Adam Hauser - VP, IR Chris Homeister - CEO Kirk Geadelmann - CFO

Daniel Moore - CJS Securities Peter Keith - Piper Jaffray Peter Benedict - Robert Baird John Baugh - Stifel Nicolaus Kate Mcshane - Citi Joseph Feldman - Telsey Advisory Group

Thank you, Operator. Good morning to everyone on the call, and welcome to the Tile Shop's second quarter earnings call.

Following our prepared remarks, the call will be open for analysts' questions. Questions will be limited to analysts and we would appreciate if participants would limit themselves to one question with one follow-up.

As a reminder, certain statements made during the call today may 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. Words such as, but not limited to, plan, expect, anticipate, believe, estimate, target and any other similar words may be used to identify forward-looking statements.

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 the earnings press release issued today and in the Tile Shop's filings with the Securities and Exchange Commission.

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

Please see the company's earnings release for a reconciliation of those non-GAAP financial measures, also available on the Investor Relations section of our website at investors.tileshop.com. With that, let me now turn the call over to our Chief Executive Officer, Mr.

Chris Homeister.

Thanks Adam. Good morning everyone, and thank you for joining us today.

I'm here with Kirk Geadelmann, our CFO, and we appreciate you joining us this morning as we report our results from the second quarter of 2017. The results announced this morning for the second quarter were below our expectations.

Despite falling short of the growth standards that we have set over the past two years in the second quarter, we made progress in many key focus areas, delivered another significant reduction toward bank debt on the heels of strong free cash flow, opened four new store successfully, achieved strong growth in several markets and grew our earnings per share. Perhaps most importantly, after a soft April, we approximately achieved our sales plans and delivered mid-single digit comparable store sales growth over the final two months of the quarter.

This gives us optimism for return to stronger growth and financial results for our business as we transition to the second half of the year. Let me now share some further details from our second quarter.

Sales for the quarter were $89.5 million. The $89.5 million of revenue represented growth of 6.2% versus last year including comparable store sales growth of 0.5%.

As just mentioned, the lower comp growth during the quarter was isolated to April and a key driver to the overall sales results in the quarter was slightly weaker than expected sales conversion rate which was influenced by several factors that Kirk will discuss shortly. We achieved modest growth in traffic and average ticket during the quarter versus the prior year period and we delivered double-digit comps in many markets during the quarter.

Gross margin rate for the quarter was 69.7%, our 8th consecutive quarter with gross margin rate of 69.6% or better. Adjusted earnings per share in the quarter was $0.15 representing growth of 7%, bringing down another $8 million of debt in the quarter and bringing our bank debt to its lowest level in 5 years.

Our inventory levels continue to be well-managed with inventory growth of 6.6% with 13 additional stores and one additional DC from the prior year period. Retail talent development remains a key area of focus and opportunity - and our efforts in this area yielded several successful results in the second quarter.

In the quarter, sales associate turnover was down at over 20% from the prior year period continuing our consistent progress on improving this important metric. Assistant and senior assistant managers, key roles for successful store operations and providing a source of future store manager candidates had turnover levels that were down approximately 15% from the prior year period.

Employee turnover also made strong improvements in our distribution centers and store warehouses and this continued in the second quarter of 2017. We continue to feel lower turnover levels, broad benefits in serving our customer base and driving efficiencies in our store operations.

Average store manager tenure continues to trend at approximately the highest level in over four years. We held our second of senior assistant manager leadership development training session for the year during the second quarter.

This developmental opportunity for high performing system managers continues to be highly successful with current leaders for future store manager opportunities. The continued growth of our business with the professional customer segment has been critical to our success since 2015.

In the second quarter, sales growth with Pro customers strongly outpaced overall growth leading to another meaningful increase in Pro mix during the quarter. We are excited about several new products we have recently added to our assortment that we expect to be popular items with our professional customers in the coming quarters.

Strong execution of our store unit growth strategy is another key focus area for the Tile Shop in 2017. In the second quarter, we opened four new store locations.

Our seventh store in the Dallas market located in Fort Worth, our fourth location in the Denver market, our second store in the Nashville Tennessee market and our fourth location in the Greater Atlanta area located in Buckhead. We continue to build our new stores for less than $1 million on average for the significant decline from our prior historical average of approximately $1.4 million.

Our ability to build new stores at a significantly reduced cost combined with strong revenue performance at these locations over the past several quarters further validates the benefits we believe this can have for long-term cash flow, and return on capital for the company. The slowdown that occurred in the second quarter from the growth levels we achieved for the previous nine quarters was certainly below the expectation that we set for ourselves.

