Radio Shack (RSH)
There have been a number of articles and blog posts discussing whether Radio Shack is a true value investment or is just a value trap. I’m not sure it’s possible to know which it is a priori. My investment thesis regarding Radio Shack is that if you buy in at a low enough price and you monitor what’s going on, there is a good probability (say 3x upside vs. 1x downside) of earning a decent return. Worst case, I think, is that you find yourself with ‘dead money’ for a couple of years, and in these times of low interest rates ‘dead money’ is not so devastating. But the real question, then, is what is the ‘low enough price’? That’s what I’ll attempt to lay out for myself here in this post. As I wrote in my last post, I’ve taken a small initial position in Radio Shack. I fully expect the share price to decline further, maybe much further, and I’m also factoring in a cut or elimination of the dividend. I’m fully prepared for current operating problems to get significantly worse before they get better. In sum, if you, like me, are considering an investment in RSH shares, you better have a strong stomach and lots of staying power.
Though I’d looked at RSH a few times over the past year, I only became seriously interested a couple of months ago when I noted that Francis Chou has a significant position (3.6% of his portfolio) which he had purchased in the 2nd quarter of 2011 and added to in the final quarter of last year at prices considerably higher than the then-current price. I promised myself, though, that I would show restraint. Given the poor financial results of the 4th quarter and the announcement that in all likelihood there would be an operating loss for the first quarter of 2012, there was no reason to begin a position immediately. I figured that end-of-quarter window dressing would keep negative pressure on the share price. Furthermore, the shares were trading around book value of $7.59 and, given my investment hypothesis, I felt I needed a significant discount to intrinsic value if I wanted a margin of safety. As you know I’m not a DCF kind of guy but rather an asset based investor. This being retail, actually the former is probably more appropriate, but you can’t teach an old dog new tricks; I have always liked to use tangible book value as a proxy for intrinsic value, so that’s what I did here. I set an initial entry target price of 80% of year-end 2011 book value, about $6.00, well aware that book value continues to deteriorate. We hit that price last week. Well, almost; I give my enthusiasm a bit of leeway and set a limit price of $6.07.
Before I take a closer look at valuation, I want to provide some share price history. I think this is important when used in conjunction with historical operating performance, though not necessarily as an indication of future share price. Also this kind of explicit review brings into consciousness potential biases based on recent share price movements, for example, the fact that one year ago RSH was selling for $24 a share doesn’t mean that today’s price of $6.00 makes the shares a bargain. The company could simply be in terminal decline. Similarly, just because the share price has been in decline over the past year doesn’t mean it will continue to decline. Viewing share price over a longer period, say the past 15 years, can more helpful and aid in dispelling such biases. In the case of Radio Shack, shares traded as high as $75 during the internet bubble, before falling back to the $18 range in 2003. More interesting perhaps, is that the share price has followed a pattern of alternating lower lows and lower highs every two or three years; the share price rose after 2003 to a high of $35 only to fall back to the $14 range in 2006, then made another high in 2007 close to $35 before falling again to $6.70 during the 1st quarter of 2009, the equity nadir of the financial crisis, before once again rising to $24 last year. Looking at the 15-year chart of RSH share prices, one immediately sees that despite the long-term decline, there have been a number of periods during which the share price doubled, or even tripled. One might surmise that such an occasion could well be recurring currently. It should be remembered, however, that this is all very anecdotal, and in no way do I believe that past price movements have predictive power.
Now let’s move on to more important things, like earnings, financial position and cash flow. I’ll lay out a few of what I consider the more salient data points from the 2011 annual report. You should, in any case, read the whole thing yourself, as the annual report is quite clear and succinct (not like the Gramercy Capital AR!).
The company runs 7,000 US outlets of which about 4,500 are traditional Radio Shack stores. It also has a growing (though slowly) international presence in Mexico and has committed to expand in Asia with a partner. The company had revenues of $4.4 billion in 2011 and more or less $4 billion each of the prior 4 years. Operating income was about $350 million annually during the years 2007-2010 , falling to $155 million in 2011. Likewise, net income averaged about $200 million annually in 2007-2010 then fell to $72 million in 2011. If we took the $200 million annual earnings achieved over the 2007-2010 period as normalized earnings, with today’s share count that would equate to about $2 per share. An 8-10x multiple on those earnings would imply a share price of $16-$20. Just for a point of reference, mind you!
