TILE SHOP HOLDINGS, INC. - Annual Report: 2017 (Form 10-K)

 



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



FORM 10-K



☒     Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2017 

or

☐     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to



Commission File Number: 001-35629



TILE SHOP HOLDINGS, INC.

(Exact name of registrant as specified in its charter)





14000 Carlson Parkway, Plymouth, Minnesota 55441

(Address of principal executive offices, including zip code)



(763) 852-2950

(Registrant’s telephone number, including area code)



Securities registered pursuant to Section 12(b) of the Act:





Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐    No ☒



Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ☐   No ☒



Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒     No ☐



Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒     No ☐



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☐



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. 



If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐     No ☒



The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter was approximately: $819,229,877.  



As of February 16, 2018, the registrant had 52,152,031 shares of common stock outstanding.





---

 

TILE SHOP HOLDINGS, INC. FORM 10-K



 

 



 

---

 



PART I

 

ITEM 1. BUSINESS



Overview



The Tile Shop, LLC (“The Tile Shop”) was founded in 1985 and Tile Shop Holdings, Inc. (“Holdings,” and together with its wholly owned subsidiaries, including The Tile Shop, the “Company” or “we”) was incorporated in Delaware in June 2012. We are a specialty retailer of natural stone and manufactured tiles, setting and maintenance materials, and related accessories in the United States. Our assortment includes over 4,000 products from around the world. Natural stone products include marble, travertine, granite, quartz, sandstone, slate, and onyx tiles. Manufactured tiles include ceramic, porcelain, glass, cement, wood look, and metal tiles. The majority of our tile products are sold under our proprietary Rush River and Fired Earth brand names. We purchase our tile products, accessories and tools directly from our network of suppliers. We manufacture our own setting and maintenance materials, such as thinset and sealers under our Superior brand name, as well as work with other suppliers to manufacture private label products. As of December 31, 2017, we operated 138 stores in 31 states and the District of Columbia, with an average size of approximately 20,300 square feet. We also sell our products on our website.



We believe that our long-term vendor relationships, together with our design, manufacturing and distribution capabilities, enable us to offer a broad assortment of high-quality products to our customers, who are primarily homeowners and professionals, at competitive prices. We have invested significant resources to develop our proprietary brands and product sources and believe that we are a leading retailer of natural stone and manufactured tiles, setting and maintenance materials, and related accessories in the United States.



In 2017, we reported net sales and income from operations of $344.6 million and $25.8 million, respectively. Our 2016 and 2015 net sales were $324.2 million and $293.0 million, respectively, and our 2016 and 2015 income from operations was $32.9 million and $29.2 million, respectively. We opened fifteen new stores in 2017 and intend to open three new stores in 2018. As of the end of fiscal years 2017 and 2016, we had total assets of $270.7 million and $265.3 million, respectively.



Competitive Strengths



We believe that the following factors differentiate us from our competitors and position us to continue to grow our specialty retailer business.



Inspiring Customer Experience –  In each store, our products are brought to life by showcasing a broad array of the items we offer in up to 50 different vignettes of bathrooms, kitchens, fireplaces, foyers, and other distinct spaces. Our stores are spacious, well-lit, and organized by product type to simplify our customers’ shopping experience.



Broad Product Assortment at Attractive Prices –  We offer over 4,000 manufactured and natural tile products, setting and maintenance materials, accessories, and tools. We are able to maintain competitive prices by purchasing tile and accessories directly from producers and manufacturing our own setting and maintenance materials.



Customer Service and Satisfaction  – Our sales personnel are highly-trained and knowledgeable about the technical and design aspects of our products. We offer weekly do-it-yourself classes in all of our stores. In addition, we provide one-on-one installation training as required to meet customer needs. We accept returns up to six months following the date of the sale, with no restocking fees.



Worldwide Sourcing Capabilities –  We have long-standing relationships with our tile suppliers throughout the world and work with them to design products exclusively for us. We believe that these direct relationships differentiate us from our competitors.



Proprietary Branding  – We sell the majority of our products under our proprietary brand names, which helps us to differentiate our products from those of our competitors. We offer products across a range of price points and quality levels that allow us to target discrete market segments and to appeal to diverse groups of customers.



Centralized Distribution System – We service our retail locations from five distribution centers. Our distribution centers, located in Michigan, Oklahoma, New Jersey, Virginia, and Wisconsin, are positioned to cost effectively service our existing stores.



Strategic Plan



Key elements of our strategy include:

 

Best Assortment – We offer an extensive assortment of over 4,000 natural stone and manufactured tile products, setting and maintenance materials, accessories and tools. Our assortment is tailored to provide homeowners and professional customers distinctive fashion-forward products. We feature unique products and partner with industry-leading designers to curate collections that are sold

---

 

exclusively in our stores. Our buying team sources products from across the world to provide our customers with good, better and best options to appeal to their individual tastes and budgets. We continuously refine our product assortment of setting and maintenance products, including installation materials and tools, to meet the changing and growing needs of our professional customers. We believe the ongoing emphasis placed on maintaining a best-in-class assortment is a critical component of our strategy. In 2018, we plan to add a significant number of new products to our assortment. We are committed to maintaining a product assortment that meets the needs of an upscale, fashion conscious homeowner, as well as all of the professional customers who serve that homeowner.

 

Best Service – We are committed to providing our customers a high degree of in-store service through our motivated, well-trained store team members. We continue to make investments to improve our hiring, management and development training practices which have resulted in significant reductions in sales associate turnover and increased our average manager tenure. The improvement in turnover and manager tenure has proven to contribute to better product knowledge, store leadership, and overall customer experience. We also engage with our customers through our e-commerce website (TileShop.com), which provides inspiration, enhanced product information and research and design tools that support product selection. In 2018, we plan to add to the number of regional sales leader positions, increase sales and warehouse staff compensation, and invest in customer relationship management and content management capabilities. Our exceptional customer service gives customers the ability to design with confidence.

 

Best Presentation – We bring our products to life in our stores by showcasing a broad array of the items we offer in up to 50 different bathroom, kitchen, fireplace, foyer and other vignettes. We also showcase our products on our website. In 2018, we plan to continue refining our website to provide more inspirational and informative content, promote our design appointment capabilities, enhance our sampling process, and introduce a new platform to promote professional customer commerce. Additionally, we plan to make investments to remodel vignettes in approximately 30 stores, enhance our in-store merchandising and simplify the process to execute product transitions. We are committed to maintaining our reputation as a destination store where customers find inspiration.

 

We plan to increase our existing store base by three stores in 2018. All stores we intend to open in 2018 will be located in existing markets where we will be able to leverage economies of scale in marketing, distribution and store talent. Longer term, we believe we have exceptional opportunities to continue to add stores in existing markets and expand into new markets. Additionally, we will continue to focus on strategies to further enhance the return on our new store investments by selecting retail spaces that provide us the opportunity to reduce the initial investment to build a new store and, in some cases, the ongoing occupancy costs.



Sales Model



We principally sell our products directly to homeowners and professionals. With regard to individual customers, we believe that due to the average cost and relative infrequency of a tile purchase, many of our individual customers conduct extensive research using multiple channels before making a purchase decision. Our sales strategy emphasizes customer service by providing comprehensive and convenient educational tools on our website and in our stores for our customers to learn about our products and the tile installation process. Our website contains a broad range of information regarding our tile products, setting and maintenance materials, and accessories. Customers can order samples, view catalogs, or purchase products from either our stores or website. Customers can choose to have their purchases delivered or picked up at one of our stores. We believe this strategy also positions us well with professional customers who are influenced by the preferences of individual homeowners.



Our stores are designed to emphasize our products in a visually appealing showroom format. Our average store is approximately 20,300 square feet, with a majority of the square footage devoted to the showroom and several thousand square feet of warehouse space, which is used primarily to hold customer orders waiting to be picked up or delivered. Our stores are typically accessible from major roadways and have significant visibility to passing traffic. We can adapt to a range of existing buildings, whether free-standing or in shopping centers. All of our stores are leased.



Unlike many of our competitors, we devote a substantial portion of our store space to showrooms, including samples of our over 4,000 products and up to 50 different vignettes of bathrooms, kitchens, fireplaces, foyers, outdoor living, and other distinct spaces that showcase our products. Our showrooms are designed to provide our customers with a better understanding of how to integrate various types of tile in order to create an attractive presentation in their homes. Many stores are also equipped with a training center designed to teach customers how to properly install tile.



A typical store staff consists of a manager, an assistant manager, sales associates, and a warehouse leader. Our store managers are responsible for store operations and for overseeing our customers’ shopping experience. We offer financing to customers through a branded credit card provided by a third-party consumer finance company.



---

 

Marketing



We utilize a variety of marketing strategies and programs to acquire and retain customers, including both consumers and trade professionals. Our advertising primarily consists of digital media, direct marketing, including email and postal mail, in store events, and mobile and traditional media vehicles, including newspaper circular/print ads, radio, out-of-home and video. We continually test and learn from new media and adjust our programs based on performance.



Our e-commerce site, TileShop.com, supports desktop, tablet, and mobile devices and is designed for consumers, trade professionals and industry stakeholders to learn about our brand, our value propositions, and our product assortment and installation techniques, and to look up our store locations and account information. It hosts our Design Studio, a collaborative platform that enables the creation of customized 3D design renderings to scale, allowing customers to bring their ideas to life. On social media, #TheTileShop provides current and prospective customers a high level of brand engagement and enables customers to share their finished projects in our inspiration gallery. TileShop.com also serves as a commerce platform for our customers who want to purchase products within or outside of our physical store footprint. Products can be delivered to a job site, home, or store location.



Products



We offer an extensive and complete assortment of natural stone and manufactured tile products, sourced directly from our suppliers. Natural stone products include marble, travertine, granite, quartz, sandstone, slate, and onyx tiles. Manufactured tiles include ceramic, porcelain, glass, cement, wood look, and metal tiles. Our wide assortment of accessories, including trim pieces, mosaics, pencils, listellos, and other unique products encourage our customers to make a fashion statement with their tile project. This also helps us to deliver a high level of customer satisfaction and drive repeat business. We also offer a broad range of setting and maintenance materials, such as thinset, grout, sealers, and accessories, including installation tools, shower and bath shelves, drains, and similar products. We also offer customers delivery service through third-party freight providers. We sell most of our products under our proprietary brand names, including Superior Adhesives & Chemicals, Superior Tools & Supplies, Rush River, and Fired Earth. In total, we offer over 4,000 different tile products, setting and maintenance materials, and accessory products. The percentage of sales by product category were comprised of the following for the years ended December 31, 2017 and 2016:





Suppliers



We have long-standing relationships with our suppliers throughout the world and work with them to design and manufacture products exclusively for us. We believe that these direct relationships differentiate us from our competitors.  



We currently purchase tile products from approximately 250 different suppliers. Our top ten tile suppliers accounted for 50% of our tile purchases in 2017.  Our largest supplier accounted for approximately 18% of our total purchases in 2017.  We believe that alternative and competitive suppliers are available for most of our products. Purchases were made from the following continents for the years ended December 31, 2017 and 2016:







---

 

Distribution and Order Fulfillment



We take possession of our products in the country of origin and arrange for transportation to our distribution centers located in Michigan, Oklahoma, New Jersey, Virginia and Wisconsin. We also manufacture many of our setting and maintenance materials in Michigan, Oklahoma, Virginia, and Wisconsin. We maintain a large inventory of products in order to quickly fulfill customer orders.



We fulfill customer orders primarily by shipping our products to our stores where customers can either pick them up or arrange for home delivery. Orders placed on our website are shipped directly to customers’ homes from our distribution centers or a local store. We continue to evaluate logistics alternatives to best serve our store base and our customers. We believe that our existing distribution facilities will continue to play an integral role in our growth strategy, and we expect to establish one or more additional distribution centers to support geographic expansion of our store base and to support our store growth plans.



Competition



The retail tile market is highly-fragmented. We compete directly with large national home improvement centers that offer a wide range of home improvement products, including flooring. In addition, we also compete with regional and local specialty retailers of tile, factory-direct stores, a large number of privately-owned, single-site stores, and online-only competitors. We also compete indirectly with companies that sell other types of floor coverings, including wood floors, carpet, and vinyl. The barriers of entry into the retail tile industry are relatively low and new or existing tile retailers could enter our markets and increase the competition that we face. Many of our competitors enjoy competitive advantages over us, such as greater name recognition, longer operating histories, more varied product offerings, and greater financial, technical, and other resources.



We believe that the key competitive factors in the retail tile industry include:



We believe that we compete favorably with respect to each of these factors by providing a highly diverse selection of products to our customers, at an attractive value, in appealing and convenient store locations, with exceptional customer service and on-site instructional opportunities. Further, while some larger factory-direct competitors manufacture their own products, many of our competitors purchase their tile from domestic manufacturers or distributors when they receive an order from a customer. We also believe that we offer a broader range of products and stronger in-store customer support than these competitors.



Employees



As of December 31, 2017, we had 1,634 employees, 1,488 of whom were full-time and none of whom were represented by a union. Of these employees, 1,292 work in our stores, 76 work in corporate, store support, infrastructure or similar functions, and 266 work in distribution and manufacturing facilities. We believe that we have good relations with our employees.



Property and Trademarks



We have registered and unregistered trademarks for all of our brands, including 20 registered trademarks. We regard our intellectual property as having significant value and our brands are an important factor in the marketing of our products. Accordingly, we have taken, and continue to take, appropriate steps to protect our intellectual property.



Government Regulation



We are subject to extensive and varied federal, state and local government regulation in the jurisdictions in which we operate, including laws and regulations relating to our relationships with our employees, public health and safety, zoning, and fire codes. We operate each of our stores, offices, and distribution and manufacturing facilities in accordance with standards and procedures designed to comply with applicable laws, codes, and regulations.



Our operations and properties are also subject to federal, state and local laws and regulations relating to the use, storage, handling, generation, transportation, treatment, emission, release, discharge and disposal of hazardous materials, substances, and wastes and relating to the investigation and cleanup of contaminated properties, including off-site disposal locations. We do not incur significant costs complying with environmental laws and regulations. However, we could be subject to material costs, liabilities, or claims

---

 

relating to environmental compliance in the future, especially in the event of changes in existing laws and regulations or in their interpretation.



Products that we import into the United States are subject to laws and regulations imposed in conjunction with such importation, including those issued and enforced by U.S. Customs and Border Protection. We work closely with our suppliers to ensure compliance with the applicable laws and regulations in these areas.



Financial Information about Geographic Areas



A majority of our revenues and profits are generated within the United States and nearly all of our long-lived assets are located within the United States as well. We have also established a sourcing office based in China.



Available Information



We are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Exchange Act requires us to file periodic reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Copies of these reports, proxy statements and other information can be read and copied at the SEC Public Reference Room, 100 F Street, N.E., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. These materials may be obtained electronically by accessing the SEC’s website at http://www.sec.gov.



We maintain a website at www.tileshop.com, the contents of which are not part of or incorporated by reference into this Annual Report on Form 10-K. We make our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports available on our website, free of charge, as soon as reasonably practicable after such reports have been filed with or furnished to the SEC. Our Code of Business Conduct and Ethics, as well as any waivers from and amendments to the Code of Business Conduct and Ethics, is also posted on our website.

 

ITEM 1A. RISK FACTORS



The following are significant factors known to us that could adversely affect our business, financial condition, or operating results, as well as adversely affect the value of an investment in our common stock. These risks could cause our actual results to differ materially from our historical experience and from results predicted by forward-looking statements. All forward-looking statements made by us are qualified by the risks described below. There may be additional risks that are not presently material or known. You should carefully consider each of the following risks and all other information set forth in this Annual Report on Form 10-K.



Our business, financial condition and operating results are dependent on general economic conditions and discretionary spending by our customers, which in turn are also affected by a variety of factors beyond our control. If such conditions deteriorate, our business, financial condition and operating results may be adversely affected.



Our business, financial condition and operating results are affected by general economic conditions and discretionary spending by our customers. Such general economic conditions and discretionary spending are beyond our control and are affected by, among other things:

---

 

If such conditions deteriorate, our business, financial condition and operating results may be adversely affected. In addition, increasing volatility in financial and capital markets may cause some of the above factors to change with a greater degree of frequency and magnitude than in the past.

 

Our ability to grow and remain profitable may be limited by direct or indirect competition in the highly-competitive retail tile industry.



The retail tile industry in the United States is highly competitive. Participants in the tile industry compete primarily based on product variety, customer service, store location, and price. There can be no assurance that we will be able to continue to compete favorably with our competitors in these areas. Our store competitors include large national home centers, regional and local specialty retailers of tile, factory direct stores, privately-owned, single-site stores and online-only competitors. We also compete indirectly with companies that sell other types of floor coverings, including wood floors, carpet, and vinyl sheet. In the past, we have faced periods of heightened competition that materially affected our results of operations. Certain of our competitors have greater name recognition, longer operating histories, more varied product offerings, and substantially greater financial and other resources than us. Accordingly, we may face periods of intense competition in the future that could have a material adverse effect on our planned growth and future results of operations. Moreover, the barriers to entry into the retail tile industry are relatively low. New or existing retailers could enter our markets and increase the competition that we face. In addition, manufacturers and suppliers of tile and related products, including those whose products we currently sell, could enter the United States retail tile market and start directly competing with us. Competition in existing and new markets may also prevent or delay our ability to gain relative market share. Any of the developments described above could have a material adverse effect on our planned growth and future results of operations.