At the same time, there were many positives from the quarter to continue building upon including a continued reduction in employee turnover, solid growth over professional customer business, and continued strong first year performance from our recently opened stores. In addition, the introduction of a number of new products during the third quarter gives us confidence that we can deliver a strong second half that result in 2017 being a highly successful year.

And with that, let me now turn the call over to Kirk for further discussion on the quarter and our outlook.

Thanks Chris. This morning we reported net sales of $89.5 million for the second quarter of 2017, which represents an increase of $5.2 million or 6.2% over sales of $84.3 million in the same quarter of last year.

Comparable store sales growth was 0.5% in the quarter. This was the result of a meaningful shortfall to our plan in April.

We can identify that over half of our April shortfall was a result of a decline in orders generated during the four-week of Easter, when we are closed on Sunday in comparison to a non-holiday week in the prior year. Typically, our second quarter revenue volume is very similar to the first quarter, regardless of Easter timing.

So we were optimistic we can offset our April shortfall over the months of May and June. We were pleased that over the period of May and June we returned to mid-single digit comparable store sales growth, and approximately achieved our sales plan.

However, we weren't able to outperform our original expectations for those periods. So the quarter fell short based in our April result.

It is important to note that prior year comparisons for comp growth were very similar across all three months of the second quarter. Beyond the April shortfall, a slightly weaker conversion rate was the primary driver of slowed growth.

We believe the most significant contributors to the conversion rate result were inconsistent execution across markets and new product launches being back half weighted in 2017 than last year. The sequential decline in comparable store sales growth in the second quarter was generally consistent between mature stores open more than four years, and at stores opened less than four years.

Gross profit increased $3.6 million in the second quarter or 6.2% over last year. Gross margin of 69.7% was unchanged from Q2 of last year.

The gross margin in the quarter resulted from solid inventory control partially offset by a slightly more promotional environment. Our selling, general and administrative costs for the quarter were $50.7 million as compared to $47 million in the second quarter of last year.

Second quarter 2017 SG&A included approximately $300,000 of special charges related to litigation expenses. We concluded the second quarter with 130 stores, an 11% increase versus the conclusion of last year's second quarter when our store count was 117.

Depreciation and amortization, rent, property taxes, utilities and other occupancy costs, primarily related to store growth represented approximately $2.4 million of SG&A growth versus the prior year during the quarter. This amount included approximately $450,000 of preopening expenses.

The remaining SG&A growth was driven primarily by compensation, benefit costs and advertising expenses resulting from growth in sales, locations, and employee headcount, as well as continued investments to reduce turnover and drive retail talent development. Adjusted EBITDA was $19.1 million in the second quarter representing growth of 0.8% versus the prior year period.

Adjusted EBITDA margin was 21.4%, a decrease of 115 basis points versus the prior year driven entirely by sales deleverage resulting from 0.5% comparable store sales growth. The non-GAAP net income presentation in the earnings release adjusts our GAAP quarterly results by eliminating special charges and then applies the tax rate to the result.

This presentation results the non-GAAP income for the quarter of approximately $7.9 million, growth of 11.7% versus the prior year period. The current year non-GAAP income translates into a basic and fully diluted Q2 earnings per share of $0.15, growth of 7.1% versus Q2 of last year.

Turning to our balance sheet as of June 30, we ended the quarter with $12 million of cash and approximately $19 million of long-term debt. We paid down over $8 million of debt during the quarter.

We were pleased with our quarter end inventory of $67.3 million which represented less than 7% growth from last year during the quarter that missed our sales plan but still experienced 11% store growth and includes one additional distribution center location. Capital expenditures were approximately $10 million in the quarter primarily related to new store openings, various IT investment, in the DC projects, and store remodel and merchandising activity.

As detailed in our earnings release this morning, we are providing updated expectations for the full year based on where we are through the conclusion of the second quarter and our current outlook for the remainder of the year. I will highlight the key items that were updated this morning from our last guidance provided in April.

From a topline perspective, our full year sales expectation has shifted from $350 million to $370 million to $350 million to $365 million. The reduction at the top end of the range is primarily related to the second quarter.

Our outlook for full-year comparable store sales growth is unchanged at low to mid-single digits and the implied comp outlook for H2 is approximately flat to high single-digits. With approximately 15 new store openings expected this year, our capital expenditures are now expected to be approximately $35 million, the upper end of our prior outlook of $30 million to $35 million.

