One thing that bothered me when I purchased Trans World Entertainment Corporation (TWMC) was their earnings and cash flows.  Essentially, the business is seasonal.  The fourth quarter makes most of the company’s sales and all of its earnings.  So if they have a bad fourth quarter, they are toast.  

I also found their seasonal reductions to accounts payable not very comforting:

Cash used by operating activities was $172.8 million for the thirty-nine weeks ended October 29, 2005.  The primary uses of cash were a $106.4 million seasonal reduction of accounts payable, a $21.6 million reduction in income taxes payable, and a $46.5 million increase in merchandise inventory. The Company’s inventory and accounts payable are heavily influenced by the seasonality of its business. A significant reduction of accounts payable occurs annually in the fiscal first quarter, reflecting payments for merchandise inventory sold during the prior year’s holiday season.  Similarly, merchandise inventory increases each year throughout the fall season and peaks during the holiday selling season.  The seasonality of the Company’s earnings in its fiscal fourth quarter also results in the timing of substantially all income tax payments to be made subsequent to year end. These cash uses are offset by a significant cash source in the fiscal fourth quarter from the seasonal increase in sales during the holiday season (see Note 3 of Notes to the Condensed Financial Statements).

At first the seasonal reduction seemed like a normal course of business.  But after many months of thought, I have realized this is really just an obvious sign of a tough business where margins are thin and volume is everything.  Put another way: TWMC takes a huge risk every year by purchasing tons of inventory - with cash they do not necessarily have – and then hopes to sell it all during Christmas for a profit.  What would happen if there was a recession?  They could end up losing a lot.  Or they might not have any cash to pay their hefty inventory bills.  Or they would rack up a pile of debt.
 
Despite these factors, I ignored my instincts and took the risk.  Obviously that didn’t turn out very well for me.  Not just because the stock went down, but when it went down, I lost all confidence.  I realized I did not have a solid thesis for holding the stock other than it being cheap.  

Even so, the company is not that cheap.  Have you ever been to a Closing-Out sale?  That’s when a store going out of business has to get rid of their inventory by selling everything at a huge discount.  If you reduce TWMC’s inventory by 50%, the book value becomes $4.05.  Hmph!  All of a sudden Price/Book is no longer under one!  Not so cheap anymore!  Note to myself:  From now on, start reducing inventory by 50% in all calculations (unless inventory is a sellable commodity like oil or gold).

In short, these lessons cost me a 30% loss.  Can you still make money on this stock?  I think so.  Judging by their 2003 history, any good news will probably send TWMC rocketing.  But are there better opportunities with less risk?  I also think so.  And that’s where the cash will be redeployed shortly.