If we fail to successfully manage the challenges that our planned growth poses or encounter unexpected difficulties during our expansion, our revenues and profitability could be materially adversely affected.



One of our long-term objectives is to increase revenue and profitability through market share gains. Our ability to achieve market share growth, however, is contingent upon our ability to open new stores and achieve operating results in new stores at the same level as our similarly situated current stores. We anticipate opening three stores in fiscal year 2018. There can be no assurance that we will be able to open stores in new markets at the rate required to achieve market leadership in such markets, identify and obtain favorable store sites, arrange favorable leases for stores, obtain governmental and other third-party consents, permits, and licenses needed to open or operate stores in a timely manner, train and hire a sufficient number of qualified managers for new stores, attract a strong customer base and brand familiarity in new markets, or successfully compete with established retail tile stores in the new markets that we enter. Failure to open new stores in an effective and cost-efficient manner could place us at a competitive disadvantage as compared to retailers who are more adept than us at managing these challenges, which, in turn, could negatively affect our overall operating results.



Our same store sales fluctuate due to a variety of economic, operating, industry and environmental factors and may not be a fair indicator of our overall performance.



Our same store sales have experienced fluctuations, which can be expected to continue. Numerous factors affect our same store sales results, including among others, the timing of new and relocated store openings, the relative proportion of new and relocated stores to mature stores, cannibalization resulting from the opening of new stores in existing markets, changes in advertising and other operating costs, the timing and level of markdowns, changes in our product mix, weather conditions, retail trends, the retail sales environment, economic conditions, inflation, the impact of competition, and our ability to execute our business strategy. As a result, same store sales or operating results may fluctuate and may cause the price of our securities to fluctuate significantly. Therefore, we believe that period-to-period comparisons of our same store sales may not be a reliable indicator of our future overall operating performance.



We intend to open additional stores in both our existing markets and new markets, which poses both the possibility of diminishing sales by existing stores in our existing markets and the risk of a slow ramp-up period for stores in new markets.



Our expansion strategy includes plans to open three additional stores in existing markets during 2018.  In future periods, we intend to continue opening stores in new and existing markets. Because our stores typically draw customers from their local areas, additional stores may draw customers away from nearby existing stores and may cause same store sales performance at those existing stores to decline, which may adversely affect our overall operating results. Additionally, stores in new markets typically have a ramp-up period before sales become steady enough for such stores to be profitable. Our ability to open additional stores will be dependent on our ability to promote and/or recruit enough qualified store managers, assistant store managers, and sales associates. The time and effort required to train and supervise a large number of new managers and associates and integrate them into our culture may divert resources from our existing stores. If we are unable to profitably open additional stores in both new and existing markets and limit the adverse impact of those new stores on existing stores, it may reduce our same store sales and overall operating results during the implementation of our expansion strategy.



---

 

Our expansion strategy will be dependent upon, and limited by, the availability of adequate capital.



Our expansion strategy will require adequate capital for, among other purposes, opening new stores, distribution centers, and manufacturing facilities, as well as entering new markets. Such expenditures will include researching real estate and consumer markets, leases, inventory, property and equipment costs, integration of new stores and markets into company-wide systems and programs, and other costs associated with new stores and market entry expenses and growth. If cash generated internally is insufficient to fund capital requirements, we will require additional debt or equity financing. Adequate financing may not be available or, if available, may not be available on terms satisfactory to us. In addition, our credit facility may limit the amount of capital expenditures that we may make annually, depending on our leverage ratio. If we fail to obtain sufficient additional capital in the future or we are unable to make capital expenditures under our credit facility, we could be forced to curtail our expansion strategies by reducing or delaying capital expenditures relating to new stores and new market entry. As a result, there can be no assurance that we will be able to fund our current plans for the opening of new stores or entry into new markets.



If we fail to identify and maintain relationships with a sufficient number of suppliers, our ability to obtain products that meet our high quality standards at attractive prices could be adversely affected.



We purchase flooring and other products directly from suppliers located around the world. However, we do not have long-term contractual supply agreements with our suppliers that obligate them to supply us with products exclusively or at specified quantities or prices. As a result, our current suppliers may decide to sell products to our competitors and may not continue selling products to us. In order to retain the competitive advantage that we believe results from these relationships, we need to continue to identify, develop and maintain relationships with qualified suppliers that can satisfy our high standards for quality and our requirements for flooring and other products in a timely and efficient manner at attractive prices. The need to develop new relationships will be particularly important as we seek to expand our operations and enhance our product offerings in the future. The loss of one or more of our existing suppliers or our inability to develop relationships with new suppliers could reduce our competitiveness, slow our plans for further expansion, and cause our net sales and operating results to be adversely affected.



We source the over 4,000 products that we stock and sell from approximately 250 domestic and international suppliers. We source a large number of those products from foreign manufacturers, including 50% of our products from a group of ten suppliers located in Asia, Europe and the United States. Our largest supplier accounted for approximately 18% of our total purchases in 2017.  We generally take title to these products sourced from foreign suppliers overseas and are responsible for arranging shipment to our distribution centers. Financial instability among key suppliers, political instability, trade restrictions, tariffs, currency exchange rates, and transport capacity and costs are beyond our control and could negatively impact our business if they seriously disrupt the movement of products through our supply chain or increase the costs of our products.



Our ability to offer compelling products, particularly products made of unique stone, depends on the continued availability of sufficient suitable natural products.



Our business strategy depends on offering a wide assortment of compelling products to our customers. We sell, among other things, products made from various natural stones from quarries throughout the world. Our ability to obtain an adequate volume and quality of hard-to-find products depends on our suppliers ability to furnish those products, which, in turn, could be affected by many things, including the exhaustion of stone quarries. If our suppliers cannot deliver sufficient products, and we cannot find replacement suppliers, our net sales and operating results may be adversely affected.



If our suppliers do not use ethical business practices or comply with applicable laws and regulations, our reputation could be harmed due to negative publicity and we could be subject to legal risk.



We do not control the operations of our suppliers. Accordingly, we cannot guarantee that our suppliers will comply with applicable environmental and labor laws and regulations or operate in a legal, ethical, and responsible manner. Violation of environmental, labor or other laws by our suppliers or their failure to operate in a legal, ethical, or responsible manner could reduce demand for our products if, as a result of such violation or failure, we attract negative publicity. Further, such conduct could expose us to legal risks as a result of the purchase of products from non-compliant suppliers.



Failure to address product safety concerns could adversely affect our sales and results of operations.



If our products do not meet applicable safety standards or our customers’ expectations regarding safety, we could experience lost sales and increased costs and be exposed to legal and reputational risk. All of our suppliers must comply with applicable product safety laws, and we are dependent on them to ensure that the products we sell in our stores comply with all safety standards. Events that give rise to actual, potential or perceived product safety concerns could expose us to private ligation and result in costly product recalls and other liabilities. In addition, negative customer perceptions regarding the safety of the products we sell could cause our customers to purchase from our competitors, resulting in a decrease in our sales. In those circumstances, it may be difficult and costly for us to regain the confidence of our customers.

---

 

 If customers are unable to obtain third-party financing at satisfactory rates, sales of our products could be materially adversely affected.



Our business, financial condition, and results of operations have been, and may continue to be affected, by various economic factors. Deterioration in the current economic environment could lead to reduced consumer and business spending, including by our customers. It may also cause customers to shift their spending to products that we either do not sell or that generate lower profitably for us. Further, reduced access to credit may adversely affect the ability of consumers to purchase our products. This potential reduction in access to credit may adversely impact our ability to offer customers credit card financing through third-party credit providers on terms similar to those offered currently, or at all. In addition, economic conditions, including decreases in access to credit, may result in financial difficulties leading to restructuring, bankruptcies, liquidations and other unfavorable events for our customers, which may adversely impact our industry, business, and results of operations.



Any failure by us to successfully anticipate consumer trends may lead to loss of consumer acceptance of our products, resulting in reduced revenues.



Our success depends on our ability to anticipate and respond to changing trends in the tile industry and consumer demands in a timely manner. If we fail to identify and respond to emerging trends, consumer acceptance of our merchandise and our image with current or potential customers may be harmed, which could reduce our revenues. Additionally, if we misjudge market trends, we may significantly overstock unpopular products and be forced to reduce the sales price of such products, which would have a negative impact on our gross profit and cash flow. Conversely, shortages of products that prove popular could also reduce our revenues.



We depend on a few key employees, and if we lose the services of these employees, we may not be able to run our business effectively.



Our future success depends in part on our ability to attract and retain key executive, merchandising, marketing, and sales personnel. If any of these key employees ceases to be employed by us, we would have to hire additional qualified personnel. Our ability to successfully hire other experienced and qualified key employees cannot be assured and may be difficult because we face competition for these professionals from our competitors, our suppliers and other companies operating in our industry. As a result, the loss or unavailability of any of our key employees could have a material adverse effect on us. Specifically, our founder and former Chief Executive Officer currently serves as our interim Chief Executive Officer and no assurance can be given that a suitable replacement can be hired.



The burden of debt under our existing credit facility and additional debt could adversely affect us, make us more vulnerable to adverse economic or industry conditions, and prevent us from fulfilling our debt obligations or from funding our strategies.

 

We have entered into a credit facility with Fifth Third Bank, Bank of America, N.A., and The Huntington National Bank on June 2, 2015. As of December 31, 2017, our term loan balance was $11.3 million and the balance on our revolving line of credit was $15.0 million. The amount of available future borrowings on our revolving credit facility was $60.0 million as of December 31, 2017. The terms of our credit facility and the burden of the indebtedness incurred thereunder could have serious consequences for us, such as: 

---

 



Our credit facility also contains negative covenants that limit our ability to engage in specified types of transactions. These covenants limit our ability to, among other things:



A breach of any of these covenants could result in an event of default under our credit facility. Upon the occurrence of an event of default, the lender could elect to declare all amounts outstanding under such facility to be immediately due and payable and terminate all commitments to extend further credit, or seek amendments to our debt agreements that would provide for terms more favorable to such lender and that we may have to accept under the circumstances. If we were unable to repay those amounts, the lender under our credit facility could proceed against the collateral granted to them to secure that indebtedness.

 

If we fail to hire, train, and retain qualified store managers, sales associates, and other employees, our enhanced customer service could be compromised and we could lose sales to our competitors.



A key element of our competitive strategy is to provide product expertise to our customers through our extensively trained, commissioned sales associates. If we are unable to attract and retain qualified personnel and managers as needed in the future, including qualified sales personnel, our level of customer service may decline, which may decrease our revenues and profitability.



If we are unable to renew or replace current store leases, or if we are unable to enter into leases for additional stores on favorable terms, or if one or more of our current leases is terminated prior to expiration of its stated term and we cannot find suitable alternate locations, our growth and profitability could be negatively impacted.



We currently lease all of our store locations and certain distribution center locations. Many of our current leases provide us with the unilateral option to renew for several additional rental periods at specific rental rates. Our ability to renegotiate favorable terms on an expiring lease or to negotiate favorable terms for a suitable alternate location, and our ability to negotiate favorable lease terms for additional store locations, could depend on conditions in the real estate market, competition for desirable properties, our relationships with current and prospective landlords, or other factors that are not within our control. Any or all of these factors and conditions could negatively impact our growth and profitability.



Compliance with laws or changes in existing or new laws and regulations or regulatory enforcement priorities could adversely affect our business.



We must comply with various laws and regulations at the local, regional, state, federal, and international levels. These laws and regulations change frequently and such changes can impose significant costs and other burdens of compliance on our business and suppliers. Any changes in regulations, the imposition of additional regulations, or the enactment of any new legislation that affects employment/labor, trade, product safety, transportation/logistics, energy costs, health care, tax, or environmental issues, or compliance with the Foreign Corrupt Practices Act could have an adverse impact on our financial condition and results of operations. Changes in enforcement priorities by governmental agencies charged with enforcing existing laws and regulations could increase our cost of doing business.



We may also be subject to audits by various taxing authorities. Changes in tax laws in any of the multiple jurisdictions in which we operate, or adverse outcomes from tax audits that we may be subject to in any of the jurisdictions in which we operate, could result in an unfavorable change in our effective tax rate, which could have an adverse effect on our business and results of operations.



---

 

The final impacts of the Tax Cuts and Jobs Act could be materially different from our current estimates, which could have an adverse effect on our business and results of operations.



On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) was enacted into law and the new legislation contains several key tax provisions that affect us, including a one-time mandatory transition tax on accumulated foreign earnings and a reduction of the corporate income tax rate to 21% effective January 1, 2018, among others. We are required to recognize the effect of the tax law changes in the period of enactment, including determining the transition tax, re-measuring our U.S. deferred tax assets and liabilities and reassessing the net realizability of our deferred tax assets and liabilities. Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”) allows us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. Since the Tax Act was passed late in the fourth quarter of 2017, and ongoing guidance and accounting interpretation is expected over the next twelve months, we consider the accounting of the transition tax, deferred tax re-measurements, and other items to be incomplete due to the forthcoming guidance and our ongoing analysis of final year-end data and tax positions. Our estimated impact of the new law is based on management's current knowledge and assumptions. We expect to record any adjustments in the next year in accordance with the guidance provided in SAB 118.



As our stores are generally concentrated in the midwest, mid-Atlantic, south and northeast regions of the United States, we are subject to regional risks.



We have a high concentration of stores in the midwest, mid-Atlantic, south and northeast regions. If these markets individually or collectively suffer an economic downturn or other significant adverse event, there could be an adverse impact on same store sales, revenues, and profitability, and the ability to implement our planned expansion program. Any natural disaster, extended adverse weather or other serious disruption in these markets due to fire, tornado, hurricane, or any other calamity could damage inventory and could result in decreased revenues.



Our results may be adversely affected by fluctuations in material and energy costs.



Our results may be affected by the prices of the materials used in the manufacture of tile, setting and maintenance materials, and related accessories that we sell. These prices may fluctuate based on a number of factors beyond our control, including: oil prices, changes in supply and demand, general economic conditions, labor costs, competition, import duties, tariffs, currency exchange rates, and government regulation. In addition, energy costs have fluctuated dramatically in the past and may fluctuate in the future. These fluctuations may result in an increase in our transportation costs for distribution from the manufacturer to our distribution centers and from our regional distribution centers to our stores, utility costs for our distribution and manufacturing centers and stores, and overall costs to purchase products from our suppliers.



We may not be able to adjust the prices of our products, especially in the short-term, to recover these cost increases in materials and energy. A continual rise in material and energy costs could adversely affect consumer spending and demand for our products and increase our operating costs, both of which could have a material adverse effect on our financial condition and results of operations.



Our success is highly dependent on our ability to provide timely delivery to our customers, and any disruption in our delivery capabilities or our related planning and control processes may adversely affect our operating results.



Our success is due in part to our ability to deliver products quickly to our customers, which requires successful planning and distribution infrastructure, including ordering, transportation and receipt processing, and the ability of suppliers to meet distribution requirements. Our ability to maintain this success depends on the continued identification and implementation of improvements to our planning processes, distribution infrastructure, and supply chain. We also need to ensure that our distribution infrastructure and supply chain keep pace with our anticipated growth and increased number of stores. The cost of these enhanced processes could be significant and any failure to maintain, grow, or improve them could adversely affect our operating results. Our business could also be adversely affected if there are delays in product shipments due to freight difficulties, strikes, or other difficulties at our suppliers’ principal transport providers, or otherwise.



Our success depends on the effectiveness of our marketing strategy.



We believe that our growth was achieved in part through the effectiveness of our marketing strategies. Historically, we have used internet, print, and radio advertisements containing discounts and promotional offers to encourage customers to visit our stores. A significant portion of our advertising was invested to support the opening of new stores and directed at professional customers. In future periods, we intend to de-emphasize the use of discount offers to attract customers. Limited use of discount and promotional offers in future periods could fail to attract customers resulting in a decrease in store traffic. While our marketing strategy continues to support our growth strategy and remains focused on professional customers, we have broadened the reach and frequency of our advertising to increase the recognition of our value proposition and the number of customers served. We may need to further increase our marketing expense to support our business strategies in the future. If our marketing strategies fail to draw customers in the future,

---

 

or if the cost of advertising or other marketing materials increases significantly, we could experience declines in our net sales and operating results.



Natural disasters, changes in climate and geo-political events could adversely affect our operating results.



The threat or occurrence of one or more natural disasters or other extreme weather events, whether as a result of climate change or otherwise, and the threat or outbreak of terrorism, civil unrest or other hostilities or conflicts could materially adversely affect our financial performance. These events may result in damage to, or destruction or closure of, our stores, distribution centers and other properties. Such events can also adversely affect our work force and prevent employees and customers from reaching our stores and other properties, can modify consumer purchasing patterns and decrease disposable income, and can disrupt or disable portions of our supply chain and distribution network.



Our ability to control labor costs is limited, which may negatively affect our business.

 

Our ability to control labor costs is subject to numerous external factors, including prevailing wage rates, the impact of legislation or regulations governing healthcare benefits or labor relations, such as the Affordable Care Act, and health and other insurance costs. If our labor and/or benefit costs increase, we may not be able to hire or maintain qualified personnel to the extent necessary to execute our competitive strategy, which could adversely affect our results of operations.