From a bottomline perspective, we now expect non-GAAP earnings per share of $0.49 to $0.56 versus previous guidance of $0.50 to $0.57 and we now expect adjusted EBITDA of $72 million to $78 million versus previous guidance of $74 million to $80 million. There are two primary drivers of the adjustment to our EPS and adjusted EBITDA outlooks.

First, our Q2 sales shortfall versus our expectations. In addition in the second half of 2017, we are now planning incremental SG&A expense in excess of $1 million related to work to identify and prioritize growth and expansion opportunities across a variety of areas.

This expense is expected to occur pretty evenly across Q3 and Q4. We feel the timing is appropriate to invest in this work as we are committed to new store openings of mid-teens in 2018 and beyond.

Significant West Coast expansion is in our future. Innovation continues to be rapid across the flooring industry and consumer behaviors and preferences continue to quickly evolve.

This investment will identify and prioritize opportunities in a timely fashion as we continue to significantly scale our business. Finally a lower full-year tax rate expectation is partially offsetting the impact of the Q2 sales shortfall and the incremental half 2 expense on earnings per share.

With that operator, we can now turn the call over for questions.

So just taking a step back, when we put our foot on the accelerator over the last couple of quarters in terms of new store growth - little bit of hiccup this quarter. Just kind of step back and relay your confidence that - the new store openings wasn't a distraction and just your confidence on being able to get back towards mid-single-digit comp store sales growth while still accelerating store base and I have quick follow-up?

Thank you.

We remain confident certainly in our ability to deliver our long-term and back half opportunity of driving stronger growth in the back half. And we certainly expect to be in the low to mid single digit comp as you know discussed the past.

I don't really view the acceleration of our new store growth as a distraction. I feel very confident and quite pleased with the overall performance of our new stores.

But we certainly brought on to the company over the last several years and the last several quarters in particular. So we remain confident in our growth prospects over the back half of the year.

As I indicated in my prepared remarks and we certainly are very pleased with our overall new store performance that we've seen to-date.

And can you just elaborate on the two main points that were the drivers of the quarter. I guess one the timing around Easter not sure if I kind of call all that and two, weaker conversion rate, any specific markets, store classes or any factors that you've been able to isolate or identify?

Thank you.

As we look back at the quarter, we certainly felt like the Easter shifts could have some impact, you can certainly argue that looking at the data. I think the most important thing is that I think we felt like it would be helpful to provide some color on the monthly sales trends given the fact that our overall topline result was a bit disappointing.

In terms of that the other factor conversion, we had a lot of markets that did very well from a conversion perspective but we had a few that didn't do as well and I think it's fair to say that as we analyze each one of them in depth, there's just a variety of factors that are contributing to some of that performance. We need to get back on consistent performance in some of those markets.

We certainly have very clear action plans developed and feel confident that we can take advantage of the traffic that we have.

Last one I'll sneak in. Any update on trends thus far in July as far as comp store sales?

Thank you.

I'm not going to talk about intra-quarter performance but I just reiterate again optimism for return to historic growth in the back half from a financial standpoint across the Board including returning to our expected guidance range of certainly low to mid single-digit comp for the chain.

I wanted to get your thoughts on I guess what I would classify as air pockets that you experienced in two out of your last three quarters particularly around holiday periods be talking about Q4 and then now Q2. So is there anything that you're thinking about differently on a go forward basis and how you might manage through some of these holiday periods to avoid those sales slowdown?

I would say as we look back to one of those air pockets, in Q4 the driver in Q4 as we talked about in the call was a different organic growth driver. The scene there was, we seem to experience a little bit of a traffic decline particularly in the latter part of the quarter.

Throughout Q4 we really felt like as we talked about we executed pretty well based on the traffic we had. Our conversion rate was solid and our average ticket growth was there, they were pretty consistent with what we saw throughout 2016 by quarter.

I would say that this quarter and quarter two it was unique to Q4 where we felt pretty good about our traffic throughout the quarter and our average ticket was up but our conversion rate was down slightly. And as we looked at the data as I mentioned earlier - it wasn't a broad-based decline, there was pockets within our business, it wasn’t really unique to any vintage of store, it was really certain markets.

And again the reason for that slight decline in conversion rate seems to be a variety of factors pretty unique to each market. And so we have action plans developed and we feel good that we should be able to execute on those action plans.

Okay. And I guess when you look at the some of the weakness by market.

So you have a competitor that's come public here recently - I guess the stock markets maybe a little more focused on competition as of late. Are you seeing any competitor overlap that's impacting that conversion in those markets?

