If you walk into a Tuesday Morning store, you might not be all that impressed.  It’s the epitome of closeout stores, a kind of higher-end Big Lots, or rich-man’s Family Dollar. The merchandise in this case is typically upscale home furnishings, house wares, gift items, some toys, and a very limited selection of sporting goods, to name a few.  But, this retailer, which is not small with more than 840 stores in 47 states as of last June, continues to chug through this recession.  What’s more, the company is a net/net.

It was a net/net 5 weeks ago when it hit a low price of $.51, and it’s still a net/net today, despite the fact that it’s up 319% since then.   The company was profitable on a trailing twelve month basis through December, although that’s likely to change when the company reports final third quarter numbers on April 27.

Yet shares have surged, due in part to a rising market tide, perhaps a light at the end of the economic tunnel, and the fact that Q3 sales dropped a better than expected -6.4%, while same store sales fell 9.5%.  The company, although light on details until the earnings call (other than that sales fell to $167 million from $178.4 million for the quarter; and earnings will be in the -$.15 to-$.17) also announced that trends and customer traffic appear to be improving.

With current assets of $278 million and total liabilities of $118 million, Tuesday morning’s net current asset value of $160 million is far in excess of its $91 million market cap.  Although operating in a treacherous retail environment, the company carries just $2 million in long-term debt.

Of course, retailers that don’t own their real estate, as is Tuesday Morning’s case, typically have operating leases, which don’t show on the books.  Tuesday Morning currently has $190.5 million in operating leases, which can’t and should not be ignored.

But, at its current price of $2.10, Tuesday Morning is trading more or less as a call option on what was once a pretty decent business; a call option on a pickup in the economy and consumer spending. It’s certainly not for the faint of heart, but net/nets, especially retail net/nets usually aren’t.

Tuesday Morning
Ticker: TUES
Price: $2.10
Market Cap: $91 million
Net Current Asset Value (NCAV): $160 million
Mkt Cap/NCAV: .57
P/E: 74 (through December)
Cash: $5.8 million
Debt: $ 2 million
Enterprise Value: $80 million
Locations: 842 (June, 2008)
Price/Book: .37

Jonathan Heller, CFA
Position:  Long TUES

Common stock investing is inherently risky, and those risks cannot be divorced from the rewards that come with them. Often, it isn’t easy to separate the speculative from the investment component of a common stock commitment. On this topic, Ben Graham, author of the classic The Intelligent Investor, has written most clearly:

Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing;  (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

With that caveat, here’s Wellcare Group (WCG), a stock that has a reasonable chance of going higher once its legal problems are resolved and its earnings normalized. As such, it may present an intelligent speculation.

First, a quick background. Wellcare is a healthcare management organization focused on Medicare and Medicaid, government-run entitlement programs for the elderly and low-income population. It has over 2.5 million members enrolled in its programs nationwide, with a large portion of them in Florida.

Its stock hovered around $120 per share when in October 2007 about 200 FBI agents raided its Tampa campus. The stock collapsed to $40, wiping out $3.3bn in shareholder value. The uncertainty was large; there was no official word of what the FBI raid was for, although newspaper reports stated that one of Wellcare’s subsidiaries had overbilled the government by $35m. In this context, the share price collapse was wildly overdone.

A quick resolution of the problem didn’t happen. Instead, the company went “dark,” not filing its quarterly and yearly financial statements and risking stock exchange delisting for its non-compliance. Periodic SEC filings kept shareholders apprised of the slow progress, but it wasn’t until early 2009 that things became clearer. The company finally filed all of its late financial statements and set a shareholder’s meeting – the first since the FBI raid – for July 30.

Wellcare is well capitalized. As of 12/31/2008, it had about $1.2 billion in cash and $153 million in debt. This debt proved to be another Achilles heel for the stock. When the company reported in 2008 that it was in technical default for not having filed its financial statements, the price dropped precipitously yet again. Fairholme Capital, which owns nearly 20% of the stock, bought a majority of the debt, likely in a move to protect its equity investment.

Throughout this misadventure, the stock has swung wildly, hitting a low of $6.12 in November and $6.23 in March of this year. Yet Wellcare’s core business remains sound, generating substantial free cash flows. The exact number for 2008 involves reversing a goodwill write-down and removing a non-recurring $103m in litigation expenses, but a normalized estimate of $4 in free cash flow per share is probably on the conservative side. While there is significant regulatory uncertainty surrounding its Medicare and Medicaid businesses, at the current price of around $13.80, it’s hard to find a way to lose.

Yet all of these uncertainties – particularly those surrounding the FBI investigation – are still large, which is where the speculative component of this investment comes in. There might be a probability of the government’s penalties being larger than expected. The company is also facing various lawsuits related to its illegal activities, including a class-action lawsuit. Defending against these will cost management’s time and shareholders’ cash.

On the other hand, Wellcare may soon begin conducting conference calls with shareholders and analysts, may soon settle with the government by paying a fine, and may ultimately get sold to a larger competitor, such as UnitedHealth Group. After it fired its disgraced former management, the board brought in Charles Berg, formerly a UnitedHealth executive, Oxford Health Plans CEO and “deal guy.”

With these factors in mind, and taking into account Graham’s three points above, Wellcare may seem like an intelligent speculation after all.