Our business operations could be disrupted if our information technology systems fail to perform adequately or if we are unable to protect the integrity and security of our customer information.



We depend upon our information technology systems in the conduct of all aspects of our operations. If our information technology systems fail to perform as anticipated, we could experience difficulties in virtually any area of our operations, including but not limited to replenishing inventories or delivering products to store locations in response to consumer demands. It is also possible that our competitors could develop better online platforms than us, which could negatively impact our internet sales. Any of these or other systems-related problems could, in turn, adversely affect our revenues and profitability.



In connection with payment card sales and other transactions, including bank cards, debit cards, credit cards and other merchant cards, we process and transmit confidential banking and payment card information. Additionally, as part of our normal business activities, we collect and store sensitive personal information related to our employees, customers, suppliers and other parties. Despite our security measures, our information technology and infrastructure may be vulnerable to criminal cyber-attacks or security incidents due to employee error, malfeasance or other vulnerabilities. Any such incidents could compromise our networks and the information stored there could be accessed, publicly disclosed, lost or stolen. Third parties may have the technology and know-how to breach the security of this information, and our security measures and those of our banks, merchant card processing and other technology suppliers may not effectively prohibit others from obtaining improper access to this information. The techniques used by criminals to obtain unauthorized access to sensitive data change frequently and often are not recognized until launched against a target; accordingly, we may be unable to anticipate these techniques or implement adequate preventative measures.



Many states have enacted laws requiring companies to notify individuals of data security breaches involving their personal data. These mandatory disclosures regarding a security breach often lead to widespread negative publicity, which may cause our customers to lose confidence in the effectiveness of our data security measures. Any security breach, whether successful or not, would harm our reputation and could cause the loss of customers.



Our insurance coverage and self-insurance reserves may not cover future claims.

 

We maintain various insurance policies for employee health and workers’ compensation. We are self-insured on certain health insurance plans and are responsible for losses up to a certain limit for these respective plans. We are also self-insured with regard to workers’ compensation coverage, in which case we are responsible for losses up to certain retention limits on both a per-claim and aggregate basis.



For policies under which we are responsible for losses, we record a liability that represents our estimated cost of claims incurred and unpaid as of the balance sheet date. Our estimated liability is not discounted and is based on a number of assumptions and factors, including historical trends and economic conditions, and is closely monitored and adjusted when warranted by changing circumstances. Fluctuating healthcare costs, our significant growth rate and changes from our past experience with workers’ compensation claims could affect the accuracy of estimates based on historical experience. Should a greater amount of claims occur compared to what was estimated or employee health insurance costs increase beyond what was expected, our accrued liabilities might not be sufficient and we may be required to record additional expense. Unanticipated changes may produce materially different amounts of expense than that reported under these programs, which could adversely impact our operating results.



---

 

We are involved in a number of legal proceedings and, while we cannot predict the outcomes of such proceedings and other contingencies with certainty, some of these outcomes could adversely affect our business, financial condition and results of operations.



We are, and may become, involved in shareholder, consumer, employment, tort or other litigation. We cannot predict with certainty the outcomes of these legal proceedings. The outcome of some of these legal proceedings could require us to take, or refrain from taking, actions which could negatively affect our operations or could require us to pay substantial amounts of money adversely affecting our financial condition and results of operations. Additionally, defending against lawsuits and proceedings may involve significant expense and diversion of management's attention and resources.



The market price of our securities may decline and/or be volatile.

 

Our common stock price may be volatile and all or part of any investment in our common stock may be lost.

 

The market price of our common stock could fluctuate significantly. Those fluctuations could be based on various factors in addition to those otherwise described in this report, including:



In addition, the stock market may experience significant price and volume fluctuations. These fluctuations may be unrelated to the operating performance of particular companies but may cause declines in the market price of our common stock. The price of our common stock could fluctuate based upon factors that have little or nothing to do with our company or its performance.



If we discontinue or alter our quarterly dividend program, or if we are unable to pay quarterly dividends at intended levels, our reputation and stock price may be harmed.



The payment of, or continuation of, our quarterly dividend is at the discretion of our Board of Directors and is dependent upon our financial condition, results of operations, capital requirements, general business conditions, tax treatment of dividends in the United States, potential future contractual restrictions contained in credit agreements and other agreements and other factors deemed relevant by our Board of Directors. Additionally, because our quarterly dividend program requires the use of a moderate portion of our cash flow, our ability to pay dividends will depend on our ability to generate sufficient cash flows from operations in the future. This ability may be subject to certain economic, financial, competitive and other factors that are beyond our control. Any failure to pay quarterly dividends after we have announced our intention to do so, or any changes to our quarterly dividend program, may negatively impact our reputation, our stock price, and investor confidence in us.



We are a holding company with no business operations of our own and depend on cash flow from The Tile Shop to meet our obligations.



We are a holding company with no business operations of our own or material assets other than the equity of our subsidiaries. All of our operations are conducted by our subsidiary, The Tile Shop. As a holding company, we will require dividends and other payments from our subsidiaries to meet cash requirements. The terms of any future credit facility may restrict our subsidiaries from paying dividends and otherwise transferring cash or other assets to us, although our current facility does not restrict this action. If there is an insolvency, liquidation, or other reorganization of any of our subsidiaries, our stockholders likely will have no right to proceed against their assets. Creditors of those subsidiaries will be entitled to payment in full from the sale or other disposal of the assets of those subsidiaries before us, as an equity holder, would be entitled to receive any distribution from that sale or disposal. If The Tile Shop is unable to pay dividends or make other payments to us when needed, we will be unable to satisfy our obligations.



Concentration of ownership may have the effect of delaying or preventing a change in control.



Our directors and executive officers, together with their affiliates, beneficially hold approximately 25% of our outstanding shares of common stock. As a result, these stockholders, if acting together, have the ability to influence the outcome of corporate actions requiring stockholder approval. This concentration of ownership may have the effect of delaying or preventing a change in control and might adversely affect the market price of our securities.

---

 



Anti-takeover provisions contained in our certificate of incorporation and bylaws, as well as provisions of Delaware law, could impair a takeover attempt.



Our certificate of incorporation and bylaws contain provisions that could have the effect of delaying or preventing changes in control or changes in our management without the consent of our Board of Directors. These provisions include:



These provisions, alone or together, could delay hostile takeovers and changes in control of us or changes in our management.



As a Delaware corporation, we are also subject to provisions of Delaware law, including Section 203 of the Delaware General Corporation Law, which prevents some stockholders holding more than 15% of our outstanding common stock from engaging in certain business combinations without approval of the holders of substantially all of our outstanding common stock. Any provision of our certificate of incorporation or bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for our common stock.



ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 



---

 

ITEM 2. PROPERTIES



As of December 31, 2017, we operated 138 stores located in 31 states and the District of Columbia with an average square footage of approximately 20,300 square feet. The table below sets forth the locations (alphabetically by state) of our 138 stores in operation as of December 31, 2017.





  



We lease all of our stores. Our approximately 15,000 square foot headquarters in Plymouth, Minnesota is attached to our store. We own four regional facilities used for distribution of purchased product and manufacturing of setting and maintenance materials, located in Spring Valley, Wisconsin; Ottawa Lake, Michigan; Ridgeway, Virginia; and Durant, Oklahoma, which consist of 69,000, 271,000, 134,000, and 260,000 square feet, respectively.  We also lease a distribution facility in Dayton, New Jersey that is 103,000 square feet.



We believe that our material property holdings are suitable for our current operations and purposes. We intend to open three new retail locations in 2018.

 

ITEM 3. LEGAL PROCEEDINGS



The Company was a defendant in a consolidated class action arising in 2013 alleging it failed to disclose certain related party transactions in the Company’s SEC filings and press releases. In January 2017, the plaintiffs and the Company agreed to settle the lawsuit for $9.5 million.  The court approved the settlement and entered an order dismissing the action on June 14, 2017.



The Company also is a nominal defendant in three actions brought derivatively on behalf of the Company by three shareholders in 2015.  The plaintiffs allege that the defendant-directors and/or officers breached their fiduciary duties by failing to adopt adequate internal controls for the Company, by approving false and misleading statements issued by the Company, by causing the Company to violate generally accepted accounting principles and SEC regulations, and by permitting the Company’s primary product to contain illegal amounts of lead. The complaints also allege claims for insider trading and/or unjust enrichment. The Company moved to dismiss the actions, or in the alternative, to stay the actions.  Those motions have not yet been decided.  



By letter dated May 19, 2016, a shareholder of the Company demanded that the Board of Directors investigate alleged breaches of fiduciary duty related to the same matters described above and take action against certain present and former officers and directors of the Company. The Board of Directors has appointed a committee of two independent directors to investigate and evaluate the matters raised in the demand letter, and to recommend to the Company’s Board of Directors what actions, if any, should be taken by the Company with respect to the matters raised in the demand letter.  



Based on the Company’s assessment of the derivative actions and demand, the range of resulting loss is not expected to have a material impact on the Company’s financial statements. 



The Company is also, from time to time, subject to claims and disputes arising in the normal course of business.  In the opinion of management, while the outcome of such claims and disputes cannot be predicted with certainty, the Company’s ultimate liability in connection with these matters is not expected to have a material adverse effect on the results of operations, financial position, or cash flows. 



ITEM 4. MINE SAFETY DISCLOSURES



None.

 

---

 

Part II



ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES



Our common stock is traded on The Nasdaq Stock Market under the symbol “TTS”. The following table shows the high and low sale prices per share of our common stock as reported on The Nasdaq Stock Market for the periods indicated:







As of February 16, 2018, we had approximately 85 holders of record of our common stock. This figure does not include the number of persons whose securities are held in nominee or “street” name accounts through brokers.



As of February 16, 2018, we had outstanding a total of 52,152,031 shares of common stock. The last reported sales price for our common stock on February 16, 2018 was $8.45.



Dividends Paid Per Share







Prior to 2017, we did not pay dividends to our stockholders.  On February 21, 2018 we declared a $0.05 dividend to stockholders of record as of the close of business on March 5, 2018.  The dividend will be paid on March 16, 2018.  It is our intent to continue to pay quarterly dividends in the future; however, we may suspend or change this program at any time and there can be no guarantee that we will continue to pay dividends in any specific amount or at any specific time. 



Securities Authorized for Issuance Under Equity Compensation Plans



For information on our equity compensation plans, refer to Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”



Recent Sales of Unregistered Securities



None.



Issuer Purchases of Equity Securities



None.

  

---

 

Stock Performance Graph

 

The graph and table below present our cumulative total stockholder returns relative to the performance of the S&P SmallCap 600 and the Dow Jones U.S. Furnishings Index for the period commencing December 31, 2013 and ending December 31, 2017, the last trading day of fiscal year 2017. The comparison assumes $100 invested at the close of trading on December 31, 2012 in (i) our common stock, (ii) the stocks comprising the S&P SmallCap 600, and (iii) the stocks comprising the Dow Jones U.S. Furnishings Index. All values assume that all dividends were reinvested on the date paid. The points on the graph represent fiscal quarter-end amounts based on the last trading day in each fiscal quarter. The stock price performance included in the line graph below is not necessarily indicative of future stock price performance.



 



---

 

ITEM 6. SELECTED FINANCIAL DATA

 

The following table sets forth selected historical financial information derived from (i) our audited financial statements included elsewhere in this report as of December 31, 2017 and 2016 and for the years ended December 31, 2017,  2016,  and 2015 and (ii) our audited financial statements not included elsewhere in this report as of December 31, 2015,  2014, and 2013 and for the years ended December 31, 2014 and 2013. The following selected financial data should be read in conjunction with the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and the related notes appearing elsewhere in this report.

 







Reconciliation of Non-GAAP Adjusted EBITDA to GAAP Net Income (Loss)







Our management does not consider these non-GAAP measures in isolation or as an alternative to financial measures determined in accordance with GAAP. The principal limitations of these non-GAAP financial measures are that they exclude significant expenses and income that are required by GAAP to be recognized in our consolidated financial statements. In addition, they are subject to inherent limitations as they reflect the exercise of judgments by management about which expenses and income are excluded or included in determining these non-GAAP financial measures. In order to compensate for these limitations, management presents non-GAAP financial measures in connection with GAAP results. We urge investors to review the reconciliation of our non-GAAP financial measures to the comparable GAAP financial measures and not to rely on any single financial measure to evaluate our business.

 

---

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



You should read the following discussion and analysis together with “Selected Financial Data” and our consolidated financial statements and related notes included elsewhere in the Annual Report on Form 10-K. Among other things, those historical consolidated financial statements include more detailed information regarding the basis of presentation for the financial data than are included in the following discussion. This Annual Report on Form 10-K contains “forward-looking statements” within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. In some cases, you can identify these statements by forward-looking words such as “anticipate,” “believe,” “can,” “continue,” “could,” “depend,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “project,” “seek,” “should,” “target,” “will,” “will likely result,” “would,” and similar expressions, although some forward-looking statements are expressed differently. The forward-looking statements in this Form 10-K relate to, among other things, our anticipated new store openings, remodeling plans, and growth opportunities; our business strengths, marketing strategies, competitive advantages and role in our industry and markets; our strategic plan and the anticipated benefits of our strategic plan; legal proceedings; our intended future process for determining and assessing compensation; our expectations for the future use of equity incentive plans; our expectations regarding financing arrangements; our expectations with respect to dividend payments; supply costs and expectations, including the continued availability of sufficient products from our suppliers; costs and adequacy of insurance; our expectations with respect to ongoing compliance with the terms of our credit facility; the effect of regulations on us and our industry and our compliance with such regulations; our expectations regarding the effects of employee recruiting, training, mentoring, and retention; and our expectations regarding the impact of federal corporate tax reform.



These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause our actual results, performance, or achievements to differ materially from any expected future results, performance, or achievements expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be deemed forward-looking statements. These risks and uncertainties include, but are not limited to:





There is no assurance that our expectations will be realized. If one or more of these risks or uncertainties materialize, or if our underlying assumptions prove incorrect, actual results may vary materially from those expected, estimated, or projected. Such risks and uncertainties also include those set forth under “Risk Factors” in Item 1A of this Form 10-K. Our forward-looking statements speak only as of the time that they are made and do not necessarily reflect our outlook at any other point in time. We undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or for any other reason.

 

Overview



We are a specialty retailer of natural stone and manufactured tiles, setting and maintenance materials, and related accessories in the United States. We offer a wide selection of products, attractive prices, and exceptional customer service in an extensive showroom setting. As of December 31, 2017, we operated 138 stores in 31 states and the District of Columbia, with an average size of approximately 20,300 square feet. We also sell our products on our website.



We purchase our tile products and accessories directly from suppliers and manufacture our own setting and maintenance materials, such as thinset, grout, and sealers. We believe that our long-term supplier relationships, together with our design, manufacturing and distribution capabilities, enable us to offer a broad assortment of high-quality products to our customers, who are primarily homeowners and professionals, at competitive prices. We have invested significant resources to develop our proprietary brands and product sources, and we believe that we are a leading retailer of natural stone and manufactured tiles, setting and maintenance materials, and related accessories in the United States.



We believe that the highly-fragmented United States retail tile market provides us with a significant opportunity to expand our store base. We opened fifteen new stores in the United States in 2017, and plan to open three stores in 2018. We believe that there will continue to be additional expansion opportunities in the United States and Canada. We expect store growth will drive increased net

---

 

sales and income from operations. Our growth plans also require us to maintain significant inventory on-hand in order to fulfill orders at these new locations.



The table below sets forth information about our net sales, operating income and stores opened from 2015 to 2017.





Net cash provided by operating activities was $45.7 million, $53.6 million and $60.3 million for 2017,  2016 and 2015,  respectively, which was used to fund operations, new stores, construction activities and debt repayments. We expect to continue to fund the majority of our capital expenditures and daily operations from our operating cash flows. As of December 31, 2017, we had cash of $6.6 million and working capital of $43.5 million.

 

Key Components of our Consolidated Statements of Operations



Net Sales Net sales represents total charges to customers, net of returns, and includes freight charged to customers. We recognize sales at the time that the customer takes possession of the merchandise or when final delivery of the product has occurred. We recognize service revenue, which consists primarily of freight charges for home delivery, when the service has been rendered. We are required to charge and collect sales and other taxes on sales to our customers and remit these taxes back to government authorities. Total revenues do not include sales tax because we are a pass-through conduit for collecting and remitting sales tax. Sales are reduced by an allowance for anticipated sales returns that we estimate based on historical returns.



Same store sales growth is the percentage change in sales of comparable stores period-over-period. A store is considered comparable on the first day of the 13th full month of operation. When a store in relocated, it is excluded from the same stores sales growth calculation. Same store sales growth amounts include total charges to customers less any actual returns. We include the change in allowance for anticipated sales returns applicable to comparable stores in the same store sales calculation.



Cost of Sales Cost of sales consists primarily of material costs, freight, custom and duties fees, and storage and delivery of product to the customers, as well as physical inventory losses and costs associated with manufacturing of setting and maintenance materials. 



Gross Profit Gross profit is net sales less cost of sales. Gross margin rate is the percentage determined by dividing gross profit by net sales.



Selling, General and Administrative Expenses Selling, general, and administrative expenses consists primarily of compensation costs, occupancy, utilities, maintenance costs, advertising cost, shipping and transportation expenses to move inventory from our distribution centers to our stores, depreciation and amortization.



