Tile Shop Holdings Inc (TTSH) 2014 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to The Tile Shop third-quarter earnings conference call.

(Operator Instructions)

As a reminder, this conference may be recorded. I would now turn the call over to your host, Adam Hauser, Director of Investor Relations.

Thank you, operator. Good morning to everyone on the call, and welcome to The Tile Shop's third-quarter earnings call. Joining us on the call today are Bob Rucker, CEO and Founder of The Tile Shop; Chris Homeister, Chief Operating Officer; and Kirk Geadelmann, our Chief Financial Officer.

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

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 provision 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 to identify forward-looking statements may be made.

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 latest 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 issued for a reconciliation of those non-GAAP financial measures. With that, let me now turn the call over to our Chief Executive Officer, Mr. Bob Rucker. Bob?

Good morning. Today, we announced our third-quarter financial results which Chris and Kirk will discuss in greater detail during the course of the call. As you read in our press release this morning, I have elected to retire from The Tile Shop, and Chris Homeister has been unanimously approved by the Board of Directors to become the CEO of the Company, beginning on January 1, 2015. Chris has also been elected as a member of the Board of Directors, with his term to begin early next year.

I will remain in a full-time capacity at The Tile Shop through August 1, 2015, where I will be advising Chris and working with the other members of the management team in building out our programs and initiatives for the coming year. I will remain an active Board member at the Company, and will always be available to Chris and his team on any topic where they feel I can add my expertise and counsel.

When I started the Company in 1985 in Rochester, Minnesota, I felt that we could bring a different and unique experience to purchasing tile and natural stone products. Over the course of the last 29 years, we have continued to modify and enhance our business model, to provide the best products from around the world at a fair price, to introduce design ideas to consumers with our investment in vignettes, and always provide great customer service by having knowledgeable and highly-trained sales associates interact with our residential and professional customers, so that they would always be treated right.

I take great pride in standing behind the products that I have selected over the years and ensuring that we always exceeded our customers' expectations. This is the heart of what The Tile Shop has always been, and what sets us apart from our competitors.

I am very proud of the business that I have built, where we now have 105 stores in 30 states, and feel that we are just getting started. I continue to get highly energized by visiting our stores across the country, and speaking to all of our sales men and women about how we can better serve our customers, by offering them the best experience that is available in our industry.

I feel that our management team has never been stronger during my time in leading the Company. We have individuals on the management team who are experts in their field, who love retail, and who have a laser focus on exceeding the needs of our customer base.

I'm absolutely confident that Chris is more than ready to lead the Company going forward. I have worked very closely with Chris over the past year, and have been very impressed with his ability to learn our industry while drawing on his extensive past experiences to improve our operations on a variety of fronts. Chris brings a broad array of great operational experiences, in-depth retail knowledge, global sourcing and merchandising experiences, strong business and financial acumen, and the ability to connect on an individual basis with key vendors across the world.

I have also enjoyed seeing Chris connect firsthand with our store managers and associates, as we continue to expand our retail store footprint across the country. Chris and I have traveled all over the world over the past year. We have visited all of our key vendors, and I am confident that under Chris's leadership, the team that we've put in place in-country as well as here at our corporate office, is well-positioned to grow and ultimately expand our sourcing activities. We can expand with existing vendors, and also by sourcing products from new countries, such as Mexico, in a more significant way going forward.

The time is right for me to write the next chapter of my life, as I have good health and a wonderful family, and am looking forward to spending more and more time with them, as we travel the world. I will always remain an active member of The Tile Shop, and Chris knows he can call on me at any time, as I love the Company and what it represents to people.

I'm immensely proud of how we've positively changed the lives of thousands of people who have worked for The Tile Shop both past and present, and will always be humbled by the dedication and loyalty they are showing to the Company and to me over the years. The Tile Shop is poised for great success, and I am looking forward to watching the Company grow and prosper in the coming years ahead.

Thank you to our investors, who have believed in me and the Company as we went public a couple years ago. I firmly believe that the best years of the Company are directly ahead. Now, let me turn the call over to our future CEO, Chris Homeister.

Thank you, Bob. Let me begin by thanking Bob and the entire Board of Directors for selecting me for this incredible opportunity to lead The Tile Shop. I'm very proud to lead the organization that Bob has built over the course of the past three decades. I feel the future is very bright for the organization, as we continue to improve upon our business model.

Bob has been a tremendous mentor to me during my time at The Tile Shop, and I sincerely appreciate his counsel in teaching me about the industry, and also discussing with him how we can better serve our customers while improving our financial performance and return on capital. During the course of my 20-plus-year career, I've had the opportunity to lead organizations that were in high growth, dynamic, and ever-changing environments.

I feel my background of global sourcing, merchandising, retail operations, supply chain, and finance will be highly beneficial to the organization, as we continue to grow our store base. I love retail, sourcing new products to present to customers, and how we are able to inspire customers, as they invest in their homes.

