How Do You Get 140% Stock Growth on Negative Earnings?

Inventory selection and management is the key to top-and bottom-line growth for retail, especially discount retailers. Tuesday Morning  has experienced a 140% return this year, which surpassed the returns of Big Lots  and Target .

BIG Chart


BIG data byYCharts

Profitable discount retailers have to be good at selecting inventory
Have you ever watched one of those reality TV shows about pawn shops? The pawn shop loses money if it pays too much for inventory. The key to profitability is buying the right inventory at the right price. Tuesday Morning and Big Lots are no different.

With 820 stores in 42 states, Tuesday Morning isn't your average discount retail shop. "We provide an outlet for manufacturers and other sources looking for effective ways to reduce excess inventory resulting from order cancellations by retailers, manufacturing overruns, bankruptcies and excess capacity," says management. In other words, the company's business model is no different from that of a pawn shop; it buys excess inventory and sells it for less than department stores sell it for. This makes the process of selecting inventory -- deciding what to buy and what price to buy it at -- absolutely critical to profitability.

Rapidly declining ROA
Due to the nature of the retail business model even higher-margin stores like Target must be concerned with the movement of inventory. Since inventory represents such a large portion of assets for both high- and low-margin retail, the management of that inventory is critical to earnings growth.

One of the most commonly used measures of efficiency is return on assets, or ROA. In general, the higher the ROA, the more efficient management is considered to be at managing the company's assets, namely inventory. Tuesday Morning is that red line at the bottom of the following graph. It's been at the bottom for the past five years and took a nose dive in 2012.

BIG Return on Assets (TTM) Chart

BIG Return on Assets (TTM) data by YCharts

Write-downs increase sales transactions and decrease profitability
While Tuesday Morning has negative earnings and a declining ROA, it has one of the best same-store sales growth rates in the industry at 9.1%. That's right, negative earnings combined with high same-store sales growth rates equals a stock price that's up over 100% -- go figure.

When you see this scenario in retail look for write downs -- write downs increase sales transactions at the expense of earnings, which makes them a great tool for managers to kick-start sales growth. However, this is a bad business plan because eventually analysts catch on.

So to recap, in exchange for 9.1% same-store sales growth, Tuesday Morning marked down inventory by approximately 26%, which falls directly through to earnings. "The effect of a 0.5% permanent markdown in the value of our inventory at September 30, 2013," said the company, "would result in a decline in gross profit and an increase in the loss per share for the fiscal year ended September 30, 2013 of $1.3 million and $0.03, respectively." The company wrote down inventory by $41.5 million, which means inventory was marked down by approximately 20%.

That accounted for ($1) of the ($1.30) earnings per share loss. The company attributed the rest of the EPS shortfall, approximately ($0.30), to additional markdowns. In other words, when combined with the original write down, buyers spent approximately 26% more on inventory than they should have, which is a big issue.

So, what's fueling the current stock growth?
At the heart of the bottom-line growth for Tuesday Morning and top-line growth for Big Lots is inventory. It doesn't matter how good a pawn broker is if the pawn shop overpays for inventory.

Tuesday Morning is the blue line at the bottom of the graph. You will notice it's going in the exact opposite direction of the stock price, which is a bit of a conundrum.

TUES EPS Diluted (TTM) Chart

TUES EPS Diluted (TTM) data byYCharts

The inventory management process is critical for discount retailers, and Tuesday Morning is among the few that's concentrating on making improvements to its buying strategy. The company recently installed a new inventory management system that provides sales and inventory reporting on a daily basis. If the new system can help the company to implement a more efficient buying strategy (read: one that eliminates the need for costly write downs), it may be able to create the earnings needed to support the current stock price.

Which company is killing off old-school retailers?
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

The article How Do You Get 140% Stock Growth on Negative Earnings? originally appeared on Fool.com.

Fool contributor C Bryant has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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