When Your Business Competes In Price, Advertising

December 19, 2007 by Joe Ponzio

The retail sector has been getting crushed lately. Though that breeds panic in most, it presents wonderful buying opportunities for long-term investors. Let me preface with this: I have heard it grouped in the same conversation with sub-prime loans. Are we really to believe that people will stop shopping? Can we compare that to banks lending money to people who can’t pay?

But I digress. Let’s take a look at a business that seems underpriced, but may not be a buy just the same – even if it is down 75% for the year.

Tuesday Morning Corporation (TUES). Through their 800+ stores, they are a “closeout retailer of upscale home furnishings, housewares, gifts and related items in the United States” (according to their most recent Form 10-K/T. Best I can tell, it appears as though TUES takes the products that other retailers no longer want to carry and sells them for 50%-80% off.

In reality, I think it is a great business model. In my humble opinion, I believe that there are enough people in the US that would want nice things but are willing to wait until after they are no longer on the cutting-edge of fashion or design and are selling at 50% off. Does a coffee maker ever really go out of style?

Still, a great business model doesn’t always make for a great business. Here are some of the problems that I see in Tuesday Morning Corporation.

Competition

“We believe the principal factors by which we compete are price and product offering.” When a business has to be the cheapest provider in order to get the business, it will likely be forced to choose between growth and survival. How can it comfortably allocate its $11.9 million of cash if it may be forced to slash prices (and revenue) on a whim?

Key Operating Strengths

“Our success is based on the following operating strengths…We distinguish ourselves from other retailers with a unique ‘event-based’ selling strategy, creating the excitement of multiple ‘grand openings’ and ‘closeout sales’ each year…”

This is where the art of investing and business comes into play. Anyone who has ever truly studied advertising knows that event-based sales programs drive short-term results. In the long-run, however, they tend to be more expensive and less effective at driving long-term growth.

There is a genius in the field of advertising and I would recommend that everyone (and I mean everyone) read, study, and memorize The Wizard of Ads: Turning Words into Magic and Dreamers into Millionaires and anything and everything else by Roy H. Williams (but specifically, the Wizard of Ads series). Then, subscribe (it’s free) to the e-mail based Monday Morning Memo. Doing so will help you understand why TUES may also not necessarily have as large of a “Loyal Customer Base of Brand Savvy and Value-Conscious Consumers” it believes it has.

Getting back to Tuesday Morning Corporation.

The Website

You shouldn’t judge a book by its cover. And yet, most people do. The majority of their target customer base (“consisting primarily of women ranging in age from 35 to 54 from middle and upper-income households with a median annual family income of approximately $60,000”) is surfing the web and shopping online.

They likely expect more out of the Tuesday Morning website than is presently offered. For example, the closest location to me is roughly 7 miles away. I am not going to fight Chicago traffic to go to a store when I have no clue what they have today – and at what prices.

The Numbers

Tuesday Morning looks extremely cheap. For example, assuming just 5% growth for the next ten years (ignoring the future beyond that and the equity value), TUES has an intrinsic value of $6.71 a share. I know – this totally strays from my formula. Why? I wanted to throw a quick value down because I knew I wouldn’t be buying TUES as it stands. Why go through any extra work if I don’t like the business.

At $4 and change, TUES appears to be underpriced. In addition, it is paying a handsome 12% dividend. Still, I can’t buy this company today because I don’t know if it will be able to continue growth – even at 5%. It has some major fundamental problems in its advertising that may hurt the business and forever leave it stuck in a pricing battle. (If it fixed its advertising problem, it would be able to build a better customer base and compete less on pricing alone.)

If Tuesday Morning Fixes Their Problems

Tuesday Morning is a difficult business because they have a wonderful model and a great idea, but it is not being executed to maximize long-term growth. At the pace they are going, they will likely be forever putting out fires and trying to stay above water.

In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen.

It’s not a difficult business to understand, but a difficult business to run (read: generate maximum excess owner earnings) as it currently operates. If management proactively begins fixing the company’s weak advertising and pricing structures, the business may have the potential to be great. Still, to do so, the company will have to plow its owner earnings into proper advertising and make a fundamental shift in its direction. That would likely mean greater losses before a turnaround. Tuesday Morning has cockroaches in it’s advertising – and that leads to cockroaches in so many other places.

The TUES Summary

As attractive as the price seems relative to the valuation of the business, there are so many obstacles and stumbling blocks to this business that I do not have the confidence I need to commit money. I’ve said it before: Try to invest in businesses in which you are both comfortable and confident.

I may be sacrificing potential growth; still, I’ll take confidence and low-stress with nice returns over uncertainty with the potential to make a killing. Remember: There is a business behind that stock and price follows value.

Two Additional Points (in case you were wondering)

What is a Form 10-K/T? The Form 10-K filed with the SEC is a company’s annual report. You’ll also see 10-K/A – an amended 10-K. The 10-K/T (which you’ll rarely see) is a transitional report. In the case of TUES, it was used because the company changed its fiscal year end from December 31st to June 30th. The 10-K/T was the “annual” report for the shortened 6-month period. The June 30, 2008 annual report will revert back to 10-K.

Why did I change the intrinsic value calculation? I didn’t. The goal is to find value. If you found a wonderful business selling for less than, say, two years worth of owner earnings, there would be no need to do a full valuation on the company because it would be a screaming, obvious buy. In the case of TUES, I’m not buying today because the business needs work. As such, the valuation doesn’t matter one bit. I showed the valuation above simply because the business is selling for less than ten years worth of owner earnings – a steal in the case of a wonderful business, a pass when the business has problems that need to be addressed.

A Note From Joe Ponzio

This section is for comments from F Wall Street visitors. Do not assume that Joe Ponzio agrees with or otherwise endorses any particular comment just because it appears or remains on this website.