Notwithstanding the current quarter's disappointing results, which we will discuss shortly, I remain fully convinced long-term opportunity presented by The Tile Shop's superior and dynamic business model. This is what originally attracted me to the Company. This is why I'm more enthusiastic than ever about our prospects, as we move into my new role.

The Tile Shop is a tremendous business, and has historically driven superior financial results to its investors. The specific reasons that I feel why Tile Shop is and will continue to be a great business are the following: We have consistently outpaced the industry in a highly fragmented market, building a leading position in a category poised for sustained growth, we're very strong relative to almost any other retailer, given our margins.

Best-in-class customer benefits in the form of six-month return policy, never a restocking fee and 100% guarantee on our manufactured products and setting materials. The largest and most diverse product assortment in the industry. We have a best-in-class store experience with over 50 beautiful store vignettes, showcasing hundreds of tile and stone selections, inspiring our customers to think about how they personalize their project.

Highly knowledgeable store associates that are able to advise our customers on every phase of their purchase. And lastly, a strong leadership team is in place to drive the next phase of growth for the Company. We have accomplished a great deal over the past year, but we have underperformed relative to our own and external expectations during 2014.

My observations for the underperformance are outlined as follows: First, while we have done an excellent job of adding to and strengthening the corporate staff relative to our aggressive store expansion, the Company has not been able to keep that same pace at the retail store level. We've doubled our store base over the past three years.

During this period of dramatic growth, we have not consistently maintained a sufficient supply of tenured and well-trained store managers and sales staff to meet that growth, as successfully as we've been accustomed. In a majority of stores with year-to-date comp sales declines, you can trace it back to management movement that incurred due to our significant store growth. It has always been the case at The Tile Shop that the number one factor for store success is a strong store manager and sales staff.

Secondly, approximately half of our stores were opened in 2012 or later, yet account for about 30% of the 2014 sales. These store investments have yet to evolve far enough along the maturity curve, where they are able to contribute four-wall EBITDA margins approaching our mature store base. About 75% of new stores since 2012 were in new markets, which further challenges their movement up the maturity curve. The significant expansions in new markets prove the challenges and staffing the stores with our historical manager profile has amplified EBITDA margin deleverage.

Third, we've invested in infrastructure capable of supporting an aggressive long-term store expansion. We have invested in assets ahead of our actual expansion, such as our Grant, Oklahoma distribution center, e-commerce upgrades and a handful of additional corporate positions, including a new sourcing and merchandising leader. This hurts operating margins in the short-term, but we believe will provide long-term benefits.

Based upon the challenges that I've just outlined, let me now focus on what we are doing to address them and turn the Company to higher levels of growth and profitability. The first topic that I would like to discuss is around our plans for new store openings. We are reducing our planned store openings for the next year to a range of low to mid teens.

Five of these stores are expected to be in new markets for The Tile Shop, with the remainder opening in existing markets. A combination of fewer store openings and a significantly higher percentage of stores opening in existing markets will make it easier to get ahead of hiring and training challenges that we have encountered recently.

In addition, we will continue to optimize the store layout, merchandising selection, and overall look and feel of the store. This will include selecting and operating future sites that are below our historical square footage, which will allow the Company to lower our capital outlay per store and increase our sales productivity on a square foot basis.

A second area of focus is centered around retail talent identification and training. We are modifying the retail field organization to include a new position, called market managers. This position will be accountable for grabbing the overall market growth strategy for a specific DMA, and will be also accountable for talent identification and development of assistant managers and ultimately new store managers. This position will be financially incented to select, train, and ultimately have their managers placed within our network of stores.

In order to maintain high customer service levels and common connection points with our customers, we are hiring an additional 18 full-time assistant managers that we have identified as high potential individuals, that will immediately enter into a manager in training program. A full classroom and on the job training program has been developed that we will follow by placing these leaders in to stores, or locations that have natural turnover. We expect the costs associated with these programs will be fully covered by the incremental sales lift within the store that they're assigned to, as well as significantly diminishing disruption in the stores.

The third item is that we're expanding our focus on the professional customer. While the professional customer has always been an important client for The Tile Shop, we feel we have a significant opportunity to expand our penetration with this customer segment going forward. We have hired a seasoned and tenured leader to direct our efforts in developing a best-in-class professional program. We believe this additional focus will pay dividends in the coming quarters, and we will provide updates to our progress on this front in the future.

In addition, we continue to improve and refine our website, including improving organic search and by continuing to add to the site's functionality, including the recently-launched ship to store for free option that is available to all customers. We will also be announcing soon a new product sampling program, that will offer many of our most popular mosaics for reduced cost, that will be shipped directly to a customer's home. Lastly, working capital management continues to remain a key area of focus as we look to optimize our inventory levels at the store, distribution centers, and in-transit inventory with vendors. As previously stated, we have no plans for a new distribution center through at least 2015.

