Tuesday Morning and Zales at Bargain Prices

The first two months of performance for the Best Portfolio puts us ahead of the SP500 benchmark by a healthy 4.13%, despite a few setbacks on certain names and a very confusing and volatile market environment. The unprecedented events of the past six months, with massive government intervention both here and abroad, as well as many false starts and direction changes for policies designed to address the crisis, have thrown many portfolios for a loop. Our choice of the resource sector was a good one, and we actually made good money on our one financial holding, STT. On the other hand, we’ve suffered serious disappointments in a few energy names, although we like the overall profile of stocks like MRO, EXC, TPP and COP.

At times, the market baffles even the best of analysts and managers, as irrational viewpoints lead to grossly distorted price swings in either direction. Investors went crazy over the dotcoms and ludicrous B-2-B stocks ten years ago, aided by rampant fraud by the accountants and auditors (can you say “Big 4”?) as well as an outrageous no-holds-barred promo campaign by the Wall Street IB hustlers. Most of those investors ended up with a pocketful of zeroes, and a stack of research reports that could be used as fireplace starters – or evidence in civil suits. The homebuilders and subprime/predatory mortgage originators made a huge move beginning six years ago, as Wall Street chose “don’t worry, be happy” as an investment theme, instead of “don’t you think we should have some minimum regulatory oversight when firms are creating trillions of bad paper?”

Now we find ourselves mired in unpayable debt and with years of housing inventory to clear, and a largely-frozen credit system, if you can even call it that. The credit picture is beginning to thaw, thanks to government acquiescence to the extortionate bailout demands of the “banks” as we used to call them. Stock prices sank to absurd levels, and we made hay out of a few bargain situations; but prices have now begun to recover strongly, as investors awaken to the intoxicating scent of a huge rally and truly stunning bargains in a variety of sectors. We aren’t going to opine as to whether this is a “bear market” rally, or the start of a long advance that correlates to underlying asset, name brand and franchise values, as well as the recognition that stocks can go up quite a lot in an inflationary economy, especially if we put the paddles to the “global growth” story and revive a heartbeat there.

While we remain baffled by HL and CAG, we are sticking with all of our current names. Hecla suffers from an aversion to precious metals stocks and a distrust of shaky management, while ConAgra is caught in a nasty price war with Nestle (NSRGY.PK) and Del Monte (DLM) in frozen foods, and the drop in commodities prices is hurting its trading business, according to reports. The economy is bad for restaurants, but should be OK for budget-minded shoppers who want to eat dinner at home more, or take a frozen entrée to work for lunch, instead of paying five times as much to go out. We think that CAG will do just fine going forward, and their last quarter was a mild beat on reasonably solid performance, with sales growing 6.1% y-o-y for the quarter, but gross margin slipping from 24.1% to 22.5%. Looking ahead, several analysts who follow the sector closely have projected a rise in GM for the upcoming May quarter, which would reverse three straight quarters of GM decline at CAG.

In the bargain category, we found a couple of home-grown names right here in the Dallas area – Zale Corp (ZLC) and Tuesday Morning (TUES). We have added a modest starter position in both, and also added another 1,000 shares of RIO, the Brazilian mining conglomerate that remains quite undervalued at present, due to a tough market for iron ore and nickel. RIO is the largest iron ore producer in the world, and ranks very high in global nickel production, thanks to buying the Canadian giant Inco in 2006. Despite robust competition in iron ore from mega-miners BHP and Rio Tinto (RTP), we think RIO is way too cheap at $13 so we bought more, and also maintained our overall exposure to mining and resources after our FCX position was called away for a huge short-term profit at the March expiration. One other mining note – copper rose above $2 this past week – a healthy sign for miners as well as the general global economy. We have enjoyed huge gains in both Quadra (QADMF.PK) and FCX, and expect that copper will hold up well as the economic pallor fades.

