RadioShack Doesn't Offer Much Hope

 | Jul 16, 2013 | 4:00 PM EDT
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Famed investor Benjamin Graham, author of Security Analysis and The Intelligent Investor, made a fortune from what he called "cigar butts." These stocks were often poorly operating businesses that sold for less than liquidation value. Graham would purchase those stocks with the hope that there was one last "puff" of profit left.

Not all of those investments worked out positively, but Graham would bet on dozens of stocks that were trading at less than book value, and hope for the best.

RadioShack (RSH) looks like a cigar butt. The firm's core operating business is rapidly deteriorating, the firm is generating negative free cash flow, and recent rumors suggest  that the company is hiring advisors to help shore up its balance sheet (some see that as the beginning of a pre-packaged bankruptcy). Of course, the company refuted the idea, saying it was only in routine discussions. The firm had $820 million worth of liquidity at the end of the first quarter.

Few businesses will admit whole-heartedly that the core business is failing and that liquidity has become an issue. Still, RadioShack's story is all too familiar. The company's business model is certainly in question. Further, operating cash flow is falling off a cliff, causing the company to invest less in stores, making stores even less appealing to consumers and perpetuating the operating cash flow problem.

RSH Operating Cash Flow
Company filings, Valuentum

RadioShack also has a large debt load that was manageable when the company's earnings were strong. However, debt becomes a huge hurdle when cash flow generation deteriorates.

Some may be convinced that recently hired CEO Joe Magnacca is the right man to lead the turnaround. The former Walgreen (WAG) executive seems to grasp the importance of a great store design. The company opened one of its newly remodeled stores in Manhattan, with the goal of drawing a younger crowd, but we likely won't get much commentary on the performance until the firm's next earnings call. It may be a step in the right direction, but we doubt it will matter much.

For one, RadioShack's business remains highly dependent on smartphone sales, which are going in the wrong direction at the company. From CFO Dorvin Lively on the first-quarter conference call: "The majority of the assortments in our stores and others are now, on a smartphone basis, much higher dollar amounts and typically at a lower gross margin rate."

In other words, RadioShack's smartphone revenue is growing while its gross margins shrink. Net-net, we believe that's likely a negative for the company. More importantly, everyone sells smartphones. Amazon (AMZN), Wal-Mart (WMT), Best Buy (BBY) and the mobile carriers themselves are selling smartphones. What makes RadioShack better than the competition? We really cannot identify anything.

Further, almost every competitor is in a stronger financial position than RadioShack, so if price wars were to escalate, RadioShack would be in the worst position to absorb lower gross margins.

The next obvious concern we have with RadioShack is finding a reason why the business needs to exist. Virtually all of the hobbyist items found at RadioShack can be found on Amazon or eBay (EBAY), often at lower prices. The rest of RadioShack's product assortment is really no different from that at any other consumer-electronics seller, and we simply do not see how it can compete with online retailers.

We already mentioned that everyone sells smartphones. Everyone also sells commodity computers and TVs. Though the company has survived a long time, we simply do not see a compelling reason for it to exist.

Though we doubt the remodeling efforts will be enough to drive consumers into stores, there is always a chance the turnaround could work (albeit a very slim chance). At this time, RadioShack doesn't have enough cash in its coffers to renovate its 4,000-plus stores, but that could change if free cash flow suddenly improves. This is an upside risk, but we doubt it will happen. The company has tried repositioning itself throughout the years (remember "The Shack"?) and failed.

The odds of Amazon taking over RadioShack are not high, but this is another upside risk. The thesis goes that Amazon could acquire a large store footprint to allow users to interact with Kindles and create mini-distribution areas to help boost the firm's same-day delivery service. RadioShack's 4,000-plus locations and inventory overlap could make it a compelling acquisition target.

But we're not getting too excited about this idea either. Barnes & Noble (BKS) could easily shutter many of its stores in the coming years, and Sears Holdings (SHLD) will likely divest favorable operating leases in the near term. J.C. Penney (JCP) could also shrink its store base if results flounder. In short, there will be plenty of real estate (if Amazon wants it), and we do not see why RadioShack's footprint is more attractive -- especially since stores wouldn't have excess room for storage.

As an operating business, we do not believe RadioShack is worth much. Our fair value estimate range is $1 to $3 per share, and we see a 2.28% chance that the equity is worthless.

We note, however, that its net (book) value remains above the current share price, even when we take a large haircut to the value of its net plant, property and equipment and inventory balances. Though we believe PP&E is likely worth less than its value on the balance sheet, given the relative unattractiveness of much of the firm's store footprint, the firm's net asset value is still positive at this time.

RSH Net Asset Value
Company filings, Valuentum

Still, we don't believe that valuing RadioShack on a net-asset-value basis is an accurate way of evaluating the business.  We are confident that it will not simply close shop and give the remaining proceeds to shareholders (or get bought out as an operating entity). Rather, we believe the company will continue to operate and experience further deterioration in its fundamentals. If this occurs, its cash balance could fall meaningfully.

Ultimately, RadioShack's core business is crumbling, and rumors of the firm needing additional liquidity lead us to believe that second-quarter results will be weak (with potentially negative free cash flow). We're steering far away from the shares.

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