Is Tuesday Morning on the Acquisition Block?

Jack Kleinhenz, chief economist for the National Retail Federation, recently said, "There is a lot of competition in retail, and they have very thin margins. There's going to be a sorting among retailers." Rumors around that sorting process may have already started, and this may be what's fueling Tuesday Morning shares.

See below for a chart of diluted EPS over the past five years for Tuesday Morning, Target, Big Lots, and Dollar General. That's Tuesday Morning down at the bottom, and yet its shares are up over 140%. Note that Target is at the top, but slowly trending down and Dollar General is making a slow and steady climb upward. For the most part, the stock prices of these retailers mimic their earnings, but not with Tuesday Morning.

TUES EPS Diluted (TTM) data by YCharts

A little context
Much of this post refers to fiscal year 2013, which for Tuesday Morning ended in June of 2013. It is also important to note that Tuesday Morning has been struggling with earnings for the past five years.

Big Lots is the the larger version of Tuesday Morning, from a business model perspective. Like Tuesday Morning, Big Lots is also struggling, but its stock price is struggling too.

Target is a large box retailer like Big Lots. While Target is a considered a "high-end" discount retailer, they've also had some difficulty with earnings, which have been declining over the past year.

The one shining star is Dollar General, with positive earnings growth on top of positive earnings.

Tuesday Morning, on the other hand, has negative earnings growth on top of negative earnings. Then, in the second quarter of fiscal 2013, the company wrote off approximately 20% of its inventory, earnings took a nose dive, and the stock went up even more. One possibility is that it's in play to be acquired. Another possibility is that the market likes inventory writedowns.

BIG data by YCharts

Inventory devaluation charge
In 2012 and 2013 Tuesday Morning made significant investments in inventory management systems, which resulted in "an inventory devaluation charge recorded in the second quarter of fiscal 2013 in the amount of $41.8 million. The effect of this charge was a 5% decrease in gross margin rate." To put that into perspective, without the writedown the company would have only announced a $14 million loss instead of a $56 million loss.

Big Lots recently announced that it was going to close down its wholesale and Canadian operations. The company expects $44 million to $47 million in asset writedowns next year, but then again Big Lots stock is moving in the same direction as its earnings -- down.

Let's back up for a quick overview on the writedown process and the effect of writedowns on earnings and inventory.

What is a writedown
In accounting, a business can purchase inventory and never have the purchase hit the income statement. The inventory is stored on the balance sheet and only charged against net income if it is sold. If the value of inventory declines, its value is marked down or written off. A portion of the inventory is then transferred from the balance sheet to the income statement and deducted from the cost of sales as if it were sold. As a result, there's a decrease in earnings even though no cash has exchanged hands. This is why permanent writedowns are referred to as non-cash transactions. The actual inventory is still sitting in the warehouse and will be sold at a marked-down price in the future.

When a company writes down inventory it is communicating two things: gross margin is about to take a hit, and someone overpaid for inventory or misjudged customer appetite. These aren't value added events. Some analysts may argue that a write-off is a non-cash transaction that doesn't affect company cash flows, and therefore shouldn't be counted against the future cash flows of the company. This would be a decent argument for why the stock didn't go down, but it's a stretch as an argument for why the stock went up.

The point is, there's absolutely nothing about a writedown that should add value to a stock's price.That doesn't mean it doesn't help.

What's happening now
Management shouldn't make a practice of writing down inventory, but if Tuesday Morning's management is implementing a new inventory management system, a one-time writedown is understandable. Perhaps the anticipation of the system implementation is what's driving the stock. Maybe the writedown is being interpreted as a necessary step to get the earnings it deserves. Or, maybe the new management is thinking about selling the company. Only time will tell.