Tuesday Morning Is Testing Investors' Patience

| About: Tuesday Morning (TUES)

Summary

I still think the TUES story is intriguing from a long-term standpoint, with the company zigging while retail as a whole is zagging.

But near-term execution is a concern, and so is management turnover; are the problems temporary, or is that what happens when a hedge fund manager runs a retailer?

I'm sticking with my hedged position for now, but execution needs to improve quick.

I still like the story around $4, but I'm more hesitant to commit new capital after the Q2 report.

Simply as an observer, I do like the story at Tuesday Morning (NASDAQ:TUES). The company is trying to execute an old-fashioned model - a focus on in-store shopping with a "treasure hunt" feel, basically no online presence - in an industry where peers are doing the exact opposite. There's room for substantial improvement in its supply chain, and Tuesday Morning is testing other changes throughout its operations. The company is focusing on improving its real estate, and successfully: relocated stores (nearly 100 have been moved at this point) get a ~50% sales lift. And even with all the movement, Tuesday Morning is one of, if not the, most consistent revenue growth stories in retail, with comp increases steady, and based on rising traffic, no less.

The catch for some time has been that, by management's own admission, this is a multi-year story, which leads to an, "OK, but why buy now?" issue for the bull case. Meanwhile, the company now is run by Steven Becker, a former activist fund manager who targeted Tuesday Morning back in June 2012. The whole situation sounds like a reality show for stock nerds. We took an activist fund manager with no previous CEO experience, and a brand-new management team, and gave them a struggling retailer to run...

The fiscal Q2 report (TUES fiscal years end in June) earlier this month, along with management reshuffling announced two and half weeks prior, strike me as a microcosm of the investment case here. Tuesday Morning grew comps 3.8% in the quarter, a pretty impressive figure for a retailer these days. Even more impressive was the fact that the company was going against a two-year comp stack of nearly 17% - and according to the Q2 call, it grew comps through a 4.9% rise in transactions, something even successful retailers aren't doing of late.

And yet TUES sits below $4, having completed a round-trip from $4 to $22 that began when Becker (then a principal at Becker Drapkin) took his initial stake in the retailer. With the revenue growth came more turnover in management ranks, more execution problems in the supply chain, further margin compression, and a Q2 call that seems to imply a longer timeframe toward any real operational improvement. While some of the strategic changes appear to have paid off in terms of comps, earnings continue to decline: Tuesday Morning actually now is unprofitable on a trailing twelve-month basis, after managing to eke out a profit for most of the past decade.

For now, I'm sticking with my hedged position (I am short puts, a position I rolled forward ahead of Q2), because I still see some potential in the long-term story. But even though I entered that position knowing that patience would be required, I admit I'm already getting a bit frustrated. The long-term case here isn't broken, but the time value of money matters, and even a solid turnaround plan can't work if the company doesn't execute.

Higher Comps And Lower Earnings

In at least one sense, Tuesday Morning's turnaround has been a roaring success. Same-store sales grew 3.9% in FY13, 6.1% in FY14, 7.2% in FY15, and 7.8% in FY16. Again, that type of growth is basically unheard-of in brick-and-mortar retail over that period - and, again, it's come from higher traffic. Even accounting for the relocated stores - which are better locations, with higher rents - both comps and transactions have remained consistently positive. And through what has been perceived as a disappointing first half, the trend has held, with comps up 4.3% on a 5.4% rise in transactions.

The problem has been below the top line. Adjusted EPS was $0.12 in 2012, turned negative in 2013 (-$0.02), and improved to a penny in 2014. 2015 looked stronger, at $0.24, but those figures were below expectations heading into that year. Earnings declined again in FY16, to $0.08, and now have turned negative again, even backing out one-time costs excluded from Adjusted EBITDA.

At some point, for TUES to salvage any value for the equity, there needs to be some leverage in the model. The company is on track for a five-year comp stack in the range of 32% (assuming a 4% full-year comp in FY17) - and yet earnings are likely to decline over that period. In Q2, gross margin declined 290 bps. On the Q2 call, CFO Stacie Shirley said supply chain issues led to costs that were double a previously cited $2-3 million. But even the high end of that range only implies ~180 bps of compression. SG&A deleveraged 80 bps as well, driven by higher rent and higher advertising.

