TRANSFORMATION IN DECLINE
My Thesis & A Little History
The deep undervaluation of Trans World Entertainment Corporation ("Trans World") (NASDAQ:TWMC) presents a great opportunity for smaller value-focused investors/funds. The company is a specialty retailer of entertainment products and was founded in 1972 by its current CEO/Chairman Bob Higgins. Mr. Higgins is also the largest shareholder in the company with over a 50% ownership interest.
The company has been buffeted by the digital entertainment revolution and has been forced to institute dramatic changes to its product mix, lease portfolio and corporate strategy. These fundamental changes are now bearing fruit. I believe the stock market is not valuing Trans World fairly as its equity is trading below not only its tangible book value but also its net cash value!
What Has Happened?
The credit crisis accelerated the negative impact of the digital revolution on the physical entertainment retail business. The management of Trans World quickly recognized the structural decline of physical entertainment sales and aimed to cut costs faster than sales dropped to avoid the fate that befell its specialty retail competitors. And in this decline, management focused on transforming the business model to give Trans World an opportunity to profit as the sole nationally-based entertainment retailer.
It aggressively reduced its store count by over 60% from nearly 1000 stores in 2007 to the current 358 stores. In addition, it diversified the product mix away from collapsing music sales to the growing areas of "trend" merchandise (clothing, novelty items, etc.). Music, which made up nearly 80% of sales in 2000 and over 50% of sales in 2006, was reduced to less than 30% of sales in the most recent quarter. In the same period, trend & electronics sales have jumped from 9% to 16% and most recently, to 24% of sales.
Comparable store sales growth: The transformation has led to a dramatic like-for-like improvement.
Gross Margin: Large and consistent improvement as competitors' space for CDs/DVDs disappeared.
SG&A as % of Sales: Substantial reduction in operating expenses as business was "right-sized".
Net Margin/Net Income: Better product mix in fewer stores has led to a jump in profitability.
Where Is The Business Now?
Trans World has stabilized its core business and now is benefiting from its position as the sole nationally-based mall retailer of diverse entertainment products. Shelf space for CDs and DVDs in big-box retailers is shrinking and specialty retail competition has all but disappeared. This drop in supply is helping Trans World and allows it to maximize returns as the drop in demand for physical music and video decelerates. Additionally, gross margins should continue to improve as its used entertainment business increases and suppliers continue to support the last national specialty entertainment retailer.
I believe Trans World's potential will be recognized as it continues to leverage its lease portfolio and national distribution network to diversify its product mix. Trans World's strategy of expanding more into sales of trend and other items as music and video sales slowly decline should prove to extend its life span far into the future. With about 300 mall-based stores (remainder are free-standing stores), Trans World is optimally situated for such traditionally "impulse" purchases.
What Is The Investment Opportunity?
Currently, the equity market value of Trans World is $113 MM. The company has $2 MM of long-term debt (a capital lease) and has not used its line of credit since October 2010. And as of February 2013, the company holds $133 MM of cash. Thus the stock trades at nearly a 15% discount to its net cash balance.
Cash and inventory comprise nearly 95% of the roughly $305 MM in asset value. And current liabilities (primarily accounts payables and accrued expenses) make up about 80% of total liabilities. Additionally, a substantial portion of inventory can be returned to suppliers for credit drastically reducing the risk of obsolescence and large inventory write-downs. The "net-net" value, or current assets less total liabilities, of the company is roughly $160 MM. The stock trades at nearly a 30% discount to this net-net value.
And finally, the book equity value of the company is roughly $177 MM. Again on the asset side, the balance sheet only shows value for cash, inventory and minor fixed assets. The company trades at over a 35% discount to this book value. Notably, there is no value given for its nationally-based store footprint, its distribution network or management's proven competency.
What Are The Risks?
There is the risk that Trans World will not be able to manage a sudden reacceleration of the decline in "bricks-and-mortar" entertainment sales. However, the management has demonstrated the ability to reduce costs and store count faster than the drop in sales. It was able to achieve profitability even as total U.S. physical entertainment media sales dropped from $41 BN in 2008 to $22 BN in 2011 (TWMC filings). Additionally, the decline in rate of music and video sales has dramatically moderated as U.S. internet adoption has flat-lined at slightly below 80% of the population since 2008 (Pew Internet & American Life Project Surveys, March 2000 - August 2011).
