain statements made during the call today constitute forward-looking statements made pursuant to and within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 as amended.

Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from such statements. Those risks and uncertainties are described in our earnings press release issued earlier and in our filings with the SEC.

The forward-looking statements made today are as of the date of this call, and we do not undertake any obligation to update these forward-looking statements. Today's call will also include certain non-GAAP measurements.

Please see our earnings release for a reconciliation of those non-GAAP financial measures, which has also been posted to our Company website. With that, let me now turn the call over to Cabby.

Cabby?.

Thanks, Mark. Good morning, everyone, and thank you for joining us today for an update on our business and a review of our second quarter financial results. We had a good quarter, highlighted by another double-digit increase in comps and sales in excess of $100 million. It is clear that our strategic focus on our existing store base is paying off.

The team continues to execute. We've made great progress building relationships with our pros, and we have a number of exciting initiatives underway. Despite this strong performance, we see signs that the macro tailwinds we've enjoyed over the last several quarters are starting to change.

Industry analysts cite rising interest rates, slowing existing home sales and shifts in consumer spending patterns as possible reasons why we may see a slowdown in home improvement spending during the second half of 2022. We have started to observe this trend in our business as the growth in new orders has started to decelerate in recent weeks.

With that high-level overview in mind, I'd like to provide an update on our 2022 strategic objectives, surrounding our employees, execution in our stores and our supply chain. First, with respect to our employees, it is a privilege to lead such a talented team.

The skills we've cultivated across our organization are in high demand, especially given the current labor shortages and it remains challenging to attract new talent in the current environment. To stay ahead of this, we have been focused on initiatives, designed to invest in our people, enhance our culture and foster employee engagement.

Over the past year, we have refined our training, developed career paths and increased opportunities for interaction between leaders and their teams. During the third quarter, we are looking forward to holding our national sales meeting with all of our store managers, pro market managers and leadership.

It's been several years since we've been able to bring everyone together. So I think this will be an extra special event as we build relationships, reinforce best practices, celebrate milestones and build excitement surrounding our vision for the future. Second, our in-store execution continues to improve.

I am pleased with the results I've seen on a variety of different metrics, such as conversion, back-shelf attachment rates and average ticket. We saw a nice increase in pro sales during the quarter. Our pro mix exceeded 65% of our total sales.

We also successfully piloted a new technology that streamlines our process to log customer interactions such as quotes and sample orders and monitor follow-up activities. We plan to roll this tool out to the rest of our store base during the third quarter. Lastly, we have made nice progress on our supply chain initiatives over the last six months.

Our in-stock levels are back to normal, and we feel good about the level of inventory we are carrying to meet customer demands. While product availability has recently not been an issue for us, our suppliers are continuing to pass along price increases in response to inflationary cost pressures.

In the near-term, we anticipate that the cost pressure will persist. In response to these pressures, we have pulled forward certain purchases before price increases were implemented. This contributed to a $5.3 million sequential increase in inventory during the quarter.

We are also continuing to evaluate alternative sources of supply, where we are able to source high-quality products at lower prices. In short, we had a nice quarter and are positioned to stay focused on our strategy and what we can control. I'll now hand the call over to Karla to touch on our financial results.

Karla?.

Thanks, Cabby. Good morning, everyone. The $107.6 million of revenue generated during the quarter represents a new quarterly sales record. Comparable store sales increased by 12%. This improvement was largely due to an increase in average ticket, driven by our pricing actions and partially offset by a modest decrease in unit volumes.

The gross margin rate during the second quarter was 66%, which was down 310 basis points from last year's second quarter, but up 80 basis points sequentially from the first quarter. The sequential improvement was primarily due to our pricing actions and partially offset by inflationary cost pressures.

We expect the inflationary cost pressures to continue in our supply chain and our inventory costs to stay elevated in the near-term. Given the decrease in unit volumes during the second quarter, and the softening demand trend that Cab spoke about earlier, we plan to take a more conservative approach to future pricing actions.