Zales is a moderately-priced jewelry chain with several store brands, including Zales, Gordons, and Zales Outlet in the U.S., and People’s and Mappins in Canada. It also has stores in Puerto Rico. The jewelry business is tough right now, but not nearly so dismal as some short sellers have tried to suggest. Zales is losing money this year, but its balance sheet is steady enough, and it is working off an inventory overhang, like nearly every other retailer on the planet. To its credit, ZLC has also downsized its corporate offices and in late February said it would close 115 underperforming stores, as well as rationalized inventory and eliminated a number of SKUs. There was a gross misperception on the part of some investors, involving some leases that may come back on Zales as a liability, that we believe led to a vicious selloff after ZLC reported a weak Christmas season and fired its CFO. Admittedly, that combination can rattle even the Warren Buffett crowd, but if you bothered to dig into the details you would have found that things weren’t all that bad. You also would have begun to snap up shares at the laughably low prices around $1 in early March.

The mistake that some analysts made involved store leases on 113 Bailey, Banks and Biddle (BBB) stores that ZLC sold to Finlay (FNLY) (for a profit) in late 2007. Terms of that sale included a provision that ZLC would re-assume the lease obligations on those BBB stores if Finlay went BK. The obligation grew in significance as the economy worsened, and rumors began swirling that Finlay was in trouble, meaning Zales would have to handle the remaining lease payments, as agreed. The contingency was $89 million a year ago, but with the passage of time is now only $71 million as of January 31, 2009, the latest 10Q from ZLC. The lease overhang is shrinking by over $1 million per month, so is now at $69 million. And that is not a lump sum due, were Finlay to file for bankruptcy, but rather a stream of payments that ZLC would make over the next six years, roughly.

One must also consider that Zales could use the space, mostly in large malls, to open new stores, while possibly shutting down some other Zales or Gordons locations in nearby malls, if need be. It could also sub-lease the space in most cases to another merchant, or possibly even have legal standing to walk away from the obligation in the case of “dying” malls, where the anchors leave and the mall is no longer viable as a going concern. There is a lot of negotiating latitude in some lease situations, and co-tenancy clauses give tenants an out if the mall becomes trashy, fails to provide adequate security, loses a big chunk of its traffic, or the anchors leave or close up due to bankruptcy. Because there are so many twists and turns and possible outcomes, all in part driven by economic events that could go either way, ZLC does not put a contingency for this BBB lease situation on its balance sheet – but it has been disclosed in footnotes in every 10Q and 10K.

Some analysts went negative on the Zales story two years ago, with the stock at $30 as Wall Street melted down, and never looked back. ZLC also made the big mistake of using up a lot of its credit lines buying back stock. That’s my guess as to why the former CFO was out the door in mid-January, after just a couple of years at the company, but then again Zales has been a poster child for management turnover for many years. Having said that, many of the CFOs that roll out of the accounting firms and end up at various corporations are often paid way, way more than they are truly worth, and many are little more than glorified auditors, itself a tainted profession in my book.

Many of these “CFOs” end up working fancy jobs more from connections, and the semi-corrupt farm system in place for corporate accounting types who come from the audit firm (nice and cozy, right?) instead of having the multitude of management skills needed to provide solid financial management to a modern corporation. Sadly, having the accounting rulebook memorized is just a very weak job qualification. In some corporations, you may need to explore the Human Resources dept. to find employees who add less value.

At any rate, Zales became a screaming bargain about a month ago, and I began to acquire it for accounts that I manage. I decided to add it to the Best Portfolio on March 31^st, as some new names were needed going into the next quarter. One interesting aspect to the Zales story is that a hedge fund run by Richard Breeden has a huge position in the stock, and ZLC also has a very low share count due to the massive buybacks in 2008. At March 9, 2009, the filing date of the 10Q, ZLC had just 31,983,913 shares outstanding, with around 1/3 of those owned and controlled by Breeden. ZLC also had very high short interest, which was obviously misguided. This situation – severely undervalued stock plus lots of clueless shorts - can lead to explosive moves, and ZLC has risen over 100% in just the first three days of April!

