Trans World: Pre-Turnaround?

Trans World Entertainment (TWMC) is a specialty retailer in the US. It sells a collection of electronics, music and other items through the 400+ stores it operates. From a balance sheet point of view, the company looks cheap; though the company trades for just $65 million, it has net current assets of $130 million.

The problem, of course, is that the company has been burning through its assets for several years now. In the last four years, the company has lost a combined $200 million!

There are some signs, however, that things are turning around. The company has been closing unprofitable stores and cutting SG&A expenses, and this has led to a much-improved bottom line despite the commensurate reductions in revenue. In its last fiscal quarter, operating losses were less than $2 million, a $9 million improvement over last year.

Furthermore, the company has generated positive cash flow from operations for two years in a row, to the tune of a combined $60 million. A skeptic would likely point out that all of this cash flow was sourced from working capital (namely, inventory) reductions and thus may need to be reversed. However, because the company has been closing stores, this capital has been freed up permanently.

And there may even be more room for inventory reductions, as the company continues to aggressively close stores due to the timing of certain operating leases. Though Trans World has $100 million in operating leases due over the next 6 years, it will get through $47 million of that this year. This gives management a great opportunity to cherry-pick which locations it wants to keep and which it wants to close. This should be a catalyst in the direction of improved profitability.

Unfortunately, a big part of Trans World's business is in decline. The distribution of music and video programming is increasingly shifting to electronic rather than physical forms. So the company still faces a lot of headwinds, making it difficult to say if the turnaround is indeed here to stay.

Though the numbers are trending in the right direction, extrapolating continued improvement may prove to be a mistake. Some value investors may see enough upside here to justify an investment at the current price, while others may prefer to wait and see how the next few quarters play out, sacrificing potential upside in return for more assured downside protection.

Disclosure: No position

Trans World Entertainment

Would you want an interest in a retailer that sells music CDs? Neither would I. But what if the price of that retailer is just a fraction of the company's inventory? Mr. Market is still not interested, which is why you might be.

Trans World Entertainment (TWMC) trades for $60 million but has inventory of $237 million. Even if you subtract all of the company's liabilities from its inventory, the retailer still trades for much less than this conservative valuation.

We've actually discussed this company last year, but found it risky because of the large operating lease obligations it had. But the company has done well to cut costs through this rough period.

First, it has let a great many leases expire, shutting down hundreds of unprofitable locations. Operating lease obligations have fallen from $220 million a couple of years ago to around $130 million today.

The company has also focused on its more profitable lines, as it dramatically cut sales of video game products, and has increased its share in DVD and Blu-Ray devices. Efficiency has also been improved, as inventory per square foot is coming down, and new, more profitable pricing schemes are being rolled out after successful runs in test stores.

Unfortunately, the company continues to lose money, as the company suffers from both cyclical (the economy) and secular (electronic sales of music) problems. As such, while it may trade at a discount to assets, those assets are being eroded. But for a retailer such as this one, the Christmas quarter is the most important. For this company, that's also the quarter where almost half of the store's locations appear to be at the end of their lease. As a result, this company bears watching over the next few months, as it will have an opportunity to generate cash and cut expenses, which could strengthen its case as a potential value investment.

Disclosure: None

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.