We intend to pass-through future cost increases from our suppliers to our customers. However, we are not planning to raise prices to the levels required to maintain our current gross margin rates. As a result, we expect to see continued pressure on gross margin rates during the second half of 2022.

SG&A expenses increased by $2.4 million during the second quarter of 2022 when compared to the second quarter of 2021. Pay and benefits expenses, excluding bonus expense, increased by $4 million due to an increase in staffing levels, sales commissions and benefit costs.

Additionally, our store occupancy costs increased by $1 million due to an increase in common area maintenance expenses, normal store repair costs and utility billings. We also spent an additional $700,000 in marketing and $400,000 on travel during the quarter.

These increases were partially offset by a $3.1 million decrease in bonus expense during the second quarter of 2022 when compared to the second quarter of 2021. Approximately three quarters of the decrease was due to a decrease in the expected annual incentive payments and the remaining quarter was due to a decrease in sales bonuses.

Additionally, depreciation expense decreased by $700,000. Net income was $6.9 million during the second quarter of 2022 and adjusted EBITDA was $16.8 million. Our adjusted EBITDA margin rate fell 40 basis points to 15.6%, largely due to the year-over-year decrease in gross margin that was partially offset by lower bonus expenses.

Moving to the balance sheet. As of the end of the quarter, our inventory balance was $110 million. This included the pull forward of some inventory purchases that Cab mentioned earlier. We expect inflationary cost pressures to persist in the near-term.

The combination of our decision to accelerate certain purchases and the ongoing inflationary cost pressure is expected to result in elevated inventory balances over the next several quarters. As of the end of the quarter, we had $10.5 million of cash and our bank debt remained at $5 million.

In closing, we are pleased with the second quarter results and are staying proactive against a dynamic macro environment. With that, Cabby and I are happy to take any questions..

We will now begin the question-and-answer session. [Operator Instructions] The first question today comes from [Connor Jensen] with Capital Markets. Please go ahead..

Connor Jensen for Mark Smith with Lake Street Capital Markets.

I was just wondering if you could give us an update on what you're seeing in consumer behavior as you customer slowed spending at the stores or projects have been canceled due to kind of economic issues right now?.

Hey, Connor. This is Cab. Thanks for the question. With consumer spending, we're still seeing a pretty solid ticket average. What we are noticing though is the traffic is slowing a little bit here and there, knowing that it's – it's seasonality along with, I think, the macro environment.

So we expect to see our traffic slowed during the summer months, but we're seeing a little bit more in areas that are getting us to believe it's impacting our customer. So the order balance has gone down slightly, a little bit more than we would hope. But the ticket average is still very strong.

I think our inventory position has really helped us and in Q2 going into Q3 as well. We don't have a lot of delays and very few cancellations. I think people are excited to get their projects done when they have the labor there to knock it out for them..

And then maybe update us on how slowing housing trends have historically impacted you guys as the housing market kind of starts to weaken here?.

Yes. Typically, we're a few points better than existing home sales, new home sales. So when you see it being depressed, that tells us what we're in for. We're very happy with our results in Q2, and we have a significant order bank going into Q3, but we're seeing it starting to slow.

And we're not surprised by that when you look at the environment and with what's happening in housing. And I was a store manager in 2008 when all this happened. So I went through this before. And we just tightened our belts and grind through it, and people are still going to remodel.

We have a lot of customers that are – they can't get into a new house, they're going to remodel their existing. So we're positioned well for the customers that are still engaged and wanting to do work..

And then lastly, any update on how the remodel stores are performing? And any updates on growth plans for the use of capital, whether it be new stores or continued investments in the current stores?.

Yes, absolutely. We're still not out of remodels. We're pretty excited with the results. They look good. We're getting the products we want in them. And the response has been great. So we have crews out there right now, remodeling our stores. With capital allocation, we're talking about it every day.