In summary, I am very confident in the business to perform at a very high level, and my abilities to positively impact its performance. The team and I will look forward to providing future updates to all of you in the coming quarters. And with that, let me now turn the call over to Kirk to further discuss the quarter.

Thanks, Chris, and good morning, everyone. I'll begin by taking you through in greater detail on our third quarter, before discussing our outlook for the remainder of the year. Today, we reported net sales of $62.8 million for the third quarter of 2014, which represents an increase of $6 million or nearly 11% over sales of $56.8 million in the same quarter of last year.

The macro backdrop remained challenging for the specialty flooring industry in the third quarter. Given the challenging environment, we were encouraged by the 0.6% comparable store sales growth in the quarter. This marked our second consecutive quarter of sequential improvement, and represented a two-year stacked growth rate of 15.4%, our highest quarterly total this year.

The third quarter represented the second straight quarter of approximately 15% two years stacked growth at comp stores. Importantly, our four largest and most well established markets, of the Twin Cities, Chicago, DC-Baltimore, and Detroit, in aggregate, delivered approximately 4% comp growth in the quarter. These markets accounted for over 40% of our comparable store sales in the quarter, and they each approximately met or exceeded Q2 comp performance. The health of these mature markets as well as the 7% to 8% implied annual growth of our two-year stacked comp the past two quarters is a strong indicator of the continued strength of our model with customers.

Our comparable store sales fell modestly short of our expectations for the quarter. However, a much larger portion of our revenue shortfall versus our own goals occurred within our new stores. In aggregate, new stores opened in 2013 and 2014 will fall short of our historical first-year expectations.

The 36 stores opened from January 1, 2013 through the end of Q3 2014 have faced three distinct challenges: As Chris discussed, we have not been able to staff these stores with the same level of management tenure and Tile Shop experience as we were able to throughout most of our history, which saw only a handful of openings per year.

Second, 24 of these 36 openings were in new markets, with very little marketing investment. Compounding this dynamic was the fact that during the third quarter, we experienced some natural weakness related to search engine optimization, after transitioning our website in June. This has much more impact on new stores, where we've yet to establish our brand.

Third, these Company- specific challenges were paired with the sharp slowdown in existing home sales that has persisted throughout 2014. With assessing these 36 stores, about 1/5 are overcoming these challenges, and are achieving or exceeding early revenue targets based on historical norms.

About 1/5 are following modestly short of early revenue targets, which we classify as a shortfall of up to approximately 15%. About one-third of these stores are falling meaningfully short, which we classify as a shortfall in excess of 15%. The remainder of the 36 stores are too early since opening to categorize.

Certain new stores coming slowly up the maturity curve is not a new challenge at The Tile Shop. It has happened numerous times throughout our history when going in to new markets, and with no brand recognition and minimal marketing investment. The great news is what these stores have done after a slow start.

Between 2009 and 2012, we opened 26 stores. Nine of these locations fell more than 10% below our first-year sales expectation. In aggregate, these nine stores had a year-two growth rate of approximately 30%, far above our targeted year-two growth.

These previous proof points firmly reinforce our belief that stores opened in 2013 and 2014 will achieve success, despite a sluggish first year. From a real estate and site selection perspective, we believe these stores are positioned for success.

Finally, since 2012 was our first year of rapid store expansion, with 15 openings, it's worth pointing out that these stores delivered an average first-year revenue of approximately $1.8 million, right on track with our targeted goal. The challenges I have just discussed started to impact new store revenue for openings in 2013 and beyond.

The initiatives Chris outlined earlier are intended to provide very specific help to our new stores. Adding market managers to mentor new store managers. Investing in a deeper bench of well-trained assistant managers. Focusing on how to help our stores in growing their professional business accounts, and driving marketing effectiveness are all efforts we expect to fuel the performance of our new stores.

Gross profit increased $3.6 million in the quarter, or 9.2% over last year. We experienced a slight decline to a net 69.2% gross margin rate after five straight quarters of approximately 70%. The 60-basis-point decline versus our first-half rate of 69.8% was driven by corporate promotions to compete aggressively during two key holidays in the fourth quarter: Fourth of July and Labor Day. We had five-day promotional windows surrounding these holidays that see more pronounced customer traffic and orders, than other weeks during the quarter.

Our selling, general, and administrative costs for the quarter were $39.8 million, as compared to $32.2 million for the third quarter of last year. The SG&A cost in 2014 included approximately $0.2 million of non-recurring costs, primarily related to litigation expenses. We concluded the third quarter with 104 stores, a 30% increase versus the conclusion of last year's third quarter, when our store count was [80]. Consequently, when looking at the $7.6 million year-over-year increase SG&A, approximately $7 million, or 90% of the increase, is attributed to new store growth.

Nearly $4 million of the $7 million in depreciation and amortization, rent, property taxes, utilities, and other occupancy costs. The remainder of growth attributable to new stores is primarily for compensation, benefits, and shipping and transportation. Pre-opening expenses were approximately $365,000 in the quarter. The remainder of total SG&A growth not attributable to new stores, included a modest increase in advertising, a $160,000 increase in stock-based compensation, and incremental corporate leadership costs.