Pre-opening Costs Our pre-opening costs are those typically associated with the opening of new stores and generally include rent expense, compensation costs and promotional costs. We expense pre-opening costs as incurred and include these costs in selling, general, and administrative expenses.



Income Taxes We are subject to income tax in the United States as well as other tax jurisdictions in which we conduct business.

 

Non-GAAP Measures



We calculate Adjusted EBITDA by taking net income calculated in accordance with accounting principles generally accepted in the United States (“GAAP”) and adjusting for interest expense, income taxes, depreciation and amortization, non-cash change in fair value of warrants, stock based compensation expense, and special charges, which consists of equity-related transaction costs, litigation and investigation costs, and the write-off of debt issuance costs. Non-GAAP net income excludes special charges, which consist of shareholder investigation and other litigation costs, tax reform costs, and the write-off of debt issuance costs, and is net of tax.



We believe that these non-GAAP measures of financial results provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and results of operations. Our management uses these non-GAAP measures to compare our performance to that of prior periods for trend analyses, for purposes of determining management incentive compensation, and for budgeting and planning purposes. These measures are used in monthly financial reports prepared for management and our Board of Directors. We believe that the use of these non-GAAP financial measures provides an additional tool

---

 

for investors to use in evaluating ongoing operating results and trends and in comparing our financial measures with other specialty retailers, many of which present similar non-GAAP financial measures to investors.



The reconciliation of Adjusted EBITDA to net income (loss) for the years ended December 31, 2013 through December 31, 2017 is as follows:





 

The reconciliation of GAAP income to Non-GAAP income for the years ended December 31, 2017,  2016 and 2015 is as follows:













Our management does not consider these non-GAAP measures in isolation or as an alternative to financial measures determined in accordance with GAAP. The principal limitations of these non-GAAP financial measures are that they exclude significant expenses and income that are required by GAAP to be recognized in our consolidated financial statements. In addition, they are subject to

---

 

inherent limitations as they reflect the exercise of judgments by management about which expenses and income are excluded or included in determining these non-GAAP financial measures. In order to compensate for these limitations, management presents non-GAAP financial measures in connection with GAAP results. We urge investors to review the reconciliation of our non-GAAP financial measures to the comparable GAAP financial measures and not to rely on any single financial measure to evaluate our business.









---

 

Comparison of the Year Ended December 31, 2017 to the Year Ended December 31, 2016







Net Sales –  Net sales for fiscal year 2017 increased $20.4 million, or 6.3%, over fiscal year 2016, primarily due to an increase in net sales generated by fifteen stores opened in 2017 and a comparable store sales increase of 0.5%. Net sales for the fifteen new stores open less than twelve months were $18.8 million during the fiscal year 2017. Comparable store sales increased $1.6 million for the fiscal year 2017 due to an increase in the average order value, which was partially offset by a modest decline in traffic. Net sales for the fourth quarter of fiscal year 2017 increased $2.0 million, or 2.6%, over the fourth quarter of fiscal year 2016, primarily due to sales from stores not included in the comparable store base, offset by a comparable store sales decrease of 4.9%. Traffic weakened during the fourth quarter of fiscal year 2017.



Gross Profit –  Gross profit increased $9.3 million, or 4.1%, for fiscal year 2017 compared to fiscal year 2016,  primarily due to the increase in net sales. The gross margin rate decreased to 68.5% in fiscal year 2017 from 70.0% for fiscal year 2016.  The gross margin rate decline for the fiscal year 2017 was driven primarily by promotions and competitive pricing activity and product mix changes. Gross profit decreased $0.8 million in the fourth quarter of fiscal year 2017 compared to the fourth quarter of fiscal year 2016. The decrease in gross profit is primarily due to a decrease in the gross margin rate from 69.6% to 66.8% during the three months ended December 31, 2016 and 2017, respectively. The gross margin rate decline for the fourth quarter was driven primarily by promotions and competitive pricing activity tied to orders initiated during third quarter that were closed in the fourth quarter and orders generated over the Black Friday weekend. Inventory control costs and product mix changes also contributed to the decrease in gross margin for the quarter.



Selling, General and Administrative Expenses –  Selling, general, and administrative expenses increased $16.4 million, or 8.5%, in fiscal year 2017 compared to fiscal year 2016.  Selling, general, and administrative expenses as a percentage of net sales increased to 61.0% in fiscal year 2017 from 59.8% for the fiscal year 2016.  The primary driver for the selling, general, and administrative expenses increase was due to the costs associated with opening and operating fifteen new stores in 2017, including a $9.7 million increase in occupancy expenses,  a  $4.2 million increase in compensation expenses,  a  $2.6 million increase in advertising expenses and a $0.9 million increase in transportation expenses.  Additionally, we recorded asset impairment charges of $1.1 million during fiscal year 2017.  No asset impairment charges were recognized in fiscal year 2016. 



Selling, general, and administrative expenses include special charges of $1.8 million and $7.6 million for fiscal years 2017 and 2016, respectively, which consist of litigation expenses.

 

Pre-opening Costs –During fiscal years 2017 and 2016, we recorded pre-opening costs of $1.7 million and $0.9 million, respectively. The increase in pre-opening costs was due to an increase in the number of new store openings in 2017.



Income from Operations – Income from operations decreased by $7.1 million, or 21.5%, for fiscal year 2017 compared to fiscal year 2016.  The decrease is attributable to an increase in selling, general and administrative expenses and a lower gross margin rate. Operating income margin decreased to 7.5% for fiscal year 2017, compared to 10.2% for fiscal year 2016 due to increased selling, general and administrative expenses that outpaced sales growth and a lower gross margin rate.



Interest Expense –  Interest expense increased $0.1 million, or 8.3%, for fiscal year 2017 compared to the fiscal year 2016. The increase is due to an increase in the interest rates during fiscal year 2017. 



Provision for Income Taxes –  The income tax provision increased $0.5 million for fiscal year 2017 compared to fiscal year 2016.  Our effective tax rate was 55.2% in 2017 and 41.1% in 2016.  The increase in tax expense and our overall tax rate was primarily due to a $4.6 million charge taken during the fourth quarter of fiscal year 2017 to reduce the value of our deferred tax assets in accordance with the Tax Cuts and Jobs Act of 2017. The increase in tax expense was partially offset by lower income before income taxes.      

---

 

Comparison of the Year Ended December 31, 2016 to the Year Ended December 31, 2015





(1) Amounts do not foot due to rounding



Net Sales – Net sales for fiscal year 2016 increased $31.2 million, or 10.6%, to $324.2 million, compared to fiscal year 2015 as net sales in comparable stores increased $22.1 million and net sales in non-comparable stores increased $9.1 million. Net sales increased primarily due to the 7.6% increase in sales at comparable stores resulting from an increase in professional customer sales, increases in the number of orders and order size as a result of continued reductions in sales associate turnover and a continued increase in average store manager tenure. The increase in net sales generated by new stores relates to the expansion of our store base by nine locations in fiscal year 2016 and the inclusion of sales for the seven stores that opened in 2015 prior to their inclusion in comparable store sales.



Gross Profit – Gross profit increased $23.3 million, or 11.4%, for fiscal year 2016 compared to fiscal year 2015 primarily due to the increase in net sales. Gross margin rate increased to 70.0% for fiscal year 2016, from 69.5% for fiscal year 2015. The increase in the gross margin rate was primarily attributable to improved inventory control processes and better collection of revenue at stores for customer deliveries.



Selling, General and Administrative Expenses – Selling, general, and administrative expenses increased $19.6 million, or 11.2%, in fiscal year 2016 compared to fiscal year 2015. Selling, general, and administrative expenses as a percentage of net sales increased to 59.8% in fiscal year 2016, compared to 59.5% in fiscal year 2015. The increase included a $6.3 million increase in special charges related to litigation expenses. In addition, selling, general, and administrative expenses also increased due to new store openings and variable compensation expense associated with comparable store sales growth, which contributed a $6.4 million increase in compensation expenses,  a  $2.3 million increase in occupancy expenses, $1.6 million increase in transportation expenses and a $0.8 million increase in depreciation. 



Selling, general, and administrative expenses include special charges of $7.6 million and $1.3 million for fiscal years 2016 and 2015, respectively, which primarily relate to litigation expenses.

 

Pre-opening Costs – During fiscal years 2016 and 2015, we recorded pre-opening costs of $0.9 million and $0.5 million, respectively. This difference reflects the opening of nine new stores and two relocations in 2016 versus seven new stores in 2015.



Income from Operations – As a result of the increase in net sales discussed above, income from operations increased by $3.7 million, or 12.6%, for fiscal year 2016 compared to fiscal year 2015. Operating income margin increased to 10.2% for fiscal year 2016, compared to 10.0% for fiscal year 2015 due to improved sales performance, an increase in gross profit, and strong cost control, partially offset by increased litigation expenses.



Interest Expense – Interest expense decreased $0.9 million, or 33.6%, for fiscal year 2016 compared to fiscal year 2015. The decrease is due to the reduction of debt in fiscal year 2016.



Provision for Income Taxes – Income tax provision increased $1.8 million for fiscal year 2016 compared to fiscal year 2015 due to higher taxable income.





---

 

Liquidity and Capital Resources



Our principal liquidity requirements have been for working capital and capital expenditures. Our principal sources of liquidity are $6.6 million of cash and cash equivalents at December 31, 2017, our cash flow from operations, and borrowings available under our credit facility. We expect to use this liquidity for opening new stores, purchasing additional merchandise inventory, maintaining our existing stores, reducing outstanding debt, and general corporate purposes. We intend to continue our regular quarterly dividend that will enable us to return excess cash to stockholders. Future dividend payments are subject to the approval of the Board of Directors each quarter.



On June 2, 2015, we, and our operating subsidiary, The Tile Shop, LLC, entered into a credit agreement with Fifth Third Bank, Bank of America, N.A., and Huntington National Bank (as subsequently amended, the “Credit Agreement”). On December 9, 2016, the Credit Agreement was amended to permit an additional New Markets Tax Credit Financing arrangement and on February 10, 2017, the Credit Agreement was amended to permit us to make certain dividend payments. The Credit Agreement again was amended on July 17, 2017 to adjust the consolidated fixed charge coverage ratio from 2.00:1.00 to 1.50:1.00 to provide greater flexibility in declaring and making dividend payments or other distributions to stockholders. The Credit Agreement provides us with a $125.0 million senior secured credit facility, comprised of a five-year $50.0 million term loan and a $75.0 million revolving line of credit. The Credit Agreement is secured by virtually all of our assets, including but not limited to inventory, receivables, equipment and real property. Borrowings pursuant to the Credit Agreement bear interest at either a base rate or a LIBOR-based rate, at our option. The LIBOR-based rate will range from LIBOR plus 1.50% to 2.00%, depending on our leverage ratio. The base rate is equal to the greatest of: (a) the Federal funds rate plus 0.50%, (b) the Fifth Third Bank “prime rate,” and (c) the Eurodollar rate plus 1.00%, in each case plus 0.50% to 1.00% depending on our leverage ratio. At December 31, 2017 the base interest rate was 5.00% and the LIBOR-based interest rate was 3.06%. Borrowings outstanding consisted of $11.3 million on the term loan and $15.0 million on the revolving line of credit as of December 31, 2017.  There was $60.0 million available for borrowing on the revolving line of credit as of December 31, 2017. We can elect to prepay the term loan without incurring a penalty. To the extent we have an outstanding balance on our term loan, the credit agreement requires quarterly principal payments as follows (in thousands):







The Credit Agreement contains customary events of default, conditions to borrowings, and restrictive covenants, including restrictions on our ability to dispose of assets, make acquisitions, incur additional debt, incur liens, make investments, or enter into transactions with affiliates on other than terms that could be obtained in an arm’s length transaction. The Credit Agreement also includes financial and other covenants, including covenants to maintain certain fixed charge coverage ratios and rent adjusted leverage ratios. We were in compliance with the covenants as of December 31, 2017.  We intend to make principal payments due in future periods using cash from operations.



We have standby letters of credit outstanding related to our workers’ compensation and employee health insurance policies. As of December 31, 2017 and 2016, the standby letters of credit totaled $1.1 million.



We believe that our cash flow from operations, together with our existing cash and cash equivalents, and borrowings available under our credit facility will be sufficient to fund our operations and anticipated capital expenditures over at least the next 12 months.

 

Capital Expenditures



Capital expenditures in 2017,  2016 and 2015 were $40.6 million,  $27.3 million and $19.0 million, respectively.  The increase in capital expenditures is primarily due to the accelerated pace of new store openings. We opened fifteen,  nine and seven stores during fiscal years 2017,  2016 and 2015, respectively. During fiscal year 2017, $26.2 million was for new store build-out and remodels of existing stores, $7.1 million was for our information technology infrastructure in stores,  $3.1 million was for investments in our distribution and manufacturing facilities, and the remainder was for general corporate purposes. During fiscal year 2016, $16.2 million was for new store build-out and remodels of existing stores, $6.9 million was for our information technology infrastructure in stores, $4.2 million was for investments in our distribution and manufacturing facilities, and the remainder was for general corporate purposes. During fiscal year 2015, $15.6 million was for new store build-out and remodels of existing stores, $1.2 million was for investments in our distribution and manufacturing facilities, and the remainder was for general corporate purposes.



Our future capital requirements will vary based on the number of additional stores, distribution centers, and manufacturing facilities that we open and the number of stores that we choose to renovate. Our decisions regarding opening, relocating, or renovating stores, and whether to engage in strategic acquisitions, will be based in part on macroeconomic factors and the general state of the United States economy, as well as the local economies in the markets in which our stores are located. We intend to open three stores during 2018.  We also plan to remodel approximately 30 stores to support our product presentation strategy. Total capital expenditures are expected to be between $27 million and $32 million in fiscal year 2018.

---

 

 

Cash Flows



The following table summarizes our cash flow data for the years ended December 31, 2017,  2016 and 2015.







Operating Activities



Cash flows from operating activities provide us with a significant source of liquidity. Net cash provided by operating activities was $45.7 million, $53.6 million, and $60.3 million in fiscal years 2017,  2016 and 2015, respectively. The decrease in operating cash flows in fiscal year 2017 compared to fiscal year 2016 was due to lower net income, an increase in inventory, and the settlement of the shareholder litigation. The decrease in operating cash flows in fiscal year 2016 compared to fiscal year 2015 was primarily the result of increased inventory purchases during fiscal year 2016, which was associated with sales growth.  



Investing Activities



Net cash used in investing activities was $40.5 million, $27.3 million and $19.0 million in fiscal years 2017,  2016 and 2015, respectively. Net cash used in investing activities in each period was primarily for capital purchases of store fixtures and equipment, building improvements and leasehold improvements for stores opened or remodeled,  routine capital purchases of computer hardware and software, and investments in distribution centers.



Financing Activities



Net cash used in financing activities was $4.6 million, $30.5 million and $36.7 million in fiscal years 2017,  2016 and 2015, respectively. Cash used in financing activities during fiscal year 2017 was primarily for payments of long-term debt and capital lease obligations of $36.6 million and an aggregate of $10.4 million in dividends paid to stockholders, offset by net proceeds from long-term debt of $35.0 million and the release of restricted cash totaling $6.0 million.  Cash used in financing activities during fiscal year 2016 was primarily for payments of long-term debt and capital lease obligations of $37.8 million, partially offset by net proceeds from long-term debt of $10.0 million. Cash used in financing activities during fiscal year 2015 was primarily for payments of long-term debt and capital leases.



Off-balance Sheet Arrangements



As of December 31, 2017 and 2016, we did not have any “off-balance sheet arrangements” (as such term is defined in Item 303 of Regulation S-K) that could have a current or future effect on our financial condition, changes in financial condition, net sales or expenses, results of operations, liquidity, capital expenditures, or capital resources.



---

 

Contractual Arrangements



The following table summarizes certain of our contractual obligations at December 31, 2017 and the effect such obligations are expected to have on our liquidity and cash flows in future periods:











 

Critical Accounting Policies and Estimates



Our financial statements are prepared in accordance with GAAP. The preparation of our financial statements and related disclosures requires us to make estimates, assumptions, and judgments that affect the reported amount of assets, liabilities, revenues, costs and expenses, and related disclosures. We base our estimates and assumptions on historical experience and other factors that we believe to be reasonable under the circumstances, but all such estimates and assumptions are inherently uncertain and unpredictable. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from those estimates and assumptions, and it is possible that other professionals, applying their own judgment to the same facts and circumstances, could develop and support alternative estimates and assumptions that would result in material changes to our operating results and financial condition. Our most critical accounting policies are summarized below. For further information on our critical and other significant accounting policies, see the notes to the consolidated financial statements appearing in Item 15 in this Form 10-K.



Recognition of Revenue



We recognize sales at the time the customer takes possession of the merchandise or when final delivery of the product has occurred. We recognize service revenue, which consists primarily of freight charges for home delivery, when the service has been rendered. We are required to charge and collect sales and other taxes on sales to our customers and remit these taxes back to government authorities. Total revenues do not include sales tax because we are a pass-through conduit for collecting and remitting sales tax. Net sales are reduced by an allowance for anticipated sales returns that we estimate based on historical returns. Our process to establish a sales return reserve contains uncertainties because it requires management to make assumptions and to apply judgment to estimate future sales returns and exchanges. The customer may receive a refund or exchange the original product for a replacement of equal or similar quality for a period of six months from the time of original purchase. Products received back under this policy are reconditioned pursuant to state laws and resold. We believe our estimate for sales returns is an accurate reflection of future returns. Actual return trends have not varied significantly from estimated amounts in prior periods. However, if the nature of sales returns changes significantly, our sales could be adversely impacted.