We're excited about some things that we think we may be able to accomplish here this year. So I'm not putting out there any new stores right now. I'm not going to say we're not or we will. But there's other things with investments in the business that we're looking at currently, Connor..

[Operator Instructions] The next question comes from Dave Kanen with Kanen Wealth Management. Please go ahead..

Hi. Good morning. Congratulations on a nice quarter. So first question is in regards to inflation. You alluded to gross margins probably going down sequentially in the back half of the year. I'm assuming that's a function of direct COGS such as natural gas, which I know still remains elevated.

Labor probably, you're seeing continued pressures, but the one bright spot that we're tracking is transportation and container costs have come down meaningfully.

Are you starting to see that impact your business?.

Hey, David, it's Cab. We're excited that seeing these costs go down, we do have a WACC model, meaning where we order products six months before it hits our floor and our DCs. So we have – we're challenged with orders that we've placed six months ago that are still rolling through.

We say with our orders we're placing now, yes, the pricing will come down. Some of the COGS will come down, but we'll get that benefit probably in 2023. We have a $110 million in inventory that we're cycling through at a higher cost.

We are looking at resourcing, actively resourcing, looking at different areas of the world where they're not as challenged with things like natural gas or high container costs. But we see it as well. We're excited, but we have to grind away with what we got right now..

Okay. And then last quarter, you guys touched on a new product that you're going to start carrying luxury vinyl tile. And we did some checks and we see, for example, LL, Lumber Liquidators, is being impacted by F&D taking – doing very well in that space. So we're excited to see you guys enter.

I know it's early, but can you give me a preliminary read on that? I know it's a multibillion-dollar opportunity in terms of market or TAM.

What's the early read for you guys? And how should we look at the cadence as you roll it out?.

Sure. Yes. We've been carrying LVT for about a year now. It's just more of a test. We only had a few SKUs. We added a few more, and we're pretty excited with those results. So we're positioning the company to make a bigger investment into that segment.

It's a little ways out, but we're getting everything ready on our end to carry more to make mega splash in that arena. We've noticed a lot of things with our customers with pros and how they're adapting to LVT. We're seeing in other areas where you typically see carpet or hardwood.

So we're selling a lot of our tile for bathrooms, kitchens, fireplaces, mud rooms, but LVT gives you an opportunity to go in areas where typically you would never even find tile, bedrooms and laundry rooms, things like that. So we're pretty excited about it, but more to come..

Okay. And then in regards to your current credit agreements, do the covenants permit for stock buybacks? Can you tell me what's permitted, what's not? I haven't dug through that yet.

And would you guys be willing to amend that? It seems like we have an opportunity to – even though this year with traffic slowing down a little bit, even though what you omitted from your commentary is that interest rates actually have dropped almost 0.75 points from where they were a month ago and maybe going back the other way again.

Gasoline prices are down. So many of the things that affected the consumer could be coming back our way again. But we don't know. We don't have a crystal ball.

But one of the things – opportunities that we have, even if revenue were to flattened or EBITDA were to flattened is to substantially grow our earnings through share repurchases like very large share repurchases similar to what Gary Friedman did at Restoration Hardware, which has been one of the best performing stocks over the last decade in the world.

So could you comment on that for me, please, the loan covenants? And would you, if need be, potentially get amendments or augmentations to it so that we can drive earnings growth through capital allocation?.

Hey. Good morning, David. This is Mark Davis. I just want to acknowledge that, yes, our credit agreement does provide for the ability to repurchase shares as long as our leverage ratio stays below a certain point. What we would decide to do in terms of amending a credit agreement is really all hypothetical at this point.

And to that end, in terms of the broader idea that you're raising, we have a good history here of really considering various options in front of us and trying to make the right decision for the company and shareholders, and we'll continue to do so..

Okay. Guys, best of luck in the second half of the year and beyond. Thanks for your time..

Thanks, David..

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Davis for any closing remarks..

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

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect..