Thursday, July 8, 2010

Being Wary Of Retailers

The financial statements of various retailers can look very clean in some cases: decent cash balances, low debt levels, and dropping inventory levels acting as a source of cash in this tepid retail environment. In many cases, the stock prices of these retailers can seem like veritable bargains in relation to their financial statements. After all, what value investor wouldn't want to buy a company for half of what it owns in inventories alone?

However, when valuing company assets, retailers should not be placed on the same playing field as companies operating in a different space, even if the financial statements suggest two companies are identical. This is because of an accounting standard that does not require retailers to include on their financial statements a most material of liabilities: their operating leases.

Consider Trans World Entertainment (TWMC), a retailer with about 560 stores across the US. The company trades for just $60 million, even though it has current assets (mostly inventory) of around $280 million, and total liabilities of under $140 million, for a net current asset value of around $140 million.

If a manufacturing company had the types of numbers depicted above (and some do have similar), it would likely be a straight up steal, as the company could cut costs (reduce output/headcount/facilities) while sourcing cash from its inventory. Most retailers, on the other hand, are burdened with fixed operating leases that in some cases don't expire for years, reducing the ability to cut costs. While manufacturers can also have operating leases, the magnitude of these leases are normally not nearly as material as they are for retailers.

For example, Trans World has operating lease obligations of $160 million over the next five years or so. (Compare this to the company's market cap of $60 million!) Trans World lost $10 million last quarter, and it may continue to lose money (eating into its current assets) as its cost structure is not flexible enough to allow for a quick turnaround, thanks to these leases.

Not all retailers have such daunting operating leases, however. Some, like Office Depot (ODP), own land and buildings outright, which provided ODP some much-needed flexibility during a cash crunch last year. Furthermore, the expiration of operating leases can empower management with the ability to reduce costs: companies can cherry-pick which leases to renew based on store-by-store profitability, thus improving overall results. Finally, we've also seen how some companies (e.g. Build-A-Bear as described here) have been able to re-negotiate their lease requirements lower as the lessors would rather work with them rather than lose a valued client.

Nevertheless, when viewing the financials of a retailer, alarm bells should go off because of the fixed-cost nature of this industry: what is this company contractually obligated to pay in the future, and does it have the ability to make those payments? While a company may trade at a discount to its net current assets, that is no good to investors if it will continue to lose money. To avoid falling into the trap of buying such companies, it's important to consider the company's cost structure thoroughly, no matter what the financial statements say.

2 comments:

Paul said...

Saj,

excellent post as usual. Thanks for responding to my email, by they way. :)

Anonymous said...

Saj,

I think TWMC is quite undervalued. They are shutting down stores aggressively so are bringing their cost basis down. They generated $50 MM CFO last year and look to this year also. They own a real estate asset in Miami worth $15-20 MM (confirmed during the last annual meeting) that has been fully depreciated on B/S so is not reflected. The CEO is buying stock aggressively and already owns 50% (he launched a failed MBO in 2008 at ~$5). The company faces considerable headwinds but is overall a true "net-net" since it is trading at an enormous discount. And its FCF generating potential is well over its MV. Anon.

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