Inventory Valuation and Shrinkage



Our inventory consists of manufactured items and purchased merchandise held for resale. Inventories are stated at the lower of cost (determined using the weighted-average cost method) or net realizable value. We capitalize the cost of inbound freight, duties and receiving and handling costs to bring purchased materials into our distribution network. The labor and overhead costs incurred in connection with the production process are included in the value of manufactured finished goods. We provide provisions for losses related to shrinkage and other amounts that are otherwise not expected to be fully recoverable. These provisions are calculated based on historical shrinkage, selling price, margin and current business trends. These estimates have calculations that require management to make assumptions based on the current rate of sales, age, salability and profitability of inventory, historical percentages that can be

---

 

affected by changes in our merchandising mix, customer preferences, rates of sale through and changes in actual shrinkage trends. We do not believe there is a reasonable likelihood that there will be a material change in the assumptions we use to calculate our inventory provisions. However, if actual results are not consistent with our estimates and assumptions, we may be exposed to losses that could be material.



Property, Plant, and Equipment



Property, plant and equipment are carried at cost less accumulated depreciation, which is amortized over the useful life of the assets. Leasehold improvements are amortized over the shorter of their estimated useful lives or lease period (including expected renewal periods). Property, plant, and equipment are evaluated for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss is recognized when estimated undiscounted future cash flows from the operations and/or disposition of the assets are less than the carrying amount. Measurement of an impairment loss is based on the excess of the carrying amount of the asset group over its fair value. Fair value is measured using discounted cash flows or independent opinions of value, as appropriate.



If actual results are not consistent with our estimates and assumptions used in determining future cash flows and asset fair values, we may be exposed to losses that could be material.



Income Taxes



Deferred tax liabilities and assets are determined based on the difference between the financial statement basis and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We estimate the degree to which tax assets and loss carryforwards will result in a benefit based on expected profitability by tax jurisdiction. A valuation allowance for such tax assets and loss carryforwards is provided when it is determined to be more likely than not that the benefit of such deferred tax asset will not be realized in future periods. If it becomes more likely than not that a tax asset will be used, the related valuation allowance on such assets would be reduced.

 

New Accounting Pronouncements



Recently Adopted Accounting Pronouncements



In July 2015, the Financial Accounting Standards Board (“FASB”) issued a standard that simplifies the subsequent measurement of inventory. Previously, an entity was required to measure inventory at the lower of cost or market, whereby market can be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. The changes required that inventory be measured at the lower of cost and net realizable value, thereby eliminating the use of the other two market methodologies. Net realizable value is defined as the estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal, and transportation. The standard was effective for us at the beginning of fiscal year 2017.  The adoption of this new standard did not have a material effect on our financial statements.



Accounting Pronouncements Not Yet Adopted



In May 2014, the FASB issued a final standard on revenue from contracts with customers. This new standard introduces a comprehensive revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services.  In 2016, the FASB issued several amendments to the standard, including principal versus agent considerations when another party is involved in providing goods or services to a customer, the application of identifying performance obligations, and the recognition of expected breakage amounts either proportionally in earnings as redemptions occur or when redemption is remote.  Upon adoption of the new standard on January 1, 2018, we will present the gross sales returns reserve as a component of other accrued liabilities and establish a return asset that will be classified as a component of other current assets, net in the consolidated balance sheet.  Currently, we present our sales returns reserve net of the value of the return assets as a component of other accrued liabilities in the consolidated balance sheet.  Based on our assessment to date, the underlying principles of the new standard, relating to the measurement of revenue and the timing of recognition, are closely aligned with our current business model and practices.  As a result, other than the presentation of a gross sales returns reserve and a returns asset in the consolidated balance sheet, the adoption of this standard is not expected to have a material impact on our consolidated financial statements.



In February 2016, the FASB issued a standard that primarily requires organizations that lease assets to recognize the rights and obligations created by those leases on the consolidated balance sheet.  The standard is effective for fiscal year 2019, with early adoption permitted. We expect the primary impact on our consolidated balance sheets upon adoption will be the recognition, on a discounted basis, of our minimum commitments under non-cancelable operating leases resulting in the recording of right of use assets and lease obligations.  Our minimum commitments under non-cancelable operating leases are disclosed in Note 5 to our consolidated financial statements included in Part IV, Item 15 of this Annual Report on Form 10-K.  We have identified our lease management

---

 

system and are in the process of identifying and evaluating the applicable leases.  We are currently assessing the effect the new standard will have on our consolidated financial statements.



In August 2016, the FASB issued an accounting standards update with new guidance on how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments provide guidance on eight specific cash flow issues. The standards update is effective for us in fiscal year 2018 and should be applied retrospectively. We are currently assessing the effect the new standard will have on our consolidated financial statements.



In November 2016, the FASB issued new guidance on restricted cash on the statement of cash flows. The new guidance requires the classification and presentation of changes in restricted cash and cash equivalents in the statement of cash flows. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning and ending balances shown in the statement of cash flows. The new standard is effective for us in fiscal year 2018, with early adoption permitted. The guidance should be applied retrospectively after adoption. Our restricted cash balance was $0.9 million as of December  31, 2017. Upon adopting the new standard, we anticipate that we will no longer present the release of restricted cash as a financing cash inflow. Instead, restricted cash and long-term restricted cash balances will be included in the beginning and ending cash, cash equivalents and restricted cash balances in the statement of cash flows.

---

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We are exposed to market risks in the ordinary course of our business. These risks primarily include inflation, interest rate risk, and credit concentration risk.



Inflation



Inflationary factors such as increases in the cost of our products and overhead costs may adversely affect our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross profit and selling, general, and administrative expenses as a percentage of revenues if the selling prices of our products do not increase with these increased costs.



Interest Rate Risk



We are exposed to interest rate risk through the investment of our cash and cash equivalents. Changes in interest rates affect the interest income that we earn in connection with these investments, and therefore impact our cash flows and results of operation. We are also exposed to interest rate risk in connection with borrowings under our credit facility. Borrowings under our revolving credit facility bear interest at either a base rate or a LIBOR-based rate, at our option. The LIBOR-based rate ranges from LIBOR plus 1.50% to 2.00%, depending on our leverage ratio. The base rate is equal to the greatest of: (a) the Federal funds rate plus 0.50%, (b) the Fifth Third Bank “prime rate,” and (c) the Eurodollar rate plus 1.00%, in each case plus 0.50% to 1.00% depending on our leverage ratio. The base rate was 5.00% at December 31, 2017. Based upon balances and interest rates as of December 31, 2017, holding other variables constant, a one percentage point increase in interest rates for the next 12-month period would decrease pre-tax earnings and cash flow by approximately $0.3 million. Conversely, a one percentage point decrease in interest rates for the next 12-month period would result in an increase to pre-tax earnings and cash flow of approximately $0.3 million.



We currently do not engage in any interest rate hedging activity. We do not, and do not intend to, engage in the practice of trading derivative securities for profit.



Credit Concentration Risk



Financial instruments, which may subject us to concentration of credit risk, consist principally of cash deposits. We maintain cash balances at financial institutions with strong credit ratings. However, the amounts invested with financial institutions are generally in excess of FDIC insurance limits.



Foreign Currency Exchange Rate Risk

 

We are exposed to risks from foreign currency exchange rate fluctuations on the translation of our subsidiary based in China and on the purchase of goods in Chinese yuan. Purchases made in Chinese yuan were less than 15% of our total inventory purchases in both 2017 and 2016. Our exposure to foreign currency rate fluctuations is not significant to our financial condition or results of operations.



We currently do not engage in any exchange rate hedging activity and currently have no intention to do so in the foreseeable future. However, in the future, in an effort to mitigate losses associated with these risks, we may at times engage in these transactions.



ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



The consolidated financial statements of the Company and the reports of the independent registered public accounting firm, listed under Item 15 “Exhibits, Financial Statement Schedules,” are included as a separate section of this Annual Report on Form 10-K beginning on page 58  and are incorporated herein by reference.



ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.

 

---

 

ITEM 9A.     CONTROLS AND PROCEDURES



Disclosure Controls and Procedures.



Our Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the period covered by this report and concluded that our disclosure controls and procedures were effective as of the period covered by this report. Our management, including our Chief Executive Officer and Chief Financial Officer, concluded that the consolidated financial statements included in this Annual Report on Form 10-K present fairly, in all material respects, our financial position, results of operations and cash flows for the periods presented in conformity with accounting principles generally accepted in the United States.



Management’s Annual Report on Internal Control over Financial Reporting



Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) promulgated under the Exchange Act. Internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Internal control over financial reporting includes policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of an issuer’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that an issuer’s receipts and expenditures are being made only in accordance with authorizations of its management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of an issuer’s assets that could have a material effect on the consolidated financial statements. An internal control material weakness is a significant deficiency, or combination of significant deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, the application of any evaluation of effectiveness to future periods is subject to the risk that controls may become inadequate because of changes in conditions, or that compliance with the policies or procedures may deteriorate.



As required by Rule 13a-15(c) promulgated under the Exchange Act, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our internal control over financial reporting as of December 31, 2017. Management’s assessment was based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework (2013 Framework) (“COSO”). Based on management’s assessment, management has concluded that the Company’s internal control over financial reporting was effective as of December 31, 2017.



Ernst & Young, LLP, our independent registered public accounting firm, has issued a report on our internal control over financial reporting as of December 31, 2017. See Part II, “Item 8. Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. 



Changes in Internal Control over Financial Reporting 



There were no changes in internal control over financial reporting (as defined by Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended December 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



Inherent Limitations on Effectiveness of Controls



Our management, including our Chief Executive Officer and Chief Financial Officer, intends that our disclosure controls and procedures and internal control over financial reporting are designed to provide reasonable assurance of achieving their objectives. However, our management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of

---

 

changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost effective control system, misstatements due to error or fraud may occur and not be detected.



ITEM 9B. OTHER INFORMATION

 

None.

 

---

 

PART III



ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE



DIRECTORS AND EXECUTIVE OFFICERS



Executive Officers



The following table provides information about our executive officers, including their ages, as of the date of this Form 10-K.







Robert A. Rucker has been our interim Chief Executive Officer and President since October 2017. Mr. Rucker has also served as a member of our Board of Directors since June 2012 and was previously our Chief Executive Officer and President from June 2012 until December 2014. Mr. Rucker also served as an employee from January 1, 2015 through July 31, 2015 and as a consultant from August 1, 2015 through December 31, 2015. Previously, Mr. Rucker served as The Tile Shop’s Chief Executive Officer and President and as a member of its board of managers. Mr. Rucker holds a B.E.S. in Psychology and History from the University of Minnesota.



Kirk L. Geadelmann has been our Chief Financial Officer and Senior Vice President since August 2014. Mr. Geadelmann previously worked at Best Buy from June 2000 to February 2014 in various management roles including Corporate and International Controller. During his tenure at Best Buy, Mr. Geadelmann was responsible for overseeing business planning, performance management, financial accounting and SEC reporting functions. Prior to Best Buy, Mr. Geadelmann held roles with BMC Manufacturing, Arthur Andersen, Allianz Insurance and Coopers & Lybrand, where he earned his CPA certification. Mr. Geadelmann earned a B.B.A. in Accounting and Risk Management from the University of Wisconsin-Madison.



Cabell H. Lolmaugh has been our Senior Vice President and Chief Operating Officer since February 2018. Mr. Lolmaugh previously served as our Vice President, Retail Stores from October 2017 until February 2018. Previously, Mr. Lolmaugh served as our Director-Talent Development, leading our store training programs and strategy, from January 2016 until October 2017, and Director of Pro Services, leading our professional customer strategy, from July 2014 through January 2016.  Mr. Lolmaugh served in numerous key roles at a store level from January 2002 through July 2014. Prior to joining us, Mr. Lolmaugh served in the United States Marine Corps.



Board of Directors



The following table provides information about the members of our Board of Directors (the “Board”), including their ages, as of the date hereof.

 



 



Peter J. Jacullo III has served as a member of our Board since August 2012. Previously, Mr. Jacullo served as a member of The Tile Shop’s board of managers from December 2007 to August 2012. Since July 1987, Mr. Jacullo has been a self-employed investor and consultant, and he currently serves on the Board of Directors of various privately-held companies. Previously, Mr. Jacullo was a Vice President and Director of the Boston Consulting Group from May 1984 to July 1987, where he was also employed in various other

---

 

capacities from May 1978 to May 1984. Mr. Jacullo holds an M.B.A. from the University of Chicago and a B.A. in Economics from Johns Hopkins University. We believe that Mr. Jacullo is qualified to serve on our Board in light of the continuity that he provides on our Board and his experience as a professional investor.



Peter H. Kamin has served as a member of our Board since August 2012. Previously, Mr. Kamin served as a member of The Tile Shop’s board of managers from January 2012 to August 2012. Mr. Kamin is the founder of 3K Limited Partnership, an investment fund, and has served as its Managing Partner since January 2012. For the eleven years preceding the formation of 3K Limited Partnership, Mr. Kamin was a founding member and Managing Partner of ValueAct Capital. ValueAct Capital grew into a leading investment management organization during Mr. Kamin’s tenure. Prior to founding ValueAct Capital in 2000, Mr. Kamin founded and managed Peak Investment L.P. Peak was a limited partnership, organized to make investments in a select number of domestic public and private companies. Since May 2012, Mr. Kamin has been a director and member of the governance committee of MAM Software Group, Inc., a publicly-traded provider of business automation and ecommerce solutions for the automotive aftermarket. Mr. Kamin is also a director of several privately-held companies. Mr. Kamin previously served as a director of Ambassadors Group, Inc. from May 2012 to September 2015, of Rand Worldwide, Inc. from April 2012 to June 2015, of Adesa, Inc. from April 2007 to December 2011, and of Seitel, Inc. from February 2007 to December 2011, as well as previously serving as a director of several privately held companies. Mr. Kamin holds a B.A. in Economics from Tufts University and an M.B.A. from the Harvard University Graduate School of Business. Mr. Kamin is a trustee of Tufts University. We believe that Mr. Kamin is qualified to serve on our Board due to his significant experience as a director of publicly-traded companies and his substantial experience as an investor.



Todd Krasnow has served as a member of our Board since August 2012. Previously, Mr. Krasnow served as a member of The Tile Shop’s board of managers from January 2012 to August 2012. Mr. Krasnow has served as the president of Cobbs Capital, Inc., a private consulting company, since January 2005, and as marketing domain expert with Highland Consumer Fund, a venture capital firm from June 2007 to September 2017. Mr. Krasnow is currently an operating partner of Porchlight Equity, the successor firm to Highland Consumer Fund, and has served in such capacity since September 2017. Previously, Mr. Krasnow was the chairman of Zoots, Inc., a dry cleaning company from June 2003 to January 2008 and chief executive officer of Zoots, Inc. from February 1998 to June 2003. He served as the executive vice president of sales and marketing of Staples, Inc. from May 1993 to January 1998 and in other sales and marketing positions for Staples, Inc. from March 1986 to May 1993. Mr. Krasnow is a director of Carbonite, a leading cloud back-up and recovery company, and is chairman of Carbonite’s compensation committee. Mr. Krasnow is also a director of Ecentria, a privately held online marketer of optical, outdoor, and camping gear, and Bakkavor, a UK-based, publicly traded, maker of fresh prepared meals. Mr. Krasnow holds an M.B.A. from the Harvard University Graduate School of Business and an A.B. in Chemistry from Cornell University. We believe that Mr. Krasnow is qualified to serve on our Board due to his operating and management experience and his expertise in sales and marketing.



Philip B. Livingston has served as a member of our Board since August 2016. Since June 2017, Mr. Livingston has been Managing Director of 3K Limited Partnership, a private investment firm. From March 2016 to August 2016, Mr. Livingston served as part-time Chief Operating Officer of UASUSA, LLC, a manufacturer of unmanned aircraft systems based in Longmont, Colorado. Mr. Livingston served as Chief Executive Officer and a director of Ambassadors Group, Inc., a provider of educational travel experiences and online educational research materials, from May 2014 to October 2015. Prior to joining Ambassadors Group, Mr. Livingston served as Chief Executive Officer of LexisNexis Web Based Marketing Solutions, a provider of software applications and marketing services for the legal industry, until October 2013. He joined LexisNexis in April 2009 as Senior Vice President of Practice Management and served in executive management positions from April 2009 to October 2013. Previously, Mr. Livingston served as Chief Financial Officer for a number of companies, including World Wrestling Entertainment, Inc., from 2003 to 2005, Catalina Marketing Corporation, from 1995 to 1998, and Celestial Seasonings, Inc., from 1993 to 1995.  From 1999 to 2003, he served as President of Financial Executives International, one of the leading professional associations of chief financial officers and controllers. In that role, he led the organization’s support of regulatory and corporate governance reforms culminating in the Sarbanes-Oxley Act. Mr. Livingston currently serves as a director of Rand Worldwide, Inc., an operator of technology and professional services providers to the engineering community, since November 2014, and Ambassadors Group, since May 2014. He previously served as a director of SITO Mobile Ltd., a mobile advertising company, from November 2014 to February 2016 and Nexsan Technologies, Inc., a provider of secondary storage devices and archival compliance software that was acquired by Imation Corp., from 2007 to December 2012.  He is a current member of the National Association of Corporate Directors and the American Institute of CPAs (AICPA). Mr. Livingston earned a B.A. in Business Management and a B.S. in Government and Politics from the University of Maryland and an M.B.A. in Finance and Accounting from the University of California, Berkeley. We believe that Mr. Livingston is qualified to serve on our Board due to his significant experience in business and finance and his substantial experience as a director of a variety of public and private companies.



