Radioshack: Materially Undervalued
RadioShack is one of the largest retailers in the country when measured by number of stores, with over 6,000 locations. I’ve mentioned RadioShack (RSH) several times, but I don’t think I’ve ever coherently put all my thoughts on the retailer down in one place. Now is as good a time as any, so I want to share my thoughts on RadioShack, one of my portfolio’s largest holdings.
This article will break into four sections: valuation, misconceptions about the future of the industry, why I like RadioShack better then Best Buy (BBY), and future growth. I’m going to assume the reader has some familiarity with RadioShack and the consumer electronics industry in this article, but feel free to email me or post any questions as comments.
My core thesis regarding RadioShack is the company is trading at an incredibly discounted valuation despite being in an incredibly strong position for the long term and having a history of incredible returns on capital. The company is buying back shares hand over fist (seriously, they repurchased almost 15% of shares outstanding last year) at attractive valuations, and the CEO’s retirement should serve as an effective catalyst for either 1) transitioning the company to growth mode or 2) putting the company in play.
Here are some highlights from RadioShack’s past nine years.
(Note: all numbers in $m. All numbers from RadioShack’s 10-k, except free cash flow, which I took from morningstar.com.)
Before we begin discussing this, know that I used the average shares outstanding computation for my shares outstanding number. Due to the significant amount of shares repurchased in 2010, if I had used diluted shares outstanding at year end, the number would be 108 million outstanding, not 123. Just worth noting.
Anyway, the first thing that jumps out at me is, while variations have occurred, revenue, assets, store count, operating income and EBITDA are all basically the same over this entire time period (excluding 2006). While the overall trend is slightly down for everything, a big piece of that is due to a much weaker retail environment and a large amount of store closures over this time frame. This is a consistent, profitable business—pretax ROA (which I will define as operating income/total assets) has averaged 17% in this time period, and over 18% if 2006 is excluded. Even including 2006, 17% pretax ROA is incredible. Few businesses can make that sort of return consistently, and RadioShack has been doing it for years.
So what happened in 2006 that made it such an outlier? Basically, management had begun focusing too much on growing store count instead of growing profitability, and the company grew unwieldy and less relevant. The new management team, spearheaded by Julian Day, was brought in and focused on closing unprofitable stores, liquidating slow moving merchandise, and centering RadioShack at the center of mobile and smartphone sales. You may remember Julian Day as the man who spearheaded K-Mart’s turnaround and ultimate sale to Sears.
With 108 million shares currently outstanding and a share price of $14.5, the company currently has a market cap of $1.56B. The company had $569 million in cash and $640 million in debt at the end of 2010 for a net debt figure of $71 million. I actually think this slightly overstates their debt, as the company had a slight inventory/AR build up and A/P decline (in total, it sucked up ~ $110 million in cash. My guess is that this was caused by T-Mobile issues discussed later), but for conservatism sake let’s use the $70 million. This would give RadioShack an EV of ~$1.63B.
Now, by far my favorite valuation metric is EBITDA–maintaince capex (MCX). Unfortunately, it’s often difficult or nearly impossible to estimate MCX without the company providing it. I had previously estimated MCX ~$80 million, as capex had come in around that point for approximately the last five years. However, in an interesting new line on their 10-k, the company states:
“We anticipate that our capital expenditure requirements for 2011 will range from $100 million to $125 million. The nature of our capital expenditures is comprised of a base level of investment required to support our current operations and a discretionary amount related to our strategic initiatives. The base level of capital expenditures required to support our operations ranges from $40 million to $60 million. The remaining amount of anticipated capital expenditures relates to strategic initiatives as reflected in our annual plan.” (from page 29, under the "cash requirements" section)
I have checked their past 10-Ks, and they have never broken out MCX like that before. I interpret this as a the company trying to send a big sign to analysts and the investor community. I feel like this is the company saying, “We just repurchased $400 million and the stock market still doesn’t believe we’re undervalued. Here you go—here’s how much it takes to run our business. Plug it into your models and look at how much excess cash we generate. How in the heck are we getting this valuation?”
RadioShack has TTM EBITDA of $460 million and nine-year average EBITDA (from 2002-2010) of $484 million. With MCX of $40-60 million, this would place EBITDA – MCX somewhere between $400 million–440 million. Let’s be conservative and use the bottom valuation, $400 million. With EV at $1.63 billion, you are purchasing a company averaging 17% pretax ROA (and well over 20% ROE) for a tick over 4x pre-tax cash flow (note: the company may be slightly more working capital intensive now due to their focus on wireless forcing them to increase their A/R. If you are truly concerned about this, bump them up from 4x cash flow to 4.5 or 5x cash flow. It doesn’t matter—the company is still incredibly cheap).