For his part, Becker has said repeatedly that the turnaround will be a multi-year process, and that it won't be "linear". But that turnaround already has been a multi-year process, and even excluding supply chain problems, operating margin would have dropped 190 bps+ in the quarter. Again, the company is running tests on everything from marketing to staffing to logistics. The new Phoenix distribution center is supposed to be a key driver of margin expansion (guided under the previous regime to provide at least a 100 bps boost to gross margin) - once it's fully operational. There's probably more incremental improvement to come either from learnings from the recent tests and/or simply normalizing operations once those tests are complete.

But it's getting harder and harder to get away from the idea that Tuesday Morning's top-line growth simply is being purchased through higher rent, higher advertising, and lower markups. That has to call into question the viability of the turnaround plan longer-term. Furthermore, Q2 raises more concerns about whether the plan even can be executed properly.

CEO Concerns?

At this point, there have to be questions about whether a retailer led by a CEO with, ahem, no retail experience has a real chance of executing a turnaround. Turnover in the management ranks continues. Former COO Melissa Phillips was promoted through the ranks, then departed abruptly in January. Becker is taking on some of her responsibilities, and the title of President. The operational structure in the marketing department has been changed, with Becker taking control in that area as well. There was supposedly a new supply chain officer (the last one departed rather quickly), but instead Chief Information Officer Trent Taylor's title was expanded, with a senior vice president added to support him.

The issues at the Phoenix distribution center aren't welcome, in part because that DC was a core pillar of the original turnaround plan. Tuesday Morning had a single, outdated facility in Dallas serving what had become a national base; merchandise often was shipped from the Western U.S. to Dallas, only to head back several hundred miles in the same direction. That facility was supposed to be at full speed by now; the problems were supposed to be largely fixed coming out of Q1. Becker said on the Q2 call that there was a "perfect storm" in terms of the impact, but it also sounds from his commentary ("there's plenty of work to be done") as if the issues will linger, and the potential benefits not captured until FY18. Gross margin is guided to be down in the back half, likely further delaying the turnaround.

Even if this is a long-term plan, Tuesday Morning seems to be hitting repeated speed bumps along the way. And, in this space in particular, it's not just a matter of waiting another two or four quarters for the turnaround to succeed. Brick-and-mortar retail is a highly competitive, externally pressured industry at the moment. The longer it takes TUES to become a viable competitor to Pier 1 Imports (NYSE:PIR) or TJX Companies' (NYSE:TJX) HomeGoods, the less share it may be able to take once that transformation is complete. And the plan itself has to be called into question: what kind of learnings really come from testings in marketing if the department is turned over in the middle of the process?

The broader point is that it's getting more difficult to tell how much of the recent lumpiness is being driven by the bumpy nature of any turnaround, and how much is coming from disruption in executive ranks and in execution more broadly. The communication from Tuesday Morning doesn't help. There's no guidance, and a refusal to answer questions on marketing spend, category performance, and other details. The company released preliminary sales results in January, but didn't disclose higher-than-expected supply chain costs, which led to a big earnings miss in Q2 and further pressure on the stock. There are probably some valid competitive reasons for Tuesday Morning's reticence, but combined with the management turnover and execution problems it doesn't help the perception of the stock.

Valuation

All told, Q2 didn't help my bullishness toward the stock - and with TUES shares continuing to decline, clearly I'm not alone. The question with TUES has been whether the turnaround plan makes sense and/or will work in the long term. After a couple of quarters of operational questions and management turnover, there's a second question: whether this company, and this management, can execute that turnaround.

I still believe there's enough to stick around, at the lower price. As long as comps are growing, Tuesday Morning has a shot, and if the supply chain can get normalized, there's a potential for a snap-back in margins.

But I don't know when to expect any upside, one reason I'm uninterested in buying the stock (as opposed to the hedged position I hold at the moment). Certainly, the timeline seems to be stretching out, and there's a risk over CY17 that investors will lose patience altogether. Shirley did highlight the tough comparison in Q3 - 13.4% a year ago - which might have been an effort to lower expectations into that quarter. That raises some near-term risk: low-single-digit comps, a net loss, and continued supply chain problems could be a toxic combination for the stock, even with TUES trading below $4.

For now, I'll stick around - but that won't last much longer at the current rate. A patient attitude for the long term does little without better execution in the near term.

Disclosure: I am/we are long TUES.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short TUES 5 puts.

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Tagged: , Discount, Variety Stores, Earnings
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