As we discussed on previous calls, as new stores are opened, the store-related SG&A costs are disproportionately higher as a percentage of sales, than our mature stores. After the past three years, as we've doubled our store count, this has dramatically distorted our SG&A costs as a percent of sales. At the end of the third quarter, 36 of our 104 stores had been opened in 2013 or later.

I just discussed how a higher than normal portion of these new stores were performing below targeted expectations, and this has created an even more pronounced impact than originally expected on our SG&A ratio and EBITDA margins this year, and particularly in Q3. We are still expecting an improvement to SG&A ratio and EBITDA margins beginning in Q4 of this year, and meaningful improvement in 2015.

Adjusted EBITDA was $10 million in the third quarter, or 15.9% of sales. The non-GAAP net income presentation in the press release adjusts our GAAP quarterly results by eliminating non-cash expenses related to unusual or non-recurring costs, and then applies the tax rate to the result. This presentation results in non-GAAP net income for the quarter of approximately $1.6 million, which translates into a basic and fully diluted earnings per share of $0.03.

Turning to our balance sheet as of September 30, we ended the quarter with $5.7 million of cash, and $90 million of long-term debt. At quarter-end, we had approximately $20 million of borrowings available under our long-term credit facility. As we indicated on our last call, the second half of the year typically experiences a modest build in inventory from first-half levels.

Our $67.3 million ending inventory was a dramatic improvement from last year's third-quarter total of $77.1 million, down nearly $10 million or 13% despite sales growth of 11%. We still plan to end 2014 with lower ending inventory than 2013, despite opening 19 additional stores by year-end, and growing sales greater than 10%.

Capital expenditures were approximately $9 million in the quarter, primarily related to new store build out, store remodeling, improvements at the existing distribution centers, and corporate IT investment. With respect to cash flow, the Company generated approximately $7 million of free cash flow in the quarter. Importantly, we expect the year to conclude with positive free cash flow for 2014.

Regarding our outlook for the year, with the continuation of mid single digit declines in existing home sales, and approximately flat year-to-date comparable store sales growth, we are taking a more cautious view of the fourth quarter, and have modified our guidance for 2014 to reflect our year-to-date results and to recognize a more conservative estimate for the fourth quarter.

The Company now expects the following for the full year of 2014: Revenues will range between $257 million and $261 million. Comparable store sales growth will be down 1% to plus 1%.

New store revenue will be lower than our traditional first year levels. Earnings per share will range between $0.23 and $0.25 per share, assuming approximately a 69.5% gross margin rate, an effective tax rate of 40%, and 51 million fully diluted shares outstanding.

We now expect to open 19 new stores in 2014, one less than our previous outlook, driven by the timing of a new store opening. Of the 19 stores, 13 will be in new markets, and six in existing markets. CapEx is expected to range between $38 million to $40 million. Our expectation for depreciation and amortization is approximately $20 million, and stock-based compensation is now expected to be approximately $5.5 million.

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

(Operator Instructions)

Our first question comes from Peter Keith with Piper Jaffray.

Good morning, everyone. Congratulations, everyone, on the transition. And Chris, congratulations to you.

I want to talk to you about the new store productivity, because it feels like we've been on this adventurous path for two years of very rapid store growth, and I think you have been fairly consistent to say that the store growth productivity is good, it's in line with historical measures. Now there seems to be a concession that it's not.

The management turnover of the store would be an issue. But I guess, how could you give us comfort that there's not a broader issue in terms of real estate site selection and maybe you've signed some bad leases over this aggressive growth period?

Good morning, Peter. This is Chris. Thank you for the notes.

In looking at the site selection and the stores that we brought in to the Company over the last few years, I do feel confident that we do not have a real estate selection issue with any of the stores that we have in chain, that's currently at 105.

What I will say from our standpoint about how we're looking at store performance as we go forward is looking at a couple of different things. One is what is the plan for a marketing promotion standpoint, to really build that store in to the community, especially for new stores and new markets. I feel that historically we've not invested as much as we need to, or should, during that timeframe. We've had a number of different outliers, both positive and negative, on the front, Peter. So I don't feel that -- I do feel that the historic guidance that's been given has been accurate across the board.

I would then also, coupled with the fact that as we've talked about at length during the call, about the plans that we have around continuity of people in the store, it's an incredibly important item for store performance. And when you look at the continuity of store leader, which then constantly goes in to the continuity of the store staff, and given the fact that we have a very high touch transaction, that has multiple touch points coming in, where they're coming in to look at a sample, they're coming in to look at the vignettes, they're coming in to bring another individual in to the discussion, as well, having the continuity of people is incredibly important for the Company, and historically been one of the core differentiators for us as we go in to new markets.

With performance of the store not necessarily being as high as we'd like, it has led to turnover, has led to a turnover in store staff, which we feel has impacted the performance significantly during the last several quarters, in particular.

Okay. So looking out to next year, you're slowing the store growth, but I guess at a low to mid teens percentage growth rate. I'm just back of the envelope calculating that to be 12 to 16 new units. Why open any stores at all? It seems like you could maybe put a pause in here, delay some leases, and put less stress on your management and employee training process.

Well, we feel that we can, by going to the low to mid teens, it gives us a range of where we feel that we have opportunities across the board, Peter. We feel that we do have opportunities within existing markets certainly, and when you look at the ratio, we don't know what the top end is going to be at this point in time. We want flexibility about the stores that we select, and the regions we go into.

We do feel there's opportunities, and I don't want the point to be missed either, that we have many stores that are performing excellent. We have many stores within existing and new markets that are achieving our plans across the board. We feel the items that we've identified and we feel, being very frank and open with the investment community, about what are we doing to change the trajectory and we look at the common thread about -- of how it's fixed and what's fixable, and we look at the people in the store, and also reallocating some of the marketing dollars we have as well to new stores and new markets, as well.

We do feel there's opportunities. We don't feel it's a high risk strategy by moving forward with a smaller number of stores. And we expect them to perform well, as well, as we go in to next year, Peter.

Peter, let me add one thing. This is Bob Rucker. With the new stores, we've significantly stepped up our training of store managers, assistant managers. I think we've developed a much better apparatus to get people in the stores.

The key is a good, confident, and knowledgeable store manager. And I think we have answers there. We're getting that. I think we over expanded ourself there. One reason we don't want to go back to zero is because we don't need to.

Also, we need to maintain the apparatus to keep opening stores. We need our construction to keep going, the entire apparatus to keep this going. If we go back to a store a month or so, I think we will be fine. We've got a system that can handle that.

Okay. Thank you very much for the feedback.

Our next question comes from Peter Benedict with Robert Baird.

I want to start quickly with gross margin. Looks like, in the fourth quarter, it's implied to be up a bit here. With the pro initiative as well, help me understand what you think is going to be driving that and how does this effort to go after the pro a little bit more aggressively, how does that play in to the P&L going forward?

Good morning, Peter. This is Kirk.

We're really excited about the pro initiative. I think it's a little early to start talking about any meaningful impact over the next 90 days, but the early results in a couple of the markets where we've really done some good work and held some initiatives are great.

As we get further on here, over the next 30, 60, 90 days, next six months, we'll be talking more about that. Most of the progress has really been over the last 30 days, so probably not a huge Q4 impact for us. As we're thinking about the Q4 gross profit rate, we feel pretty good about the guidance, and it gives us a little bit of room to do some moderate promotions, if we think it would be helpful for our business.

When we look at the pro business, the stores that do the best for us, the highest volume, the most profitable stores also have the highest percentage of pro business. Is that because they have that, or they're just a well-developed store? It all runs together. But the pro business would be the tile contractor, the designer, and then the middle and higher-end homebuilder. We see that you get more referrals from these people, and you develop the market much more deeply with them.

That helpful. I know that you spoke about a field position to help with this. Are there any store staffing changes that need to happen to push this along?

It's an additional thing. We've tapped a long time employee, a long time store manager to head up the contractor pro business, and we've tapped another one to head up the design business. Working together we'll morph the stores in to a better position.

Once again, those stores that do the best are well developed on the contractor side, the homebuilder and tile contractor side, and they're also well developed on the design side. So we're actually better right now on the construction side, but we're also putting a lot of emphasis on the design side. As you know, when this works, we are selling fashion. The closer we can get, and the more we can hone our skills there, the more business we're going to do.

That's helpful. Then for my followup, maybe Chris, share a little bit more about the marketing plans going forward? Just want to make sure we're clear. Are you thinking of reallocating dollars to some of the new markets, or is the aggregate spend going to be up overall?

I think last year, your advertising ratio was like 2.7% of sales. How do we think about going forward what your plans are, either in dollars or as a percentage of sales, what you're going to do on marketing? Thank you.

Thanks, Peter. You should continue to look at the advertising spend being flat. I actually believe it was a little lower than 2.7%, I believe it was around 2.2%.

The approach we want to have on advertising is two-fold. One, we want to increase the penetration we have in new markets and new stores. We feel we need to give them an understanding of what The Tile Shop is, what we represent, what the value proposition is, and that we do have a different experience for a consumer as well as a contractor to come in to the store.

The second thing is that we're going to continue in the rest of our marketing approach, to continue the approach of having a dynamic and digital approach. The things that we think are really working well for us on both digital, as well as reallocating some of the things that was done internally around some of the things that when we look at the materials that we placed out there for design books, and other materials such as that, you'll see a different type of look, a look and feel.