---

 

Christopher T. Cook has served as a member of our Board since September 2014. Mr. Cook founded Sleep Experts, a Texas chain of mattress retail stores, and served as its Chief Executive Officer from 2004 until its acquisition by Mattress Firm in April 2014. Mr. Cook continued to serve as a strategy consultant to the Mattress Firm executive team until April 2016. Mr. Cook was also on the founding team of SiteStuff, a venture-backed e-commerce company and served as its Executive Vice President of Business Development until 2003. He currently serves as an advisor to the Family Place of Dallas. He is currently a member of the Young Presidents’ Organization. Mr. Cook has a B.B.A. in Finance from SMU Cox School of Business in Dallas, Texas. We believe that Mr. Cook is qualified to serve on our Board due to his in-depth involvement in founding and leading a company in the consumer retail industry and his experience creating scalable sales culture and scalable systems.



In accordance with our Certificate of Incorporation, our Board is divided into three classes with staggered three-year terms. At each annual meeting of stockholders, the successors to directors whose terms then expire will be elected to serve from the time of election and qualification until the third annual meeting following election. Except as otherwise provided by law and subject to the rights of any class or series of preferred stock, vacancies on our Board (including a vacancy created by an increase in the size of the Board) may be filled only by the affirmative vote of a majority of the remaining directors. A director elected by the Board to fill a vacancy (other than a vacancy created by an increase in the size of the Board) serves for the unexpired term of such director’s predecessor in office and until such director’s successor is elected and qualified. A director appointed to fill a position resulting from an increase in the size of the Board serves until the next annual meeting of stockholders at which the class of directors to which such director is assigned by the Board is to be elected by stockholders and until such director’s successor is elected and qualified. Any additional directorships resulting from an increase in the number of directors will be distributed among the three classes so that, as nearly as possible, each class will consist of one-third of the directors.



Our directors are divided among the three classes as follows:



Our Board met four times between January 1, 2017 and December 31, 2017. Each director attended at least 75% of the meetings of the Board and of any committee of the Board on which such director served that were held between January 1, 2017 and December 31, 2017.



INVOLVEMENT IN CERTAIN LEGAL PROCEEDINGS



Peter Jacullo III, a director, previously served as a manager and secretary of BlueEarth Biofuels, LLC, which filed for bankruptcy in May 2014 and was subsequently dissolved.



SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE



Section 16(a) of the Exchange Act requires our directors and executive officers, and persons who own more than ten percent of a registered class of our equity securities, to file with the SEC initial reports of ownership and reports of changes in ownership of our common stock and other equity securities. These executive officers, directors and greater than ten percent stockholders are required by SEC regulation to furnish us with copies of all Section 16(a) forms they file.



To our knowledge, based on a review of the copies of such reports furnished to us, our executive officers, directors and greater than ten percent stockholders complied with all Section 16(a) filing requirements during the fiscal year ended December 31, 2017, except that Mr. Krasnow filed a Form 4 on May 9, 2017 to report two sales of common stock that occurred on May 1 and 2, 2017.



CODE OF BUSINESS CONDUCT AND ETHICS



We have adopted a Code of Business Conduct and Ethics that applies to all officers, directors and employees. We intend to maintain the highest standards of ethical business practices and compliance with all laws and regulations applicable to our business. The Code of Business Conduct and Ethics is available on the “Investor Relations” section of our website, at http://investors.tileshop.com, under the “Governance Documents” heading. We intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of our Code of Ethics and Business Conduct by posting such information on our website at the web address and location specified above.



---

 

COMMITTEES OF THE BOARD OF DIRECTORS



Our Board has established the following committees: an Audit Committee, a Compensation Committee, and a Nominating and Corporate Governance Committee. The composition and responsibilities of each committee are described below. Members serve on these committees until their resignation or until otherwise determined by our Board.



Audit Committee



Our Audit Committee oversees our corporate accounting and financial reporting process, the audit of our financial statements, the audit of internal controls over financial reporting and other information included in documents containing the audited financial statements. Among other matters, the Audit Committee evaluates our independent auditors’ qualifications and independence (as required under Public Company Accounting Oversight Board (“PCAOB”) Auditing Standard No. 16, Communications with Audit Committees (AS 16)), receives from the independent auditors written disclosures regarding the auditors independence required by PCAOB Ethics and Independence Rule 3526, Communication with Audit Committees Concerning Independence, and discusses with the independent auditors, the independent auditor’s independence. The Audit Committee also determines the engagement, retention, and compensation of the independent auditors; reviews and approves the scope of the annual audit and the audit fee; discusses with management and the independent auditors the results of the annual audit and the review of our quarterly financial statements, including the disclosures in our annual and quarterly reports to be filed with the SEC; assesses the performance of the independent auditors; approves the retention of the independent auditors to perform any proposed permissible non-audit services; reviews our risk assessment and risk management processes; establishes procedures for receiving, retaining, and investigating complaints received by us regarding accounting, internal accounting controls, or audit matters; monitors the rotation of partners of the independent auditors on our engagement team as required by law; reviews our critical accounting policies and estimates; and oversees any internal audit function. Additionally, the Audit Committee reviews and approves related person transactions and reviews and evaluates, on an annual basis, the Audit Committee charter and performance. Our independent registered public accounting firm and management each periodically meet privately with our Audit Committee.  



The Audit Committee has recommended to the Board that the audited financial statements be included in our Annual Report on Form 10-K for the fiscal year December 31, 2017 for filing with the SEC.



The current members of our Audit Committee are Messrs. Jacullo, Kamin, and Livingston, with Mr. Livingston serving as the chair. All members of our Audit Committee meet the requirements for financial literacy under the applicable rules and regulations of the SEC and Nasdaq. Our Board has determined that Mr. Livingston is an audit committee financial expert as defined under the applicable rules of the SEC and has the requisite financial sophistication as defined under the applicable rules and regulations of Nasdaq. A description of Mr. Livingston’s experience is set forth above under “Directors.” Messrs. Jacullo, Kamin, and Livingston are independent directors as defined under the applicable rules and regulations of the SEC, Nasdaq and PCAOB. The Audit Committee operates under a written charter that satisfies the applicable standards of the SEC and Nasdaq, and which is available on the “Investor Relations” section of our website, at http://investors.tileshop.com, under the “Governance Documents” heading. The Audit Committee met ten times between January 1, 2017 and December 31, 2017.



Compensation Committee



Our Compensation Committee reviews and recommends policies relating to compensation and benefits of our executive officers and employees. The Compensation Committee annually reviews and approves corporate goals and objectives relevant to compensation of our chief executive officer and other executive officers, evaluates the performance of these officers in light of those goals and objectives, and sets the compensation of these officers based on such evaluations. The Compensation Committee also reviews and makes recommendations to the Board with respect to director compensation and administers the issuance of stock options, restricted stock and other awards under our equity compensation plans. The Compensation Committee reviews and prepares the necessary compensation disclosures required by the SEC. Additionally, the Compensation Committee reviews and evaluates, on an annual basis, the Compensation Committee charter and performance.



The current members of our Compensation Committee are Messrs. Jacullo and Krasnow, with Mr. Krasnow serving as the chair. All of the members of our Compensation Committee are independent under the applicable rules and regulations of the SEC, and Nasdaq, and were also independent under the prior version of Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”). The Compensation Committee operates under a written charter that satisfies the applicable standards of the SEC and Nasdaq, and which is available on the “Investor Relations” section of our website, at http://investors.tileshop.com, under the “Governance Documents” heading. The Compensation Committee met four times between January 1, 2017 and December 31, 2017.



The Compensation Committee may approve executive compensation arrangements or, in its discretion, may recommend such matters to the full Board for approval. All executive compensation is based on assessments of executive performance, which are prepared by the Compensation Committee and submitted to the full Board for review and discussion. All Compensation Committee recommendations regarding director compensation are subject to approval by the full Board. Pursuant to its charter, the Compensation

---

 

Committee may delegate any of its responsibilities to a subcommittee comprised of one or more members of the Compensation Committee; provided that the Compensation Committee is not permitted to delegate its responsibilities with respect to any executive compensation arrangements intended to comply with the prior version of Section 162(m) of the Code by virtue of it being approved by a committee of “outside directors” or intended to be exempt from Section 16(b) under the Exchange Act by virtue of it being approved by a committee of “non-employee directors.”



No executive officers may be present during any Compensation Committee voting or deliberations with respect to our Chief Executive Officer’s compensation. Our Chief Executive Officer may, at the Compensation Committee’s discretion, be present during any other voting or deliberations regarding compensation of our other executive officers.



Nominating and Corporate Governance Committee



Our Nominating and Corporate Governance Committee (the “Governance Committee”) is responsible for making recommendations regarding corporate governance; identification, evaluation and nomination of candidates for directorships; and the structure and composition of our Board and committees thereof. In addition, the Governance Committee oversees our corporate governance guidelines; approves our committee charters; oversees compliance with our Code of Business Conduct and Ethics; contributes to succession planning; reviews actual and potential conflicts of interest of our directors and officers other than related person transactions reviewed by the Audit Committee; and oversees the Board self-evaluation process. Additionally, the Governance Committee reviews and evaluates, on an annual basis, the Governance Committee charter and performance.



The current members of our Governance Committee are Messrs. Cook, Kamin and Krasnow, with Mr. Cook serving as the chair. All of the members of our Governance Committee are independent under the applicable rules and regulations of Nasdaq. The Governance Committee operates under a written charter, which is available on the “Investor Relations” section of our website, at http://investors.tileshop.com, under the “Governance Documents” heading. The Governance Committee met three times between January 1, 2017 and December 31, 2017.



---

 

DIRECTOR RECOMMENDATION AND NOMINATION PROCESS



The Governance Committee considers the following criteria, among other criteria that it deems appropriate, in recommending candidates for service on the Board:



In assessing director candidates, the Governance Committee considers diversity, age, skills, and such other factors as it deems appropriate given our current needs and the current needs of the Board, to maintain a balance of knowledge, experience and capability. The Governance Committee does not have a formal diversity policy and does not follow any ratio or formula with respect to diversity in order to determine the appropriate composition of the Board. However, to advance our goal of promoting Board diversity, the Governance Committee, and any search firm retained by the Governance Committee, includes in its list of director candidates for potential recommendation to the Board one or more qualified women and minority candidates. In the case of incumbent directors whose terms of office are set to expire, the Governance Committee reviews these directors’ overall service to us during their terms, including the number of meetings attended, level of participation, quality of performance, and any other relationships and transactions that might impair the directors’ independence. In the case of new director candidates, the Governance Committee also determines whether the nominee is independent for Nasdaq purposes, which determination is based upon applicable Nasdaq listing standards, applicable SEC rules and regulations and the advice of counsel, if necessary. The Governance Committee conducts any appropriate and necessary inquiries into the backgrounds and qualifications of possible candidates after considering the function and needs of the Board. The Governance Committee meets to discuss and consider the candidates’ qualifications and then selects a nominee by majority vote.



The Governance Committee will consider director candidates recommended by stockholders. The Governance Committee does not intend to alter the manner in which it evaluates candidates, including the minimum criteria set forth above, based on whether or not the candidate was recommended by a stockholder.



To nominate a director for the 2018 Annual Meeting, stockholders must submit such nomination in writing to our Secretary at 14000 Carlson Parkway, Plymouth, Minnesota 55441 no later than the close of business on April 12, 2018, nor earlier than the close of business on March 13, 2018. You are advised to review our Bylaws for requirements relating to director nominees.



STOCKHOLDER PROPOSALS FOR 2018 ANNUAL MEETING AND 2019 ANNUAL MEETING



In order to have been considered for inclusion in this year’s proxy statement, stockholder proposals must have been submitted in writing to us no later than January 26,  2018. In order to be considered for inclusion in next year’s proxy statement, stockholder proposals must be submitted in writing to us no later than January 25,  2019.  We suggest that proposals for the 2019 Annual Meeting be submitted by certified mail, return receipt requested. The proposal must be in accordance with the provision of Rule 14a-8 promulgated by the SEC under the Exchange Act.



Stockholders who intend to present a proposal or director nomination at the 2018 Annual Meeting without including such proposal or nomination in our proxy statement must, pursuant to our Bylaws, deliver to us notice of such proposal no earlier than March 13, 2018 and no later than April 12, 2018.  We reserve the right to reject, rule out of order, or take appropriate action with respect to any proposal that does not comply with these and other applicable requirements.

 

---

 

ITEM 11. EXECUTIVE COMPENSATION



EXECUTIVE COMPENSATION



Compensation Discussion and Analysis



This section discusses our policies and decisions with respect to the compensation of our executive officers named in the “Summary Compensation Table” below and the most important factors relevant to an analysis of these policies and decisions. The “named executive officers” to whom this discussion applies are:



Overview



We recognize that our ability to excel depends on the integrity, knowledge, imagination, skill, diversity, and teamwork of our employees. To this end, we strive to create an environment of mutual respect, encouragement, and teamwork that rewards commitment and performance and is responsive to the needs of our employees. The principles and objectives of our compensation and benefits programs for our employees generally, and for our named executive officers specifically, are to:



Each of the primary elements of our executive compensation program is discussed in more detail below. While we have identified particular compensation objectives that each element of executive compensation serves, our compensation programs are designed to be flexible and complementary and to collectively serve all of the executive compensation objectives described above. Accordingly, whether or not specifically mentioned below, we believe that each individual element, to some extent, serves each of our objectives. Further, while each of our executive officers has not been, and may not be, compensated with all individual compensation elements, we believe that the compensation provided to each individual executive officer is, and will be, consistent with the overall compensation philosophy and objectives set forth above.



Compensation Determination Process



We review executive compensation annually, including evaluating our philosophy and compensation programs as circumstances require. As part of this review process, we expect to apply the values and the objectives outlined above, together with consideration for the levels of compensation that we would be willing to pay to ensure that our compensation remains competitive and that it is meeting our retention objectives in light of the cost to us if we were required to replace a key employee. In addition, we consider the results of non-binding advisory votes on executive compensation, commonly referred to as “say-on-pay” votes. At our 2017 Annual Meeting, we held a say-on-pay vote on the compensation of our named executive officers as described in the proxy statement for that meeting. Stockholders approved the compensation of the named executive officers by a favorable vote exceeding 98% of votes cast, including abstentions. We are mindful of the opinions of our stockholders and considered these results when deciding to retain our general compensation philosophy and core objectives for the upcoming fiscal year.



Prior to 2016, our Compensation Committee did not rely on a formal peer group when determining compensation, but made reference to general market data and considered establishing a group of comparable companies for this purpose. Additionally, our Compensation Committee considered engaging a compensation consultant to provide market data on a peer group of companies in our industry. We believe that such information, together with other information obtained by the members of our Compensation Committee, would help ensure that our compensation program remains competitive. Beginning in 2016, our Compensation Committee engaged Willis Towers Watson as a compensation consultant and considered executive compensation metrics on a peer group of companies in our industry when assessing executive compensation.  We anticipate that our Compensation Committee will continue to make adjustments in executive compensation levels in the future as a result of this more formal market comparison process.



---

 

The compensation levels of our named executive officers reflect, to a significant degree, the varying roles and responsibilities of such executives. As a result of the assessment by our Board of the roles and responsibilities of our former Chief Executive Officer, Mr. Homeister, there was a compensation differential between his compensation levels and those of our other named executive officers. Our interim Chief Executive Officer, Mr. Rucker, has elected to forego all but nominal compensation due his long history with us, his interests as a major stockholder and the interim nature of his position.



Executive Compensation Program Components



Base Salary.  Base salaries of our named executive officers are initially established through arm’s-length negotiation at the time an executive is hired, taking into account such executive’s qualifications, experience, and prior salary. Base salaries of our named executive officers are approved and reviewed periodically by our Interim Chief Executive Officer, and in the case of our Interim’s Chief Executive Officer’s base salary, by our Board, and adjustments to base salaries are based on the scope of an executive’s responsibilities, individual contribution, prior experience, and sustained performance. Decisions regarding salary increases may take into account the executive officer’s current salary, equity or equity-linked interests, and the amounts paid to an executive officer’s peers within our organization. In making decisions regarding salary increases, we may also draw upon the experience of members of our Board with other companies. Base salaries are also reviewed in the case of promotions or other significant changes in responsibility. No formulaic base salary increases are provided to our named executive officers. This strategy is consistent with our intent of offering base salaries that are cost-effective while remaining competitive.



Our Interim Chief Executive Officer, Robert A. Rucker, has elected to receive an annual base salary of a nominal $24,000 due to his long history with us, his interests as a major stockholder and the interim nature of his position. This amount was chosen to avoid triggering overtime pay requirements.