The balance sheet is as straight forward as the income statement; Cash of $600 million, accounts receivable of $350 million (about equal to accounts payable), inventory of $750 million and fixed assets and other assets of $370 million offset by $315 million in accrued expenses and $670 in net long-term debt. This leaves about $750 million in shareholder equity. There are just under 100 million common shares outstanding, down 25% from the 135 million shares outstanding 5 years ago. As usual, share buybacks were effected during periods when the share price was significantly above book value and so were dilutive. [When will management, and here I mean all management not just RSH management, learn that buybacks are to be made only when shares trade below book value or, at least, intrinsic value, this latter only when SIGNIFICANTLY below a transparently calculated intrinsic value!]
Looking at returns and return hurdles, if we assumed a return to 2007-2010 profitability, net income of $200 million (certainly not a given, though), this would imply a return on equity of 27% (200/750). A fantastic return in my book, but rather unlikely to be sustainable in the long run for a company with such a narrow moat (or is it?). Likewise, calculating a ROIC using the 2007-2010 operating income averages (and assuming 80% of current cash balances are not needed) one comes up with an equally unlikely 23%. Now, these kind of returns for a stock selling at a fraction of book should be an investor’s deam. Given where the shares trade today, it seems abundantly clear that Mr. Market doesn’t think these kind of returns can be achieved again by RSH management!
Back on the balance sheet for a moment, there is a question of liquidity. The $700 million in long-term debt is comprised of a $325 million note with a 6.75% coupon due in 2019 and $375 million in convertible debentures with 2.5% coupons due in 2013. Likely there will be some funding issues next year when the convert comes due as it is unlikely to be converted (exercise price of about $23 per share). Of course, management can simply repay the debt with cash on hand, but this could significantly reduce the company’s financial flexibility at a time when they can least afford it.
Turning to the cash flow statement, it is equally simple and clear; cash increased last year by $20 million net of $115 million in share repurchases and $50 million in dividends paid out.
So what is the problem at Radio Shack and can it be solved? It appear the question is one of margins. Radio Shack maintained its profitability over the last two decades by transforming itself from a hobbyist parts store to an accessory and mobile phone store. It’s ‘moat’ for the former was the number of outlets, the immediate availability and relatively wide range of product and the quality of its knowledgeable sales force. I would venture that these have become more important, and the moat perhaps deeper, as internet purchasing has increased. Unfortunately this higher margin business has been shrinking and has been replaced by the lower margin mobile phone sales and service. The moat on the mobile phone side is significantly narrower (and shallower). Think of the competition; each service provider has its own dedicated network of sales and service outlets. Then there are the small independent retail stores. In addition, with the advent of iPhones, manufacturers are beginning to develop their own retail outlets, a la Apple store. Is there room in there for a Radio Shack? I think so. It is a multiple service provider outlet but one with a well-known brand name. Can it capitalize on this very narrow moat? That’s to be seen. Last year it stumbled when Sprint-Nextel changed their sales structure. Radio Shack responded with a sales agreement with Verizon. Will this be enough? I don’t know but I’ll be digging a bit deeper into the operational problems as we progress. I hope to do another post on this before I make any additional investment.
So what is my short term strategy? Right now I’m thinking of building a position around $5 a share. (Note: this could change in a heartbeat so don’t count on it!) If Mr. Market reacts badly to 1st quarter results this might be possible. And were the price to fall below $5 I might even see a further sell-off, as some institutional investors might be forced to exit their position due to their investing guidelines. This could happen in the near future or in the next six months to a year; timing has never been my strength. In the meantime, patience. I’ll be continuing my analysis of the company’s retail strategy waiting for the right moment to take a full position.Oh! and I’ll be taking a closer look at insider ownership and transactions in the next post as well.