Marcelo P. Lima is a securities analyst. He may be reached at MPL4@cornell.edu

Lamar Advertising (LAMR) is an outdoor advertising company with a large network of billboards (over 150,000). Fear that LAMR may default on its senior credit facility or may be unable to meet its obligation on its converts maturing 12/31/10 pushed down the prices of all of company’s securities. This fear drove LAMR’s equity value down over 50% in 4Q08 while its senior subs and converts began trading in the high-60s to low-70s. The fear of default reached a high point during 4Q08 and the company felt compelled to include a supplemental indebtedness schedule in its press release for 3Q08 results to address a “certain amount of misunderstanding and misinterpretation with [LAMR's] credit agreements and [its] outstanding debt.” As described on the 3Q earnings call, “There are three common misunderstandings in the investment community.” Two of these market misunderstandings pertain to whether the company will violate the debt-to-EBITDA covenant in the credit agreement controlling the senior credit facility (the “Credit Agreement”) and whether LAMR will be able to pay its debts as they come due. In the past month, a series of corporate events have transpired that support a scenario that could prove favorable to equity: LAMR survives any violation of the debt-to-EBITDA covenant and is able to pay off the converts, its nearest maturity debt obligations.

As described by management, the number one market misunderstanding “is that our senior credit facility total debt ratio test steps down from 6-to-1 to 5.75-to-1.” The stepdown to 5.75-to-1 from 6.00-to-1 in LAMR’s debt-to-EBITDA (the “Total Debt Ratio”) is listed on page 95 of the original Credit Agreement, dated 09/30/05, controlling the senior credit facility. On the 3Q08 earnings call, management stated the stepdown was “in the original agreement and we amended that ratio to remain at 6 to 1 for the life of the credit agreement . . . It is at 6 to 1 today and will remain 6 to 1 for the life of the loan.” What created this market misunderstanding? While not entirely sure, we’ve noticed that although page 87 of LAMR’s latest 10-K clearly lists three amendments to the Credit Agreement as exhibits 10(g)(2), 10(g)(3), and 10(g)(4), Capital IQ only lists the first amendment among the “Security Holder Rights and Agreements” in LAMR’s “Key Documents” section. This may be a source of market misunderstanding, since it is the third amendment, dated 03/28/07, to the Credit Agreement that states, without qualification, “The Company will not permit the Total Debt Ratio at any time to exceed 6.00 to 1.”

“The second misunderstanding is that [LAMR's] convertible notes . . . are included in total debt for covenant calculation purposes.” What created this market misunderstanding? There’s nothing to indicate that anything beyond the Holdco / Opco, Lamar Advertising / Lamar Media structure is to blame. The Credit Agreement only includes debt at Lamar Media for the Total Debt Ratio covenant. Lamar Advertising is the borrower on the converts due 12/31/10 that aren’t included in indebtedness for the Total Debt Ratio covenant.

The importance of the Total Debt Ratio has become particularly relevant. On 03/19/09, LAMR announced that it was “in the process of seeking an amendment to [its] senior credit facility,” and it was proposing a private placement of senior notes. The offering size of the senior notes was increased on 03/20/09 to $350 MM from $250 MM and offered at 89% of face value with a 9.25% interest rate (for a 12.56% YTM). Following on the stated purpose of the private placement to repurchase some or all of the converts, LAMR made a tender offer, expiring 04/17/09, for the converts at 92. The converts were trading around 75 immediately preceding the tender offer. The new senior notes are at the Lamar Media level and will count towards the Total Debt Ratio. Pro forma, as of 12/31/08, LAMR’s Total Debt Ratio would have been at 5.6-to-1. This has driven the company to seek an amendment.

Although management previously believed a 2009 with revenues down 10% YOY would constitute “the bottom falling out,” they mentioned that they’d never experienced that type of drop and would have to manage the two biggest costs: headcount and lease expense. Management also that stated that they weren’t planning on having to aggressively cut those costs in order to offset a (10%)+ decline in revenue. Now management is forecasting revenue down (15%) for 1Q09, and they’ve already begun drastic cost cuts (see the 4Q earnings call): 10% of the workforce has been cut and lease renegotiations have saved $10 MM on an annualized basis. All in, management estimates a (5%) decrease in opex.

Notwithstanding these significant cost cutting measures, that forecast indicates increased chances that EBITDA decreases swiftly and leads LAMR to violate its Total Debt Ratio covenant. With LAMR having cut back its digital deployment strategy and placed itself squarely in free cash flow generation mode in order to delever, the company’s lenders are likely to be willing to amend the senior credit facility. Management has stated that the bank group has said they’ll work with LAMR on an amendment—while obtaining a higher interest rate and taking in a pound of flesh in fees. JP Morgan is the administrative agent on the senior credit facility and led the purchase of the new senior notes, taking 60% of the issue (see Schedule 1 in the Purchase Agreement).

If an investor gets comfortable with the covenant default/amendment situation and the potential scenarios, a very simple estimate of EBITDA for 2009 of $400 MM and a stated maintenance capex of $15 MM puts LAMR at 10x its depressed 2009 free cash flow, assuming a (15%) decline in revenues for 1Q and (10%) for the balance of 2009 and a (5%) decrease in opex from 2008. Although LAMR is experiencing one of the worst environments it’s ever faced, one which management has never experienced before, it has an irreplaceable network of billboards with an opportunity for attractive incremental returns, beyond 2010, from investment in digital billboards and significant operating leverage through higher occupancy.