Our former Chief Executive Officer, Chris R. Homeister, was hired in October 2013 as our Chief Operating Officer at an annual base salary of $300,000. Effective January 1, 2015 and in connection with his promotion to Chief Executive Officer, Mr. Homeister’s annual base salary was increased to $400,000. In April 2016, the Compensation Committee approved an increase to Mr. Homeister’s base salary to $475,000 and in February 2017, the Compensation Committee approved an increase to Mr. Homeister’s base salary to $500,000, each on an annualized basis. Mr. Homeister’s employment ended in October 2017.



Our Chief Financial Officer, Kirk Geadelmann, was hired in August 2014 at an annual base salary of $210,000. The Compensation Committee subsequently approved increases to Mr. Geadelmann’s base salary to $212,000 in February 2015, to $250,000 in April 2016, and to $285,000 in February 2017, each on an annualized basis.



Effective August 2012, we entered into an offer letter agreement with Mr. Randazzo, which provided for an annual base salary of $200,000. The Compensation Committee subsequently approved increases to Mr. Randazzo’s base salary to $208,000 in February 2014, to $212,000 in February 2015, to $218,000 in April 2016, and to $224,500 in February 2017, each on an annualized basis. Mr. Randazzo’s employment ended in October 2017.



Ms. Maruniak was hired in March 2017 as our Senior Vice President – Supply Chain, Logistics, Store Warehouses, and Manufacturing at an annual base salary of $240,000. Ms. Maruniak’s employment ended in November 2017.



The actual base salaries earned by all of our named executive officers in 2017,  2016 and 2015 are set forth in the “Summary Compensation Table.”



2012 Omnibus Award Plan.  In June 2012, our Board and stockholders adopted an equity award plan, which became effective on August 21, 2012. The principal purpose of the equity award plan is to attract, retain, and motivate selected employees, consultants, and directors. As initially adopted, the equity award plan provided for stock based compensation awards. In February 2013, the Compensation Committee and the Board amended the equity award plan to authorize grants of performance-based awards. At the same time, the plan was renamed the 2012 Omnibus Award Plan (the “Omnibus Plan”). The Compensation Committee administers the Omnibus Plan, subject to the right of our Board to assume authority for administration or delegate such authority to another committee of the Board. Awards under the Omnibus Plan may be granted to individuals who are then our officers, employees, directors, or consultants or are the officers, employees, directors, or consultants of our subsidiaries.



Under the Omnibus Plan, 5,000,000 shares of our common stock have been reserved for issuance pursuant to a variety of stock based compensation awards, including stock options and restricted stock awards.



In the event of a change of control, as such term is defined in the Omnibus Plan, the administrator may, in its sole discretion, accelerate vesting of awards issued under the Omnibus Plan such that 100% of any such award may become vested and exercisable. Additionally, the administrator has complete discretion to structure one or more awards under the Omnibus Plan to provide that such awards will become vested and exercisable on an accelerated basis. The administrator may also make appropriate adjustments to

---

 

awards under the Omnibus Plan and is authorized to provide for the acceleration, termination, assumption, substitution, or conversion of such awards in the event of a change of control or certain other unusual or nonrecurring events or transactions.



The types of awards we intend to grant under the Omnibus Plan are as follows:



Cash Performance Awards.  In February 2015, April 2016, and February 2017 the Board and the Compensation Committee adopted specific performance targets and payout levels for each executive officer for the then-current fiscal year.



For fiscal years 2015, 2016 and 2017, Mr. Homeister was eligible to earn target cash incentive compensation equal to 75% of his year-end base salary and each of Messrs. Geadelmann, and Randazzo was eligible to earn target cash incentive compensation equal to 50% of his year-end base salary, all based on our Adjusted EBITDA for the year. For fiscal 2017, Ms. Maruniak was eligible to earn target cash incentive compensation equal to 50% of her year-end base salary, pro-rated for the partial year during which she was employed with us, based on our Adjusted EBITDA for the year. Mr. Rucker does not participate in our incentive compensation program. The target incentive compensation was payable if we achieved the Adjusted EBITDA target set forth in our budget. For fiscal year 2015, each of Messrs. Homeister, Geadelmann, and Randazzo was entitled to receive a partial incentive payment if we achieved at least 85% of our budgeted Adjusted EBITDA, and an incentive of up to double the target incentive amount if we achieved 115% of our budgeted Adjusted EBITDA and attained targeted sales goals. For fiscal years 2016 and 2017, each of Messrs. Homeister, Geadelmann, and Randazzo, and Ms. Maruniak was entitled to receive a partial incentive payment if we achieved at least 90% of our budgeted Adjusted EBITDA, and an incentive of up to double the target incentive amount if we achieved 110% of our budgeted Adjusted EBITDA and attained targeted sales goals.



The Compensation Committee reviews and certifies performance following the end of each fiscal year and may also consider discretionary factors when making awards. For fiscal year 2015, the Compensation Committee approved a payout of 55% of the target cash incentive compensation to Messrs. Homeister, Geadelmann, and Randazzo based on our performance measures. For fiscal 2016, the Compensation Committee approved a payout of 110% of the target cash incentive compensation to Messrs. Homeister, Geadelmann, and Randazzo based on our performance measures.  The Compensation Committee did not approve any payouts of the target cash incentive compensation based on our performance in fiscal year 2017.



The cash incentive compensation for which our named executive officers were eligible in 2017 is set forth in the “Grants of Plan Based Awards in Fiscal Year 2017” table. The actual cash incentive compensation earned by all of our named executive officers in fiscal years 2017,  2016 and 2015 is set forth in the “Summary Compensation Table.” 



Equity and Equity-Linked Incentives.  We intend to use equity incentive awards pursuant to our Omnibus Plan to link the interests of our named executive officers with those of our stockholders. The Omnibus Plan provides that the administrator may grant or issue stock options and restricted stock or any combination thereof. Stock options may be either nonqualified stock options or incentive stock options. We expect vesting of these equity incentive awards to be dependent in whole or in part on continued employment, in order to encourage the retention of our named executive officers through the vesting period of the awards. In some cases, vesting may also be partially based on the annual appreciation of our common stock. In determining the size of inducement and ongoing equity awards to our named executive officers, our Compensation Committee considers a number of internal factors, such as the relative job scope, the value of outstanding equity awards, individual performance history, prior contributions to us, and the size of prior awards, as well as external factors such as the levels of unvested equity awards held by our executive officers in relation to their peers at comparable companies. The Compensation Committee also intends to consider the foregoing factors for future awards.



In March 2017, we granted 40,000 non-qualified stock options to Ms. Maruniak. In May 2017, we granted 25,900 non-qualified stock options to Mr. Homeister, 13,200 non-qualified stock options to Mr. Geadelmann, and 7,700 non-qualified stock options to Mr. Randazzo.  In November 2017, we granted 26,500 non-qualified stock options to Mr. Geadelmann. These stock options were granted pursuant to the Omnibus Plan and are subject to time-based vesting over a four-year period, other than the stock options granted to Ms. Maruniak, which are subject to time-based vesting over a five-year period. Messrs. Homeister and Randazzo and Ms. Maruniak forfeited these unvested stock options upon termination of their employment.



In March 2017, we granted 20,000 shares of restricted stock to Ms. Maruniak. In May 2017, we also granted 6,100 shares of restricted stock to Mr. Homeister, 3,000 shares of restricted stock to Mr. Geadelmann, and 1,850 shares of restricted stock to Mr. Randazzo. In November 2017, we granted 11,650 shares of restricted stock to each of Mr. Geadelmann and Ms. Maruniak. These shares of restricted stock were granted pursuant to the Omnibus Plan. Our purchase option for the shares of restricted stock granted in May 2017 will lapse in four equal annual installments based on continued service. Our purchase option for the shares of restricted stock granted in March 2017 will lapse in five equal annual installments based on continued service. The risks of forfeiture for the shares of restricted stock granted in November 2017 will lapse in four equal annual installments based on continued service. We repurchased these shares of restricted stock from Messrs. Homeister and Randazzo and from Ms. Maruniak upon termination of their employment.



---

 

In May 2017, we also granted 6,100 performance-based restricted stock awards to Mr. Homeister, 3,000 performance-based restricted stock awards to Mr. Geadelmann, and 1,850 performance-based restricted stock awards to Mr. Randazzo. These performance-based restricted stock awards were granted pursuant to the Omnibus Plan. Our purchase option for these shares of restricted stock will lapse in three equal annual installments based on our performance. We repurchased these shares of restricted stock from Messrs. Homeister and Randazzo upon termination of their employment.



In July 2017, due to his status as a non-employee director and prior to his appointment as our interim Chief Executive Officer, Mr. Rucker was granted 5,038 restricted stock awards, which vest on the earlier of our next annual meeting of stockholders and July 13, 2018.



The equity grants made to our named executive officers in fiscal year 2017 are set forth in the “Grants of Plan Based Awards in Fiscal Year 2017” table and are discussed in the “Equity Grants” section of this item.



Retirement Savings.  All of our full-time employees, including our named executive officers, are eligible to participate in The Tile Shop 401(k) Retirement Plan. Employees may elect to reduce their current compensation by up to the statutorily prescribed annual limit, which was $18,000 in 2017 (or $24,000 for employees over 50), and to have the amount of this reduction contributed to the 401(k) plan. In 2017, we made a matching contribution of $0.50 for every $1.00 that each applicable employee contributed to the 401(k) plan, up to a maximum of 5% of such employee’s salary. In 2016 and 2015, we made a matching contribution of $0.25 for every $1.00 that each applicable employee contributed to the 401(k) plan, up to a maximum of 5% of such employee’s salary. Each year, this matching contribution vests as to 20% of the aggregate matching contributions for such employee, such that all past and future matching contributions will be vested after the employee has been employed by us for a period of five years.



Perquisites.   From time-to-time, we have provided certain of our named executive officers with perquisites that we believe are reasonable. We do not view perquisites as a significant element of our comprehensive compensation structure, but do believe they can be useful in attracting, motivating, and retaining executive talent. We believe that these additional benefits may assist our executive officers in performing their duties and provide time efficiencies for our executive officers in appropriate circumstances, and may consider providing additional perquisites in the future. There are no material perquisites to our named executive officers that are contractual obligations pursuant to written agreements. All future practices regarding perquisites will be approved and subject to periodic review by our Compensation Committee.



Tax Considerations.  For fiscal year 2017 and for prior years, our Board considered the potential effects of Section 162(m) of the Code on the compensation paid to our executive officers. The version of Section 162(m) applicable for fiscal year 2017 and prior years disallowed a tax deduction by any publicly-held corporation for individual compensation exceeding $1.0 million in any taxable year for the Chief Executive Officer and each of the next three most highly compensated executive officers (other than the Chief Financial Officer, if any), unless the compensation was “performance based” or based on another available exemption. The Tax Act eliminated the “performance based” exception for compensation payments beginning in fiscal year 2018 and expanded the application of Section 162(m) to the Chief Executive Officer, Chief Financial Officer and each of the next three most highly compensated executive officers. While our Compensation Committee will be further analyzing the impact of this change as well as the other changes resulting from the Tax Act on our compensation structure, at present it does not anticipate any changes because it continues to consider our performance an important factor in determining our compensation.



Compensation Committee Report



The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis with management.  Based upon this review and discussion, the Compensation Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in our proxy statement and in this Annual Report on Form 10-K for the fiscal year ended December 31, 2017.



Compensation Committee of the Board of Directors:



Todd Krasnow, Chairman

Peter J. Jacullo III

 

---

 

Summary Compensation Table



The following table provides information regarding the compensation earned during the fiscal years ended December 31, 2015 through December 31, 2017 by each of the named executive officers for each year in which each was a Named Executive Officer:















---

 



Grants of Plan-Based Awards for Fiscal Year 2017



The following table sets forth certain information regarding grants of plan-based awards during the fiscal year ended December 31, 2017:







---

 



Offer Letter Agreements



In October 2013, as the result of arm’s length negotiations, we entered into an offer letter agreement with Mr. Homeister setting forth the terms and conditions of his employment as our Chief Operating Officer. Pursuant to the offer letter agreement, Mr. Homeister was entitled to receive severance benefits if his employment was terminated by us without cause at any time or if he resigned for good reason, subject to execution of a full release in our favor. In such an event, Mr. Homeister was entitled to continued payment of his base salary for six months and an additional payment in an amount equal to six times our contribution amount for the monthly health insurance premium for him during the month immediately prior to termination. Upon a change of control, Mr. Homeister was also entitled to full vesting acceleration with respect to any unvested equity awards if he was not offered employment by the successor entity, or if he was terminated without cause or constructively terminated prior to the first anniversary of the change of control. Effective January 1, 2015, we amended Mr. Homeister’s offer letter agreement to reflect his new title of Chief Executive Officer and President and to memorialize certain compensation changes related to his promotion. All other terms of his offer letter agreement remained unchanged. Mr. Homeister’s employment was terminated on October 27, 2017. As severance, Mr. Homeister received continued payment of his base salary for six months and an additional payment in an amount equal to six times our contribution amount for the last monthly health insurance premium for him. We accelerated the vesting of options to purchase 30,000 shares granted under the Omnibus Plan and scheduled to vest on January 2, 2018, which would have otherwise expired in connection with Mr. Homeister’s termination, and to permit the exercise of all of Mr. Homeister’s vested stock options through December 31, 2018. 



We have not entered into an offer letter agreement with Mr. Rucker, but we have agreed to pay him an annual base salary of $24,000, due to his long history with us, his interests as a major stockholder and the interim nature of his position. This amount was chosen to avoid triggering overtime pay requirements.



In June 2014, as the result of arm’s length negotiations, we entered into an offer letter agreement with Mr. Geadelmann setting forth the terms and conditions of his employment as our Chief Financial Officer. In February 2017, we entered into an amendment to this offer letter, which provides that Mr. Geadelmann is entitled to continued payment of his base salary for six months and an additional payment in an amount equal to six times our contribution amount for the monthly health insurance premium for him during the month immediately prior to termination. Upon a change of control, Mr. Geadelmann is also entitled to full vesting acceleration with respect to any unvested equity awards if he is not offered employment by the successor entity, or if he is terminated without cause or is constructively terminated prior to the first anniversary of the change of control.



In June 2012, as the result of arm’s length negotiations, we entered into an offer letter agreement with Mr. Randazzo setting forth the terms and conditions of his employment. Pursuant to the offer letter agreement, Mr. Randazzo was entitled to receive severance benefits if his employment was terminated by us without cause at any time or if he resigned for good reason, subject to execution of a full release in our favor. In such an event, Mr. Randazzo was entitled to continued payment of his base salary for six months and an additional payment in an amount equal to six times our contribution amount for the monthly health insurance premium for him during the month immediately prior to termination. Upon a change of control, Mr. Randazzo was also entitled to full vesting acceleration with respect to any unvested equity awards if he was not offered employment by the successor entity, or if he was terminated without cause or constructively terminated prior to the first anniversary of the change of control. Mr. Randazzo resigned as Senior Vice President – Real Estate and Development on August 15, 2017 and served in a transition capacity until October 1, 2017. Mr. Randazzo did not receive any severance in connection with his resignation.



In March 2017, as the result of arm’s length negotiations, we entered into an offer letter agreement with Ms. Maruniak, setting forth the terms and conditions of her employment as our Senior Vice President – Supply Chain, Logistics, Store Warehouses, and Manufacturing. Pursuant to the offer letter agreement, Ms. Maruniak’s employment with us was at-will, and, upon a change in control, her unvested equity awards may have been accelerated at the sole discretion of the Compensation Committee. Ms. Maruniak’s employment was terminated on November 20, 2017. As severance, Ms. Maruniak received continued payment of her base salary for six months.



In connection with their offer letter agreements, each of Messrs. Homeister, Geadelmann, and Randazzo and Ms. Maruniak agreed not to compete, directly or indirectly, with us or solicit any of our employees or business contacts during the term of his or her employment and for a period of one year thereafter. Notwithstanding the foregoing, we may, at our election, extend the term of the

---

 

non-compete and non-solicit obligations to which Mr. Randazzo is subject to for a period of two years following termination of employment, so long as we provide him with continued payment of his base salary for twelve months (in lieu of six months) and an additional payment in an amount equal to twelve times (in lieu of six times) our contribution amount for the monthly health insurance premium for him during the month immediately prior to termination. 



Non-Equity Incentive Plan Compensation



In February 2017, the Board and the Compensation Committee adopted specific performance targets and payout levels for each executive officer for the then-current fiscal year.  For fiscal year 2017, Mr. Homeister was eligible to earn target cash incentive compensation equal to 75% of his year-end base salary and each of Messrs. Geadelmann and Randazzo and Ms. Maruniak was eligible to earn target cash incentive compensation equal to 50% of his or her year-end base salary, pro-rated for Ms. Maruniak based on the partial year during which she was employed with us, all based on our Adjusted EBITDA for the year.  The target compensation was payable if we achieved the Adjusted EBITDA target set forth in our budget.  Each of Messrs. Homeister, Geadelmann, and Randazzo and Ms. Maruniak was entitled to receive a partial incentive payment if we achieved at least 90% of our budgeted Adjusted EBITDA and an incentive of up to double the target incentive amount if we achieved 110% of our budgeted Adjusted EBITDA. See below for a table setting forth the performance targets and payout levels under the plan:



* Payout levels for percentages between the listed ranges are proportionately adjusted.