You'll see it's a little bit more focused around some exclusive collections we've had. And you'll also see some of the things we think are going to be very important for us as we -- on the look and feel of the website, as well as some of the things that you're going to see from the marketing materials we place in front of customers with all the employees.

Okay, perfect. Thanks very much.

Our next question comes from Kate McShane with Citi Research.

Good morning. My question is on the competitive environment, and just with the macro environment continuing to be challenging. Can you talk at all about some of the competitive response from this more challenging macro, but also if there's a big difference in what you're seeing in your more developed existing markets, versus the new markets where you're opening new stores.

Hi, Kate. This is Chris. Happy to talk about this topic.

When we go in to a new market, certainly, we're going in to an entrenched market that has a variety of competitors. Certainly we compete with the big box players out there, regional players, then just as importantly for our business, we're competing against a well-entrenched local distributor or local shop that's been in the market for many, many years. So we haven't seen dramatic changes within those markets.

What I'll say, as we go forward, is that we feel that we're going to be doing more events, looking at attracting that contractor crowd, the professional crowd, to bring them in for the first time to really understand what The Tile Shop is. I think we have a tremendous opportunity for awareness about what we are, the buyer proposition that we have as a Company, and talk about some of the things that we know have high, high value to both the consumer, as well as the professional customer, around our return policy, no restocking fee, and standing behind what we feel is the best in the industry on any of the products that we sell, but manufacturers, most private label stone and tile products on that standpoint.

From a promotional standpoint, we certainly -- we feel the promotional environment has certainly picked up, certainly in the Q3 timeframe. I think you've seen that with probably other companies that you follow, as demand has been soft, really across the board on both traffic on the professional side, as well as consumer, as you're looking at a multitude of different things influencing that.

Certainly, existing home sales is one of them. Home values continue to be a bit stagnant. And the general retail environment has been sluggish, as well. From a competitive standpoint, getting back to your question, we really look at it being threefold, as who we compete against in the marketplace, and we do feel that we're well positioned when we go in to a market in new stores in newer markets as well as new stores in our existing markets, as well.

Okay, that's helpful. Thank you. I just wondered if I could follow up with a question about the transition of management. And congratulations to everybody. But I know, Bob, you've been very involved, and it's been your point of differentiation of how you source your products, and where you source your product and tile from. Just wondered how that strategy might change over the transition period, or once the transition is fully made?

The goal is not to have a change at all. I believe very much, and I think our team is very aligned. I think we're probably more aligned on the go-forward proposition than we've been since we've gone public. But our whole supply chain system is predicated on creating product, creating product at relatively low cost, romancing it, bringing it forward as a fashion item, and basically buy low, sell high. And the fashion industry does that. We intend to keep doing that.

The people we've added in sourcing are very good. I'm very happy with Lindsey, and we've added a few more people there. The other thing is, I'm not going away.

My strength has always been, I'm a product guy. I'm a tile peddler. I'm in good health. I've committed fully to help wherever I can, and I intend to do that over the years.

So I don't think anything will change in product, and that hasn't been one of the things that we've overgrown. We're good on product. I think we're in a position now to actually pick up the pace on development and factor right in the middle of that. I don't see anything changing there at all, other than for the better.

Thank you.

Our next question comes from Daniel Moore with CJS Securities.

Good morning. And thank you for the candor, certainly.

I'm trying to understand, just want to go back to, historically you've promoted from within. If the issues with the newer stores are really a management bandwidth issue, help us understand how going out and hiring 15 or 20 new individuals and training them from the outside is going to turn things around? Help us understand your confidence around that, and maybe some sense of timing, how long you think that will take to really gain traction?

Hey, Dan. It's Chris.

Let me clarify one point, on the 18 additional folks that we're promoting and going into the management and training program, these are largely internal candidates. You should look at the ratio as 90 to 10 or 95 to 5. We feel we have a deep bench of existing assistant managers across the chain. We feel they're more than capable.

What we didn't have, and quite frankly, we've developed and spent a lot of time during the quarter and preceding quarters, as well, is really developing that training program, that transition plan, having a clear understanding of where people are going from store to store, making sure that there's continuity, and handoffs, as well as consumer customers, understanding best practices happening across the chain. So look at it from the standpoint of, we feel given the fact we have 105 stores and we have multiple assistant managers within a store, we feel that the bench is deep.

What we want to do is having a much more regimented approach around how they're trained, how they go in to a store and making sure that one is transitioning out of the store, we have a ready and able back fill in that store, so there's no issue or a drop-off in the existing store that they're in, and that they're also more prepared to lead the new store, as they transition out of that store in to either a new store in a new market or potentially a store that has a natural turnover in the marketplace, as well.

That's helpful. I obviously misheard, so thank you very much for that clarification.

As you opened, obviously, a significant portion of the new stores in newer markets, any thoughts or plans at this stage to potentially close any of those stores that might be orphaned, if you're not adding as many newer stores in some of those newer markets going forward?