As Kirk talked about the differences that we're seeing by market vary for a lot of reasons. I would look at from a competition standpoint, I don't view as any difference in the current situation that we find ourselves in.

In some markets in the Northeast in particular, where we've seen some significant promotional activity by a regional player and a national player joined on a public player that has an impact and that we’re addressing. And we’ll be going back - going after it aggressively.

We've also seen some of that in the Southwest as well, again not by the company but you're referring to as well. So we are looking on a market-by-market basis where if there is additional promotionality needed, and I would also look at things that we’re doing from a performance management standpoint, regionalized and localized assortments is also an important element for us.

And then a broad view of having a competitive action plan by market is also important action plan that we're further refining and promoting aggressively where appropriate.

And maybe one other question then, so you did mention at the end of the script that you’re going to accelerate the store growth to double-digit. Is that kind of the high-end of your 8% to 12% range or you contemplating that moving more towards like a mid teens growth rates?

No, we’re looking still at 8% to 12% unit growth so that would be certainly at the top end of the 12% for this year. And you should look at it and for everyone on the call look at it as a confidence that we have in opening store successfully.

We feel very good about our first half opening schedule of seven stores this year up from three last year, and nine total last year as well. So we feel very good about the new store performance how they're performing out of the gate and the seasoned leadership that we’re going into those stores as well gives us confidence to be at the top end of our range for 2017.

I'm sorry I asked about 2018, you’re making the SG&A investments to explore double-digit growth is that an acceleration above the 12%?

No Peter that's really - we've done a variety of things over the last three years, some examples include some work we've done around marketing and optimizing our marketing and we had a lot of success with that initiative. Went back to Q1 of 2015 where we tested some things and then more recently had some great success with some things we did with our new store prototype as you now and we feel really good about our new stores, slightly smaller format, we’re spending a lot less on CapEx obviously and getting some tremendous sales productivity.

So I’d say this work that I referred to in my scripted remarks was around similar things where we're - as we start to you as we said and get up to mid-teens growth we want to make sure we look at all opportunities and opportunities to optimize our current business and that's the nature of that work.

Just a little follow-up here, just on the market s that have inconsistent performance. Anything around like self cannibalization or what you guys seeing from that standpoint as you ramp up the store growth.

How are the other stores in those markets doing?

I would not look at cannibalization as you know any significant issue in the performance of mature stores in those markets. In general the cannibalization rate is exactly where we would expect it to be.

And for most markets I would say they actually have zero cannibalization rate given the fact that the length of the drive and the duration of the drive continues to be over 30 minutes long for most of our stores that we’re going - even in the most densified markets that we have. So there are few examples where that drive time is a bit less but we feel that the overall growth that we’re seeing in the market certainly offsets any of the cannibalization affect that we might be seeing on a mature store base in that particular market.

In terms of the growth opportunities - looking a little bit more closely, I mean what role is omni-channel planning in the valuation talk about kind of the online dynamics in the business right now and is there any consideration around merchandising categories or extensions that might make sense for you guys.

Well we're certainly looking at – we're constantly looking at new product categories and new product types that we might want to be looking at or evaluating from a total chain standpoint, as well as what might be noted in online environment. Certainly in the last quarter we talked about the outdoor paper category which continues to have very good success for us and we’re pleased with its overall performance from a company standpoint.

So we continue to look at what are those growth accelerants and what do we feel that we have a natural ability to extend our service for our customers and also extend our brands to other categories as we go forward. Pertaining to online, I’m not looking at bifurcated strategy between online and in-store at this moment.

I really look at online it continues to be an important element for our success as we move into the back half of the year and really for out years as well. The online channel continued to have strong growth from a sales standpoint in the quarter securing solid double-digit comp increases over last year and continues to be a strong comp driver for the company in general.

And obviously it’s the brand that people interact with the most and most frequently even when they do come into a store - because obviously those categorizing highly researched category where people are driving for inspiration trying to understand their choices that are available to them and so we’re very pleased with the online approach and the strategy that we have in place up to this point in time.

And a quick follow-up for Kirk if I can. Just on the long-term debt $19 million nice to see some more of the pay down there.

Where do you see that kind of at the end of the year Kirk and when do you think it will be in – when do we have that done with that debt? Thank you.

I think going back to our Q1 call, we talked about - we estimate that we’d probably be around $10 million of long-term debt at the end of the year. So assuming our cash balance would be similar to what has been.

We'd be net debt zero essentially. Obviously we feel really good about the strength of our balance sheet right now and we’re proud that we implemented a quarterly dividend so we feel like we’re in real good spot.