How cheap is this? Most acquisitions in the retail space (i.e., J. Crew, Jo-Ann Stores, Gymboree, etc.) are taking place around 7-9x EV/EBITDA (not Ebitda–MCX, like we just estimated. Plain EBITDA). Obviously, those stores operate in a different retail sector than RadioShack. However, their historical financial ratios (ROA, ROE, ROIC, etc.) were more or less equivalent to RadioShack. Applying the low end of the valuation (7x EBITDA) would come up with an EV of $3.15 billion, which would imply a stock price almost double today’s level (a shade over $28.50). I can’t imagine an investment bank could sign fairness opinion at a level lower than 5.5-6x EBITDA and keep a straight face or maintain its reputation. Even at that multiple, the EV would be $2.53 billion, which would give a stock price of ~$22.75 per share.
You can slice these numbers up anyway you want, but however you look at them, I think you will see that the equity is offering an incredibly discounted valuation at today’s prices.
Misconceptions about the future of the industry
So how does a company earning such incredible returns trade this cheaply? It’s actually not just specific to RadioShack. The whole industry (Conn’s (CONN), Best Buy (BBY), hhgregg (HGG), Gamestop (GME) trades for rock-bottom valuations, though Conn's is also related to some internal funding problems. Investors are concerned about the future of the industry. Basically, consumers can go into a Best Buy store, find the item they like, look it up on their smart phone, and purchase it from amazon for a lower price. Walmart (WMT) and Target (TGT) are also entering the electronics industry hard, specifically the larger electronics items (think TVs).
Finally, investors are concerned with the lack of upcoming big products to drive a new sales cycle, and also about the drop off from eventual loss of DVD/CD/videogame/GPS device sales and compressed margins from deflation in the bigger ticket items.
While these concerns are all valid, I think they are (for the most part) either myopic or completely inapplicable to RadioShack. The concern over upcoming product cycle is short-sighted because the purchase of a stock should not be based on a three- or six-month sales cycle, but rather on the future of the business and the cash flows/profits it can generate. If there’s anything we’ve learned about the electronics industry, it’s that there is always a new “hot” product on the horizon. Maybe it won’t be today or tomorrow, but it’s coming, and when it does, all of the electronic sellers will benefit. Additionally, doesn’t that ignore smartphones and tablets? Sales of those two are going gang busters and don’t seem set to get anything but stronger, though Wall Street seems to ignore that.
It’s true that the Amazon (AMZN) threat is real, but I don’t think it will ever completely cut into the retailers. Many people (including me) like to go to the stores and try the products out before they buy them, and once they’ve tried a product out, they’d rather purchase it right then and there because 1) they are impatient and 2) they want to make sure they are getting the right product. I heard the argument that online was going to destroy traditional sales back in 1999. It wasn’t true then, and I doubt it’s true now. Sure, it will continue to grab a larger piece, but there will always be a larger chunk going to “in person” retailers. There’s also the question of taxation—Amazon currently doesn’t pay sales taxes on any of their sales. I bet that changes as cash strapped states look to increase revenue, and that should present a somewhat more even playing field for the in-store retailers.
How about the threat of Walmart (WMT) and Target (TGT) in larger electronics, or the loss of videogames, Dvds, etc? I’ll address those in my next section.
Why I like RadioShack better than Best Buy (and the others)
Ok, so both Best Buy and RadioShack trade at dirt-cheap valuations, and Best Buy has a history of stronger ROE, better brand name, etc. I think investors in Best Buy will do just fine over the long term. So why do I like RadioShack more?
Quite frankly, I think RadioShack’s business model for the future is much better positioned. I see a threat of continued price deflation and huge competition from Walmart and Target in the larger consumer electronic items (such as TVs). Best Buy has tons of exposure to that area. RadioShack has almost none. Video games, DVDs and CDs will all likely become obsolete, replaced by digital distribution. Best Buy derives 20%+ of its revenue from those areas, and relies on them to drive traffic to its stores. RadioShack derives almost none (true, they get some of it from GPS, which will go away, but are easily replaceable).