We don't have any plans to close any stores now or in to the future. We actually feel that all the stores we've identified, the 36, will all have positive contributions to the Company. What we've been open about is that they haven't had the type of success, in some cases, as high as we'd like.

But I also want to be very clear that every store that we have within the chain is a positive contributor to the organization from a profitability standpoint, and we're not anywhere near from a store closure standpoint. So looking at the magnitude of what we have here, the chain from a totality standpoint is incredibly strong, and I want to make sure we leave everyone on the call and our investors that the stores that are under performing are still a positive contributor to the Company as a whole.

Great clarification. Appreciate it. Lastly, based on the guidance, obviously, EBITDA will be down a little bit year-over-year. Remind us what covenants, if any, there are to your current credit facility, either at year end or out in to 2015?

Sure, Dan. Good morning. This is Kirk.

There's two primary covenants. One is the fixed charge ratio and the other is a leverage ratio. When we amended the agreement several weeks ago, it was really the leverage ratio that we were focused on.

As you're adding new stores and incurring all the incremental occupancy costs, and primarily rent, that impacts that leverage ratio pretty materially, and particularly in a softer environment, from a macro perspective, and then when you have some newer stores that aren't getting up the revenue curve quite as quickly as they originally have in the past, that just puts a little extra pressure on that leverage ratio. But with the amendment, we feel very comfortable that we'll be good going forward.

Can you share what that is for 2015?

I don't have the numbers right here in front of me but it's in the 8K that we filed three to four weeks ago.

Thank you once again, and best of luck in the transition.

Our next question comes from John Baugh with Stifel.

Thanks for taking my questions. I guess first question is on the lower or smaller store planned openings, could you put a dollar amount on what you expect a new store to be, in terms of all-in, inventory, et cetera?

I'm sorry, John, could you repeat that question?

I'm curious as to what the total capital outlay will be for a new store going forward? You mentioned it would be a smaller sized store.

Okay. Sorry, John. This is Kirk. Good morning.

At this point we're hoping to -- so traditionally, we've invested about $1.4 million in a new store, and as we reduce the square footage of our stores going forward and look to downsize just a little bit, we're still refining what the opportunity is from an investment perspective is. We don't have any specific numbers to share, but we do think there's some opportunity there.

Okay. And then do you have any thoughts around free cash flow in 2015 at this point? What is the plan on absolute levels of debt going forward, if there is a financial goal or plan?

We'll talk about 2015 in 90 days, and give you some guidance on the next call.

Okay. And then just on the pro business, these people tend to have a better idea of what this material costs than the casual consumers. So following up on our earlier question, doesn't it stand to reason, obviously volume increases can result in higher gross profit dollars. I'm just assuming that business, if you pursue it earnestly, will have a lower margin attached with it?

John, this is Chris.

We don't necessarily feel that way. We feel that the contractor professional customer already receives a significant discount for purchasing at The Tile Shop. It's material for them, and we feel that when you factor in those discounts, it's already baked in to our model across the board that we don't view any deleverage on our gross margin ratio, gross margin percentage at all.

We feel they're an opportunity to grow that business, to share with the professional customer about the benefits of purchasing at The Tile Shop both on the front end on product selection and quality, pricing we think is a benefit, not a deterrent. Certainly on the flip side of servicing that customer, we feel that all of those things are already built in to the operating business model of the Company.

It continues to be warmly received. Certainly the new folks we talk to across the country, I think, are surprised with all three of those elements of how we can service them in a very different and meaningful way from our competitors.

Especially the designer-led business and the higher-end homebuilder business is higher margin. That's a high end category.

Thanks for the color. My last question, I think was asked earlier, but I'm not sure what the answer was. Maybe I'll ask it a little differently.

I'm curious in new stores, particularly in new markets, are there geographic challenges -- I know you've been strong in the Northeast. I think you've opened some stores in areas where there's just more tile players. Are there any themes of competition, like a floor and decor store, or some competition where you're seeing some issues, relative to what have been historically more robust areas?

This is Chris. Sorry if it wasn't more clear in answering the question.

There are clear themes from a competitive standpoint or geographic standpoint. What is clear and what we've identified from the leadership team and what we've spoken about here this morning is around the common theme can really be traced back to having that continuity of a leader from within The Tile Shop.

So we're having excellent performance across large geographies of the country, and we're also having underperformance across the same places. But when you actually go down to, it's not a competitive issue.

Certainly there's macro slowdown across the board. But when we look at it internally, the biggest opportunity that we feel to improve the performance of these stores is to increase our training, to do more around our talent identification and placement process, and to really build up that continuity in sales staff and sales leader within a store, and we feel that is the recipe and the formula that has been successful for us in the past, and certainly we feel it will continue to be successful for us going forward.

Where there's more competitors, there's more market. We've always had success going right in to the middle of the tile areas in any community we go in to, with great success.

Thank you for that color, and thanks for taking my questions.

Our next question comes from Anthony Lebiedzinski with Sidoti.