** 200% is the maximum payout level and 0% is the minimum payout level (for achievement of less than 90% of budgeted Adjusted EBITDA).



The actual Adjusted EBITDA we achieved in fiscal year 2017 was $57.2 million (which was 73% of the Adjusted EBITDA target).  This determination of the Adjusted EBITDA target resulted in no cash incentive compensation to our named executive officers for fiscal year 2017.



Equity Grants



All stock options and restricted stock awards issued in fiscal year 2017 to named executive officers were issued pursuant to the Omnibus Plan. Pursuant to the Omnibus Plan, in the event of a change in control, any unvested equity awards may be accelerated at the sole discretion of the Compensation Committee.



We have also provided for the acceleration of vesting of equity awards granted to Mr. Geadelmann in the event of our change of control. In the event of a change of control, if he is terminated without cause or is otherwise constructively terminated prior to the first anniversary of the change of control, the vesting of any unvested awards will be accelerated in full immediately prior to such termination. We believe that these acceleration opportunities will further align the interests of our executives with those of our stockholders by providing our executives an opportunity to benefit alongside our stockholders in a corporate transaction. Each of Messrs. Homeister and Randazzo were also eligible for such accelerated vesting prior to termination of their employment.



---

 

Outstanding Equity Awards at Fiscal Year-end for Fiscal Year 2017



The following table sets forth certain information regarding outstanding equity awards held by the named executive officers as of December 31, 2017:

















---

 

Option Exercises and Stock Vested for Fiscal Year 2017



The following named executive officers exercised stock options or had restricted common stock vest during the fiscal year ended December 31, 2017.







Pension Benefits



We did not sponsor any defined benefit pension or other actuarial plan for its named executive officers during the fiscal year ended December 31, 2017.



Nonqualified Deferred Compensation



No nonqualified deferred compensation was paid to or earned by the named executive officers during the fiscal year ended December 31, 2017.



Potential Payments Upon Termination or Change in Control



As discussed above in connection with each named executive officer’s offer letter agreement, Mr. Geadelmann is eligible to receive severance benefits in the event that his employment is terminated by us without cause or by him for good reason. Additionally, Mr. Geadelmann is entitled to full vesting of any outstanding equity awards in the event of a change of control, if he is not offered employment by the successor entity, or if he is terminated without cause or is otherwise constructively terminated prior to the first anniversary of the change of control. Messrs. Homeister and Randazzo were each also eligible for the same benefits prior to their termination. Upon a change of control, Mr. Rucker’s unvested equity awards may be accelerated at the sole discretion of the Compensation Committee. Ms. Maruniak’s unvested equity awards may have also been accelerated at the sole discretion of the Compensation Committee upon a change of control. The table below sets forth what each of Messrs. Homeister and Randazzo and Ms. Maruniak actually received in connection with their terminations.



The amounts payable by us to each of the named executive officers, assuming that each individual’s employment had terminated on December 31, 2017, under each scenario are as follows:







---

 



DIRECTOR COMPENSATION



Each of our non-employee directors receives an annual fee of $100,000 and the chairperson of our Board receives an additional annual fee of $75,000.  The chairperson of the Audit Committee receives an additional annual fee of $40,000 and the chairperson of each of the Compensation Committee and Nominating and Corporate Governance Committee receives an additional annual fee of $15,000.  The annual period for director compensation runs based on the date of the annual meeting.



On August 21, 2016, Messrs. Cook, Jacullo, Livingston and Rucker elected to receive compensation fully in the form of restricted stock granted pursuant to the Omnibus Plan. Messrs. Kamin and Krasnow elected to receive compensation as one-half restricted stock and one-half cash compensation, payable quarterly. The number of shares of our restricted stock granted was equal to the quotient obtained by dividing (i) the amount of the annual fee payable to such non-employee director in the form of restricted stock, as set forth above, by (ii) the average closing price on Nasdaq of our common stock over 30 trading days immediately preceding the date of grant. Messrs. Cook, Jacullo, Livingston and Rucker received 6,465, 5,622, 8,323 and 5,622 shares of restricted stock, respectively. Messrs. Kamin and Krasnow received 4,919 and 3,233 shares of restricted stock, respectively. Our purchase option for the restricted stock lapsed on July 13, 2017.



On July 13, 2017, Messrs. Cook, Jacullo, Livingston and Rucker elected to receive compensation fully in the form of restricted stock granted pursuant to the Omnibus Plan. Messrs. Kamin and Krasnow elected to receive compensation as one-half restricted stock and one-half cash compensation, payable quarterly. The number of shares of our restricted stock granted was equal to the quotient obtained by dividing (i) the amount of the annual fee payable to such non-employee director in the form of restricted stock, as set forth above, by (ii) the average closing price on Nasdaq of our common stock over 30 trading days immediately preceding the date of grant. Messrs. Cook, Jacullo, Livingston and Rucker received 5,793, 5,038, 7,053, and 5,038 shares of restricted stock, respectively. Messrs. Kamin and Krasnow received 4,408 and 2,897 shares of restricted stock, respectively. Our purchase option for the restricted stock lapses on the earlier of our annual meeting of stockholders in 2018 or July 13, 2018, contingent upon the applicable non-employee director’s continued service on our Board. Until our purchase option lapses, upon a non-employee director’s termination of service on the Board, we have the option to purchase such shares of restricted stock at a price set forth in the respective restricted stock agreement.



Director Compensation Table for Fiscal Year 2017



The following table summarizes the compensation paid to each non-employee director in the fiscal year ended December 31, 2017: 

 





---

 

 

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION



The Compensation Committee currently consists of Messrs. Jacullo and Krasnow and consisted of these same members in fiscal year 2017. None of our Compensation Committee members has ever been an executive officer or employee of ours. None of our executive officers currently serves, nor in the past year has served, as a member of the board or compensation committee (or other board committee performing equivalent functions) of any entity that has one or more executive officers serving on our Board or Compensation Committee.



PAY RATIO



As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act and related regulations, we are providing the following information about the relationship of the median annual total compensation of our employees and the annual total combined compensation of Messrs. Homeister and Rucker, each of whom served as our Chief Executive Officer during fiscal year 2017. The pay ratio included below is a reasonable estimate calculated in a manner consistent with the regulations.



For 2017, our last completed fiscal year:





Based on this information, for fiscal year 2017 the ratio of the annual total combined compensation of our Chief Executive Officers to the median of the annual total compensation of all employees was 42 to 1.



To identify the median of the annual total compensation of all our employees, as well as to determine the annual total compensation of our median employee and our Chief Executive Officers, we did the following:



Employee Count. We determined that, as of December 15, 2017 our employee population consisted of approximately 1,667 individuals all located in the United States. We selected December 15, 2017, which is within the last three months of 2017, as the date upon which we would identify the median employee because it enabled us to make such identification in a reasonably efficient and economical manner. Our employee population for purposes of the pay ratio calculation consisted of approximately 1,667 individuals, all of whom were located in the United States. We have excluded the individuals located in China from the pay ratio calculation pursuant to the de minimis exemption, as our employee population in China is less than 1% of our total employee population.



Median Employee. To identify the median employee from our employee population, we compared the amount of salary, wages, tips and overtime pay of our employees as reflected in our payroll records as reported to the Internal Revenue Service on Form W-2 for 2017. In making this determination, we annualized the compensation of any full-time employees who were hired in 2017 and were working for us on December 15, 2017, but did not work for us the entire fiscal year. We identified our median employee using this compensation measure, which was consistently applied to all our employees included in the calculation. Since all our included employees are located in the United States, as are our Chief Executive Officers, we did not make any cost-of-living adjustments in identifying the median employee.



Median Employee Total Compensation. Once we identified our median employee, we combined all of the elements of such employee’s compensation for 2017 in accordance with the requirements of Item 402(c)(2)(x) of Regulation S-K, resulting in annual total compensation of $34,238. The difference between such employee’s salary, wages, tips and overtime pay and the employee’s annual total compensation represents the value of our matching contributions to participants in The Tile Shop 401(k) Retirement Plan (estimated at $788).



---

 

Chief Executive Officers Total Compensation. Since two individuals served as our Chief Executive Officer during fiscal 2017, we combined the annual total compensation of each of Messrs. Homeister and Rucker pursuant to Instruction 10 to Item 402(u) of Regulation S-K in order to arrive at the annual total combined compensation of $1,408,905. Mr. Homeister had annual total compensation of $1,303,626, which includes base salary, stock and option awards, and accrued severance. Mr. Rucker had annual total compensation of $105,279, which includes base salary and stock awards. Due to the termination of Mr. Homeister’s employment in October 2017, his annual total compensation includes accrued severance, which we would not anticipate to be included in annual total compensation in future years.



 

---

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS



SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT



The following table sets forth, as of February 16, 2018, information regarding beneficial ownership of our common stock by:





Beneficial ownership is determined according to the rules of the SEC, and generally means that a person has beneficial ownership of a security if he, she, or it possesses sole or shared voting or investment power of that security, including options that are currently exercisable or exercisable within 60 days of February 16, 2018. Except as indicated by the footnotes below, we believe, based on the information furnished to us, that the persons named in the table below have sole voting and investment power with respect to all shares of common stock shown that they beneficially own, subject to community property laws where applicable. The information does not necessarily indicate beneficial ownership for any other purpose.



Common stock subject to options currently exercisable or exercisable within 60 days of February 16, 2018 are deemed to be outstanding for computing the percentage ownership of the person holding these options and the percentage ownership of any group in which the holder is a member but are not deemed outstanding for computing the percentage of any other person.



We have based our calculation of the percentage of beneficial ownership based on 52,152,031 shares of our common stock outstanding on February 16, 2018.

 

Unless otherwise noted below, the address for each of the stockholders in the table below is c/o Tile Shop Holdings, Inc., 14000 Carlson Parkway, Plymouth, Minnesota 55441.











*       Represents beneficial ownership of less than one percent (1%) of the outstanding common stock.



---

 

















 









---

 

EQUITY COMPENSATION PLAN INFORMATION



The following table presents our equity compensation plan information as of December 31, 2017:







 



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE



INDEPENDENCE OF THE BOARD OF DIRECTORS



As required under Nasdaq rules and regulations, a majority of the members of a listed company’s Board of Directors must qualify as “independent,” as affirmatively determined by the Board. Based upon information requested from and provided by each director concerning his background, employment, and affiliations, including family relationships, we have determined that Messrs. Cook, Jacullo, Kamin, Krasnow and Livingston, representing five of our six directors, do not have a relationship that would interfere with the exercise of independent judgment in carrying out the responsibilities of a director and that each of these directors will be “independent” as that term is defined under the applicable SEC rules and regulations and the Nasdaq listing requirements and rules. Mr. Rucker,  our Interim Chief Executive Officer and President, is not an independent director by virtue of his employment with us.  



CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



Other than as described below, since the beginning of fiscal year 2017, there have been no transactions, or series of transactions to which we were a participant or will be a participant, in which:



We employ Adam Rucker, son of Robert A. Rucker, our interim Chief Executive Officer and President, and a member of our Board, as a Director of Information Technology. In fiscal year 2017, we paid Adam Rucker a total of $120,000, consisting of base salary.  In fiscal year 2016, we paid Adam Rucker a total of $140,000, consisting of base salary and cash bonus. In fiscal year 2015, we paid Adam Rucker a total of $127,000, consisting of base salary and cash bonus. Also in fiscal year 2015, we granted stock options to Adam Rucker that had a combined grant date fair value of $44,000.  Adam Rucker also received the standard benefits provided to other of our employees during fiscal years 2017,  2016 and 2015.



Compensation arrangements with our named executive officers and directors are described elsewhere in this Annual Report on Form 10-K. There are no family relationships among any of our directors or executive officers. From time to time, we employ related persons and other family members of its officers and directors. Consistent with the policy described below, all such employment arrangements involving amounts exceeding $50,000 are reviewed by the Audit Committee. We may also sell products to related persons and related persons may purchase products or services from our suppliers for individual use. If such arrangements fall within the terms of the policy described below, they will also be reviewed by the Audit Committee.  



---

 

Policies and Procedures for Related Person Transactions



Our Board has in place a written related person transaction policy that sets forth the policies and procedures for the review and approval or ratification of related person transactions. This policy is administered by our Audit Committee and covers any transaction, arrangement, or relationship, or any series of similar transactions, arrangements, or relationships, in which we were or are to be a participant, the amount involved exceeds $50,000 and a related person had or will have a direct or indirect material interest. While the policy covers related person transactions in which the amount involved exceeds $50,000, the policy states that related person transactions in which the amount involved exceeds $120,000 are required to be disclosed in applicable filings as required by the SEC rules and regulations. Our Board determined to set the threshold for approval of related person transactions in the policy at an amount lower than that which is required to be disclosed under the SEC rules and regulations because we believe that it is appropriate for our Audit Committee to review transactions or potential transactions in which the amount involved exceeds $50,000, as opposed to $120,000. Pursuant to this policy, our Audit Committee will consider (a) the relevant facts and circumstances of the related person transaction, including if the related person transaction is on terms comparable to those that could be obtained in arm’s length dealings with an unrelated third-party, (b) the extent of the related person’s interest in the related person transaction, (c) whether the related person transaction contravenes the conflict of interest and corporate opportunity provisions of our Code of Business Conduct and Ethics, (d) whether the relationship underlying the related person transaction at issue is believed to serve the best interest of us and our stockholders, and (e) the effect that a director’s related person transaction may have on such director’s status as an independent member of the Board and eligibility to serve on committees of the Board pursuant to SEC rules and Nasdaq listing standards.



Each related person will present to our Audit Committee each proposed related person transaction to which such related person is a party, including all relevant facts and circumstances relating thereto, and will update the Audit Committee as to any material changes to any related person transaction. All related person transactions may only be consummated if our Audit Committee has approved or ratified such transaction in accordance with the guidelines set forth in the policy. Related party transactions do not include: (i) the payment of compensation by us to our executive officers or directors; (ii) indebtedness due from a related person for transactions in the ordinary course;  (iii) a  transaction in which the interest of the related person arises solely from ownership of a class of our securities where all holders of that class of securities receive the same benefit, on a pro-rata basis, from the transaction; or (iv) a transaction in which the rates or charges involved are determined by competitive bids. Additionally, certain types of transactions have been pre-approved by our audit committee under the policy as not involving a material interest. These pre-approved transactions include transactions in the ordinary course of business where the related party’s interest arises only: (a) from his or her position as a director of another entity that is party to the transaction; (b) from an equity interest of less than 5% in another entity that is party to the transaction; or (c) from a limited partnership interest of less than 5%, subject to certain limitations. No director will be permitted to participate in the approval of a related person transaction for which he or she is a related party. 

 

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES



PRINCIPAL ACCOUNTING FEES AND SERVICES



The following table presents fees for professional services rendered by Ernst & Young, LLP in fiscal year 2017 and 2016:









---

 

PRE-APPROVAL POLICIES AND PROCEDURES

 

Pursuant to its written charter, the Audit Committee is required to pre-approve the audit and non-audit services performed by our independent auditors. Notwithstanding the foregoing, separate Audit Committee pre-approval shall not be required (a) if the engagement for services is entered into pursuant to pre-approval policies and procedures established by the Audit Committee regarding our engagement of the independent auditor (the “Pre-Approval Policy”) as to matters within the scope of the Pre-Approval Policy or (b) for de minimus non-audit services that are approved in accordance with applicable SEC rules. The Audit Committee has determined that the rendering of the services other than audit services by its principal accountant is compatible with maintaining the principal accountant’s independence. For fiscal year 2017, all audit and non-audit services performed by our independent auditors were pre-approved in accordance with such pre-approval policies.

 

---

 

PART IV

  

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

  

(a)       Documents filed as part of report



1.       Financial Statements



The following consolidated financial statements of the Company and its subsidiaries are filed as part of this Annual Report on Form 10-K:

 





2.       Financial Statement Schedules

 

The information required to be disclosed within Schedule II – Valuation and Qualifying Accounts is provided within the Consolidated Financial Statements of the Company filed as part of this Form 10-K.



3.       Exhibits.



See “Exhibit Index” immediately following the signature page of this Form 10-K, which is incorporated herein by reference.

 

---

 

Report of Independent Registered Public Accounting Firm



The Board of Directors and Shareholders of

Tile Shop Holdings, Inc. and Subsidiaries



Opinion on the Financial Statements



We have audited the accompanying consolidated balance sheets of Tile Shop Holdings, Inc. and Subsidiaries (the “Company”) as of December 31, 2017 and 2016, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.



We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 21, 2018 expressed an unqualified opinion thereon.



Basis for Opinion



These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.



We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. 







/s/ Ernst & Young LLP



We have served as the Company’s auditor since 2013.



Minneapolis, Minnesota

February 21,  2018 











---

 

Report of Independent Registered Public Accounting Firm



The Board of Directors and Shareholders of

Tile Shop Holdings, Inc. and Subsidiaries



Opinion on Internal Control over Financial Reporting



We have audited Tile Shop Holdings, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Tile Shop Holdings, Inc. and Subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.



We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2017 consolidated financial statements of the Company and our report dated February 21, 2018 expressed an unqualified opinion thereon.



Basis for Opinion



The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.



We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.



Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.



Definition and Limitations of Internal Control Over Financial Reporting



A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate





/s/ Ernst & Young LLP

Minneapolis, Minnesota

February 21, 2018