It seems there is still some time to go before the last CD and DVD is played. More importantly, the collapse of specialty entertainment retailers, especially in malls in the face of digital competition, has created a profitable and uncontested niche for Trans World. The company is successfully using this tumultuous period to transition into a broader specialty product retailer.
Another risk is the potential for operating lease liabilities to limit Trans World's flexibility to manage sudden shifts in industry conditions. Fortunately, about 75% of its leases are up for renewal or termination by the end of 2014. Trans World has maintained a similar lease profile over its history and is a major factor in its ability to quickly adapt to industry shifts. Management has demonstrated discipline in avoiding lease arrangements that threaten profitability. Additionally, the lack of any nationally-based specialty entertainment retailer has allowed the company to negotiate favorable lease terms. Mall owners like the customer diversity that Trans World brings.
Though the management has demonstrated its commitment to pursuing profitability and investment returns over growth, there may be fears over future strategy. Firstly, I believe that the reason that Trans World has survived is that Mr. Higgins is such a significant shareholder of the company. He is strongly incentivized to keep the company viable and profitable. Secondly, recent new store openings (even as net store count has dropped) seem to only have been done when profitability is immediately assured. Management has emphasized that this will continue to be their strategy with new stores. And finally, management has proven that they recognize the adverse economic realities of physical entertainment sales and have been very conservative in their approach.
Capital distribution risk:
One concern is that the Chairman (Mr. Higgins) and the Board of Directors do not pay out the excess cash to shareholders in a reasonable time period. I have calculated that the company holds roughly $80 to $100 MM in excess cash as it has not used its line of credit since 2010 when it had about 50% more stores. However, I believe this concern is overblown since the Board authorized its first special dividend of $15 MM or $0.47/share just a few months ago. In the recent earnings call, management emphasized that the company's "strong financial position provides [it] many options to enhance shareholder value." I believe this statement shows their commitment to returning excess cash. Additionally, large investors have been agitating for the continuation and acceleration of significant cash distributions.
I believe that Trans World has several years left to make significant profits and cash flows for its investors. And as importantly, it has the flexibility to adjust to more adverse outcomes without endangering current shareholder value.
In my base case scenario, the decline in music and video sales is balanced by the growth in trend and other sales with stability in gross margins and cost ratios. This should allow Trans World to continue operating its current store portfolio for several more years. In this scenario, I see profitability continue at recent levels leading to cash-adjusted return on book equity of about 10%. If such an outcome prevails, I believe fair value is multiples of current market value.
In my adverse case scenario, a sudden acceleration in the decline of entertainment media sales overwhelms the growth in trend and other sales. In such a scenario, I believe that store closures will continue but margins should be maintained as Trans World continues outperforming other bricks-and-mortar entertainment retailers. However, dollar profits will shrink with sales and corporate overhead will have to be significantly reduced. I believe this scenario would force management to pursue a liquidation strategy. Such a scenario would probably take three to five years to unfold. Similar to the recent period of drastic store closures, cash balances should grow as inventory is monetized and stores are closed. If this outcome prevails, I believe management will continue paying out large special dividends as the cash balance builds. The book equity value of about $177 MM or net-net value of $160 MM becomes a more relevant fair value measure in such a scenario.
Overall, I believe Trans World is substantially undervalued by the market. The last two years of profitability has demonstrated that there is consumer demand for physical entertainment media and trend merchandise. Additionally, with no competition in its specific mall-based niche, Trans World has the potential to generate several years of sustainable returns. Therefore, the current below-liquidation market valuation of the company is unjustified. And I am confident that this discount will be corrected as the management returns cash to investors and the market realizes that this retailer has been transformed.
Disclaimer: I own/control shares in Trans World Entertainment Corp. ("Trans World") and will profit if the stock price increases. I may change my views on Trans World and the value of Trans World's shares at any time and for any reason. I disclaim any obligation to publicly notify of any such changes. Although I believe this presentation is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements therein not misleading, I make no representation or warranty, express or implied, as to the accuracy or completeness of this presentation or any other written or oral communication it makes with respect to Trans World, and I expressly disclaim any liability relating to this presentation or such communications (or any inaccuracies or omissions therein). Thus, shareholders and others should conduct their own independent investigation and analysis of this presentation and of Trans World and other companies mentioned. This presentation is not investment advice or recommendation or solicitation to buy or sell any securities. Except where otherwise indicated, this presentation speaks as of the date hereof, and I undertake no obligation to correct, update or revise this presentation or to otherwise provide any additional materials. I also undertake no commitment to take or refrain from taking any action with respect with Trans World or any other company.