Quickly, number one April gross margin versus May and June, just trying to get a feel that there was an appreciable difference you know how much additional promoting discounting you had to do to drive the single digit lot of demands?

No, there really wasn’t any differences in terms of gross margin throughout the quarter. We did talk about the fact that we are slightly more promotional but the interesting thing about our business is we don't really have a lot of impact to our gross margin when we are promotional and that's because as you know we provide discounts to our pros and we give our people the flexibility to work with retail customers on price.

So we did feel like we had some good success with the promotions we ran in the quarter particularly in May and June.

And then there is a lot of chatter about what will happen longer-term with leases in terms of converting it possibly to debt on the balance sheet. Just curious your thoughts around that how that may or not influence your thinking about store openings and debt levels in general?

Thank you.

Yes, the short answer is, we don't think it allowed any impact on our growth plans at all.

Just back to the conversion commentary. We are just a little surprised it was weaker giving all the improvement you highlighted that you made in turnover during the quarter.

So, we just wondered about the product that was introduced in April and it was well received and if you any more color on new products being introduced in the second half?

The new products that we're - so I want to just take a step back to 2016 in that first half of last year we brought in over 400 new products into the assortments and for this year the introduction of most of our new products are coming into the assortment with the exception of the outdoor paper category that I already mentioned previously on an earlier question is more back half weighted this year that has been in the past primarily for two reasons. One, from a production schedule standpoint in new countries and new vendors that we’re bringing on into our assortments primarily South America and Western Europe, and then the second is really having as production schedules really ramp up with some of the new porcelain and ceramic tiles that we’re bringing on.

We wanted to up our orders. So instead of just introducing our product and having great excess with it and then being on a stock for a prolonged period of time, we delayed - we consciously delayed some of the product introductions coming into the store so that we have available quantities of products at higher levels and balance across all of our distribution centers.

So the impact on the quarter was somewhat significant from that standpoint given the fact that we made that conscious decision and certainly was surprising to the impacts of new product introductions but we feel it’s the right decision for us based upon having the durability of products across 130 stores and growing and also have a balance correctly across our distribution centers.

Wanted to touch on, certainly you haven’t talked about yet this morning on the Pro. If you could just give us latest update, maybe running the Pro customers during the quarter and maybe where penetration stands today?

As a reference in the opening remarks, the Pros continues to be paramount to our success. It continued to strongly outpace our overall growth with double-digit growth in Q2 and we feel very good about the initiatives that we have pertaining to the Pro.

We feel that we still continue to offer the Pro unique products for his business and we feel that the opportunity - to extending credits, having in-house accounts or moving more and more of it to an online environment to help them in a mobile setting in a non-work setting where much of their work is completed and having ability to look at products in an online basis to understand inventory look up in an online basis is our important enhancements that are coming to the Pro as well. So in general we were pleased with our Pro business as a whole and we certainly view it as a core growth strategy for us as we go into the back half of 2017.

The overall mix has shifted up slightly. I would approximate of our business at this point in time.

And did the Pro grow little faster than just the typical DIY in the quarter or?

It did.

It did, okay. And then wanted to ask - I may have missed some of the response earlier but on the tax rate, can you explain why it was so much lower this quarter versus last quarter, I apologize if I missed it but just further clarification would help because I know it's bringing down the full-year, I understand because of this quarter but what was it different year-over-year?

It's primarily related to tax benefits associated with the exercise of stock options and also iso options as well. So we think the benefit has isolated the quarter but it is as you said it's bringing down the overall forecast tax rate for the year.

So you think it is just a one quarter event kind of a thing, okay.

That's forecasted.

And then just wondered to follow up, the work you guys are doing of identifying new growth, just so I'm perfect crystal clear on this. Are you talking about, I heard you say us better operating efficiencies as you grow and gain further scale.

You mentioned may be West Coast but where you referring to also other ideas or potentially a new store concept or getting into other categories of flooring like wood, or laminate or other things or is it more focused on just what you would isolated about operating efficiency so to speak.

So Joe I think I would look out it from a standpoint of where we are identifying the expense as something that for a project work that we consider for some time. I would look at it as certainly of a new executive on our team pertaining to supply chain and transportation so the efficiency - our supply chain and our merchandising is an important part of the work.

As Kirk mentioned earlier, we are very pleased with the work that has been done previously of eliminating over 20% of our CapEx for new stores in the past and I look at this as a similar vein of helping us be sharper on our execution as we continue to go on our growth story.

Thanks to everyone for joining us on the call today. We'll speak with many of you soon.

Have a great day.