The Tuesday Morning (TUES) story is also a misunderstanding in progress. TUES is a “closeout retailer” of upscale home furnishings, housewares, gifts and related items in the United States. The Company says that its “merchandise primarily consists of lamps, rugs, kitchen accessories, small electronics, gourmet housewares, linens, luggage, bedroom and bathroom accessories, toys, stationery and silk plants, as well as crystal, collectibles and silver serving pieces.“

Copying shamelessly from the recent 10Q, TUES reports:

We operated 860 discount retail stores in 45 states as of December 31, 2008. We sell closeout home furnishings, housewares, gifts and related items, which we purchase at below wholesale prices. Our stores operate during periodic “sales events” that occur in each month except January and July. We are generally closed during the first two weeks of January and July, which traditionally have been weaker months for retailers. We purchase first quality, brand name merchandise at closeout prices and sell it at prices significantly below those generally charged by department stores and specialty and catalog retailers. We do not sell seconds, irregulars, refurbished or factory rejects.

Amazingly, this stock dropped from $30 in the spring of 2005, to just 51 cents at its low a month ago! That is quite absurd, especially when you consider the strong balance sheet of TUES and its long record of steady success. In a market dominated by chart-monkeys and out-of-control “quant” trading programs, the smarter investors can find absolutely amazing bargains by simply doing a little old-fashioned DD. I will not go into a lengthy analysis of all the positives of Tuesday Morning in this report, as it is beginning to run a bit long. The TUES 12-31-08 10Q (fiscal second qtr) shows us the following:

No Long Term Debt

Zero net deferred income tax – because TUES has rarely lost money and plays no tax games. It has been solidly profitable for years – straight through recessions and good economies as well.

No Goodwill or Other “soft” assets

Stockholder’s Equity of $242.3 million, or $5.60 per diluted share – and the stock is now at $1.30 as of 4-3-09.

A lower inventory-to-store ratio than a couple of years ago – this is a sign that TUES can plan for slower sales in the present economy, yet still be a healthy operation. It’s called smart management.

I think TUES can be a $10 stock in as little as two years, and possibly even sooner, so I am a Buffett-type buyer here, in size. I do not want to overweight the Best Portfolio with a heavy dose of deep-value, but in my personal life I have done extremely well with such names as STEI, AUY, TUES and recently ZLC.

Here’s the spreadsheet at March 31^st – end of the quarter. Updates will now follow about every two weeks (hopefully) as my schedule will allow. For the record, we wrote new, May 2009 covered calls in BRCM, WFR, and STT. That means we are going for “seconds” in terms of profiting from market volatility while maintaining a core position in the stock, and picking up some small dividends as well.

One final note – it looks like Tim “Golden Goose” Geithner has capitulated to the banking capos, and it also appears that Mary Schapiro may end up being just another lackey for the corporate titans and their daisy chain Boards, instead of being an effective SEC Chair. She seems to be dragging her feet at the slightest excuse when it comes to real changes. The past two weeks have not been encouraging to our dream that, some day, these regulators will go from being pseudo-cops to actually protecting equity shareholders and the Federal Treasury.

Now, Tim’s machinations may ‘goose’ the markets, and Mary may ultimately prove contrary to the corporate exec-parasite system, but we are not going to hold our breath. I thought, and still think, that Obama can do much better in terms of appointing capable, non-incestuous regulators that don’t owe their futures to, or expect massive speaking fees (that is, kickbacks) from, their corporate idols. Larry Summers is also a huge question mark, as he is way too cozy with the hedge fund crowd, and has basically been dead wrong for years about the dangers of derivatives and global finance in general.

I will copy this part of my post here to the White House, where some scion of the wealthy class can toss it into the trash can with a wry smile. But one of these days, maybe after a few more elections move a few more of the old “rear guard” out of the Senate and House, we can get some honest Congressmen and Senators who have one basic goal in mind – that is, to protect the interests of what I believe is the Essence of Capitalism – the Equity Investor.

Comments

[davidbdc:]

If Tuesday morning becomes a $10 stock then I'll only lose half of my investment - they stopped the dividend long ago and management is merely focussed on their own survival.....keep those paychecks coming...shareholder??? Who cares about them.

Apr 07 05:29 AM

[Bill Herbert:]

davidbdc - I wouldn't give up on TUES so easily. Sorry to hear that you lost a bundle on this - I came in under $1 and have been loving it ever since. Actually, I have been to their stores many, many times and nearly always buy something - I'm amazed at the deals you can find there sometimes. I think the management has done a respectable job - are there specific issues you have with their performance?

Thanks

Apr 08 09:56 PM