When we originally purchased Pier One, at what we believed were discount prices created by an initial miss of product trends, the company had material excess cash balances and was still generating excess cash flow (although diminished). We believed the out of favor product line was temporary, and if the company was successful in turning around its merchandise selection, a return to normalized margins could create excess cash flow potential of over $1.50 per share on a stock we purchased for an average cost of $14.76 a share between June 2004 and September of 2005. The company’s balance sheet had net cash of $100 million with no debt, and even though earnings were below former levels, the company was continuing to generate excess cash flow. The balance sheet and cash flow metrics provided the company with a financial cushion while it sought to redesign its merchandise selection and return earnings to former levels. As Pier One continued to struggle to find the right merchandising mix, excess cash flow turned negative, the excess cash margin was being drawn down and our margin of safety was being reduced. We began to worry about both the company’s ability to produce free cash flow and its deteriorating balance sheet. The company continued to have fashion missteps resulting in increasing inventories relative to sales and reduced cash positions. We reached a sell decision since we were no longer confident in our valuation based on predictable free cash flow, while the balance sheet was no longer providing us with enough support to withstand continued merchandising missteps.
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