I make have missed this, but did you give down a breakdown for traffic and tickets for same-store sales, and also if you could talk about same-store sales by region?

Good morning, Anthony. This is Kirk.

No, we didn't talk about it specifically earlier. As we -- the metric we usually look at, in terms of traffic is the number of tickets, and as we look at the number of tickets over the last 90 days, it's been relatively stable.

We haven't had any changes in average, any material changes in average ticket. And obviously we're seeing some sequential improvement in comps, but it's not a significant change at this point. There's a little bit of an uptick. But nothing more than that.

As far as comp sales by region, any comments you can give us?

It's really as we talked about a little bit earlier, the strength is with our four most mature markets. Minneapolis-St. Paul, Detroit, DC-Baltimore, and Chicago. It's collectively those markets are doing about a 4 comp in the quarter, which we're very pleased with.

That's helpful color.

And also what is your longer-term outlook for gross margins? Looking back historically, the Company was close to 74% in 2011. The prior guidance used to be 70% to 72%. We know your guidance for this year. If you take a step back and look at the business next couple of years, how should we think about gross margins?

Yes, we feel pretty good that this is approximately a 70% margin business. We don't see any reason why we can't achieve that going forward.

As far as new store openings you gave us some color for next year, low to mid teens. Is that a sustainable annual rate you think will happen 2016 and beyond? If you could share some color on new store growth, that would be helpful.

Hi, it's Chris.

Certainly, we look at the opportunity for us to increase stores across the country remains strong. There's nothing that's dampened about what we can do across the country and ultimately expand and be a national retailer. So, I feel that mid-teen number is a good approximate gauge for you and your modeling purposes, and we feel very strongly that once these items are rectified, that we can continue to be aggressive in our store, penetration across both new markets, as well as existing.

So your store growth if you look at the growth in the store base it's coming down. You'll be adding some more people obviously, so with that in mind, what kind of same-store sales increase will you need to leverage SG&A expenses next year?

One thing to clarify on the investments we're making in terms of training and the talent pipeline, there won't be any significant incremental dollar investment there. It's a time investment. We're not adding incremental positions. For example, the market manager positions we talked about, each of those people is already a store manager, and in addition to their responsibilities as a store manager in a particular market, they'll also be broadening their responsibility to help the other store managers in that market as a market leader.

In terms of the assistant managers, really what we're doing there, we're not adding incremental positions. We're just identifying the most talented people that are ready to start leading and managing people earlier on in the process, and training them, and being clear on who the next group of people will be to lead our stores. And the benefit there is really the development, prior to them taking on a new store, the other benefit obviously is they know they're going to be moving at some point to another location within the market, or in some cases outside of the market.

So that if they have, for example, a lot of relationships with our pro business customers, they can make sure that there's time to transition those relationships to a new person, a new salesperson that steps in to that assistant manager role. But we don't expect, just to be clear, we don't expect any significant incremental expense from the initiatives that Chris talked about.

Okay, that's helpful color. With that in mind, what kind of same-store sales increase will you need to leverage next year?

Again, with no significant incremental investment in expense, any increase in same-store sales we get will flow through. And we'll talk about 2015 same-store sales on the next call.

Okay. Thank you very much.

Our final question comes from Joe Feldman with Telsey Advisors.

Good morning. This is Cristina Hernandez for Joe.

We wanted to ask about the 12 stores opening in existing markets, should we assume those are performing in line with expectations, or are some of those as well falling short?

Good morning, Cristina. This is Kirk.

As we talked about, many of the comp stores are doing great. Collectively, the four largest markets are doing a 4 comp. As we reported, we were close to getting to a 1 comp, but you can do the math. That means many of the other stores that are comp are doing a negative comp, or not quite as good of a comp as the ones in mature markets.

As we study those stores, it's interesting, on a year-to-date basis, the ones that are doing a more material negative comp, often, and I think it's really over two-thirds of those stores that are doing a negative year-to-date comp, have a new store manager. We can trace back some of the things we've talked about early on the call, and making sure we have a talent pipeline, so when we do have a change in store leader, we're ready for that change, and we can mitigate any top line risk that we might have.

Then as we look at the other third of the stores that are doing a negative year-to-date comp, it's interesting, if those stores have the same manager as they had last year, all of those stores last year had a positive year-to-date comp. And many of those stores, I think it's at least five of them, had comps that were 20%-plus.

The compare is really difficult. They're comping on an incredible year from last year, and it's noteworthy that a lot of these stores are pretty mature stores as well. It's just a tough compare. There's a number of things going on within our comp base, and hopefully that provides a little more clarity.

Thank you.

That concludes the Q&A session. I'll now turn the call back over to Bob Rucker for closing remarks.

Thank you, folks, for joining us this morning on our call. Wish all of you a good day. Thank you.

Thank you, ladies and gentlemen. That does conclude today's conference. You may all disconnect, and everyone have a great day.