Looking into the future, electronics items are getting smaller and smaller. As the massive amount of space devoted to video games, DVDs and CDs gets freed up, what is Best Buy going to replace them with? It seems to me like Best Buy’s huge superstore format is geared more for the electronics industry of 1990–2009, not the future. In contrast, RadioShack’s smaller category seems fit for the tablet and smart phone age. I mean, perfectly. From virtually nothing in the late 1990s, RadioShack has built wireless phone sales into 50% of its revenue in ten years. Their small store-size is really custom built to display mobile phones/tablets, and it shows in their wireless results. As electronics products continue to shift to smaller and more diverse platforms, RadioShack’s store base is custom built to capitalize on that trend.
How about management? Best Buy’s management is great, and they’ve done a good job of capital allocation. However, their international ventures have been disastrous, and their acquisition history has been spotty. In contrast, RadioShack (outside of the disastrous CompUSA acquisitions years ago) has largely stuck to its core competencies. While I wish they would leverage the balance sheet more to repurchase more shares at today’s prices, I really can’t argue with Julian Day’s allocation methods, and I think his right-hand man/replacement will do an excellent job of following in his footsteps in this regard.
On a more company-specific basis, RadioShack is cheap because of fears over brand relevance, troubles with their T-Mobile contract, the fact that they don’t carry Verizon/Apple, and fear of losing Sam’s Club kiosks. I think those will all prove to be short-termed fears that are actually long-term growth opportunities.
T-Mobile contract: RadioShack informed T-Mobile that they were in breach of their contract with RadioShack. In fact, RadioShack blamed their entire fourth quarter / full year’s earnings miss on weak T-Mobile sales (which lead to the contract breach). I think this is a pretty short term issue- RSH has a history of constructively working with their wireless partners, and they are too important of a distribution point for T-Mobile to let them go. If they can’t figure it out, AT&T’s acquisition of T-Mobile next year will likely make this fear moot.
Loss of Sam’s Clubs kiosks: At year-end 2010, RadioShack operated 417 mobile phone sales kiosks within Sam’s, down from a peak of ~600. The kiosks were profitable, and Sam’s informed RadioShack that they would be taking them over during 2011. Obviously, this is disappointing, and it will result in a $10-20 million hit to RadioShack's 2011 operating income. However, as a replacement, RadioShack signed on to operate mobile kiosks within all Target stores. This is a huge opportunity- by the middle of this year, they will be in almost 1,500 stores. Maybe the kiosks won’t be quite as profitable as the Sam’s Club kiosks, but there are so many more of them that they should drive huge incremental revenue and profit gains from the kiosks section. This also leads to the next fear.
They don’t carry Verizon or the Apple iPad—well, now they carry Verizon. The kiosk category sells Verizon phones, which should eventually lead to them negotiating with and selling Verizon in their stores (note, they did previously sell Verizon in their stores, but replaced them in 2006). Once they have Verizon in their stores, it seems a given that they would eventually carry all Apple products.
Future of the brand: People are scared about where RadioShack fits in the industry longer term. Honestly, I think they could be a dominant player. I’ve long suspected that the returns wireless carriers earned on their retail store fronts to be pretty minimal. This seems to be confirmed in the T-Mobile acquisition—one area of “synergy” potential is shutting down most or all of the T-Mobile retail outlets. Think about it—these guys aren’t in the retail business, and the retail locations are probably a source of constant customer dissatisfaction. Unless you (as a consumer) are completely married to your wireless carrier, why not shop at RadioShack, Walmart, Best Buy, etc. where you can compare all carriers, contract plans and phone options, and do so in a much more efficient sales environment? This just makes too much sense not to happen in some form over the extended long term, and when it does, RadioShack’s huge retail presence should make them the main beneficiary. This will also help with the Apple point above—in this scenario, Apple would have no choice but to eventually offer all of their products in RadioShack.
Bonus: Growth Driver + Buyout Potential
As a bonus driver of growth, Julian Day came in and focused almost exclusively on shutting down unprofitable locations, cutting costs and building wireless growth, almost to the exclusion of everything else. He will retire within the next month, replaced by James Gooch, the CFO and Day’s right-hand man. Gooch has already stated that his main goal is to drive accessory sales, which should serve as a “low-hanging fruit” that should be high margin and drive much incremental profitability. Overall, I think Day did a great job, and the installation of someone new at top should serve as an effective catalyst for switching the company from cost-cutting mode into growth mode. Day’s retirement could also serve as a real catalyst to put the company in play. The company has been frequently speculated as a buyout target (mainly from private equity, but some have speculated BBY might buy them. See here, here, and here). I think a buyout would make sense, but it’s difficult to see it occurring at anywhere near today’s prices. Still, it could serve as a nice catalyst. Even absent a buyout, RadioShack shares are so cheap that I think they make a great value investment at today’s prices.[b][/b]
Disclosure- Long RSH