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A wrong analysis of Radioshack

July 01, 2012 | About:
- EDIT -

As pointed out in the comments section, this analysis is fundamentally flawed. GuruFocus permitting, I'll leave it on the forum for future reference.


Thanks to those who pointed out where I was wrong. I have learnt something today.

=========================================================

With a market cap of $380 million and a reported net current asset value (NCAV) of $375 million, Radioshack (RSH) seems interestingly cheap. It’s not. If you read the footnotes, you will find:

1) Radioshack trades at a meaningful discount to NCAV.

2) The Company has a rock-solid balance sheet with significant excess cash.

This consistently profitable retailer isn’t just cheap, it is absurdly cheap.

Value and financial strength

As of March 31 2012, Radioshack reported current assets of $1665 million. Current assets consisted mainly of cash ($565m), inventories and receivables.

The company also reported $1280 million of total liabilities including $675 million of interest bearing debt. Of this, $375 million comes due next year. The rest ($300m) comes due in 2019.

From the 10-k:

In August 2008, we sold the 2013 Convertible Notes in a private offering. Each $1,000 of principal of the 2013 Convertible Notes was initially convertible, under certain circumstances, into 41.2414 shares of our common stock (or a total of approximately 15.5 million shares), which is the equivalent of $24.25 per share, subject to adjustment upon the occurrence of specified events set forth under terms of the 2013 Convertible Notes. Upon conversion, we would pay the holder the cash value of the applicable number of shares of our common stock, up to the principal amount of the note.

Last time I checked, 16 million shares were worth $60 million. This means the fair market value of that debt is now less than $75 million. If nothing bad happens (like the stock going up fourfold), $300 million of debt simply vanishes from Radioshack’s balance sheet. (375 m – cost to retire of 75 m). Alternatively, the CFO could pick up the phone tomorrow and offer bond holders $80 million. The only reason bond holders wouldn't take that deal is because they would be expecting a significant run-up of the stock.

If we account for the debt at fair value, total liabilities come down to $1 Billion.

This means:

1) Adjusted NCAV per shares comes in at 1665-1000/100 => $6.65

2) Radioshack has more cash in the bank ($565m) than debt ($300m + $75m).

3) No significant debt comes due before 2019.

WOW!

Radioshack trades at a 40% discount to NCAV.

Management

RadioShack has trouble keeping a dedicated CEO. In 2006, David Edmondson resigned over a falsified resume. Claire Babrowski took over as CEO for a few months. Then Julian Day, credited for the revival of Safeway and K-Mart, stepped in. Day downsized the company, closing nearly 500 stores and laying off 20% of the workforce.

Last year, Day handed the reins to James Gooch (previously CFO). Mr. Gooch (age 44) is also a former K-mart manager.

Mr. Gooch and his predecessors deserve credit for:

The smart but difficult decision to suspend the buybacks till the bonds come due. Barring a phenomenal run-up of the stock, that decision will probably generate at least $200 million in owner earnings next year.

Maintaining profitability through good times and bad.

The fact that Radioshack already is what other retailers hope to become (shop-in-a-shop).

At current depressed prices, Mr. Gooch has about half his annual income tied up in stock. In the relatively short period young Mr. Gooch has been at the helm, he has accumulated a significant amount of stock.

35024_1341066124lmM7.png

This is a competent and shareholder-friendly group of managers. It's certainly not the kind of management you typically find running a company trading at a 40% discount to NCAV. Management has been criticized for suspending the buy-backs. I believe the effect of this decison will become clear next year.

Buying back shares at current prices would be good for bond holders and bad for shareholders. The (nonlinear) math can get a bit complicated. In any case, as shares are retired by the company:

1) The number of shares bond holders get is increased (conversion rate adjustments of the convertibles)

and

2) The adjusted number represents a greater chunk of the remaining company.

and

3) The shares could run up causing the final cash-value of the convertible debt to rise.

In short, buying back shares aggressively, would mean handing the company to bondholders. The reverse too is true. Not buying back shares till after the convertibles come due means taking cash from bondholders and handing it to shareholders.

As it is, the management of Radioshack has paid owners roughly $1 billion of cold hard cash since 2007. That’s the amount Radioshack spent on buybacks and dividends; a significant amount of money for a company with a market cap of $380 million. This is as shareholder-friendly as it gets.

Business and competition

RadioShack is a leading US consumer electronics retailer. The company operates 4,500 company-owned stores in major malls and strip centers averaging 2,500 square feet per location. RadioShack's retail network also includes 1,300 wireless kiosks, 1,200 dealer outlets, and 200 company-owned stores in Mexico.

Revenue breaks down into mobility (51%), signature (31%), and consumer electronics (18%) products.

Two primary factors differentiate the company from its competition.

1) An extensive physical retail presence with convenient locations throughout the United States.

2) A trained sales staff is capable of assisting with the selection of appropriate products and accessories and, when applicable, assisting customers with service activation.

The bankruptcy of Circuit City has been offset by Amazon’s entry into the space. Though Radioshack’s service does provide some differentiation, investors are worried margins will be under pressure ging forward.

As a retailer, Radioshack compares favorably to Best Buy and in some respects to Amazon.

35024_1341066085ibpc.png

Gross margins are clearly higher and the company pays its suppliers in time. One way the competition juices its ROE is by paying suppliers later. This is a cheap form of leverage. Still, at Radioshack, ROE has historically been over 20%. 2011 saw a bad slump in earnings which depresses ROE.

The market is clearly extrapolating recent weakness far into the future. Historically, the only two years the company even came close to losing money are 2006 and 2011. These are the years they switched partners. In 2006 they ditched Verizon and in 2011 they took them back. These switches clearly depress net earnings by at least $100 million.

The Radioshack franchise has already been shown to work as a shop-inside-a-shop. This business model obviously has a positive effect on costs, asset turnover, ROA and ROE. Best-Buy and for that matter Sears are trying to transform themselves into something Radioshack already is.

Risks

In 2011, Radioshack ended its partnership with T-mobile in favor of a new one with rival Verizon. The switch caused a number of one-time charges to earnings. The same thing happened in 2006 when Radioshack ended its previous long-standing arrangement with Verizon. Such switches are obviously expensive. More of them would be bad for shareholders.

In five years, Amazon has taken a lot of market share in the electronics space. This puts pressure on gross margins. Unlike with books, I believe in the electronics space, there is a place for a retailer willing and able to select the best solution/product for a specific customer. That retailer is not Amazon.

Catalysts

After the bonds convert (August 2013), Radioshack is likely to reinstate its buy-backs.

The bonds now act as a poison pill (provisions against change of control). Once they convert, Radioshack becomes a target (pun intended).

Once the financial strength of the company is better understood, investors may no longer price the stock as if they are expecting the dividend to be cut.

At some point between now and September 2013, the company is going to record a massive GAAP profit. The market value of the fair value of the bonds will eventually be reflected in their book value. The only way this is not going to happen is if the stock quadruples before then. That's a risk worth taking.

It is possible bond holders hedged out the risk by shorting the stock. After the bonds mature (or are retired), the hedges will be removed. There may be significant covering of short positions.

Read more:

The Convertibles

A bear case

10-k

Disclosure:

This is not a recommendation to buy or sell anything. I had no position in any of the stocks mentioned at the time of writing. Any and all questions welcome as usual.

About the author:

batbeer2
I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. As of September 2012, I'm the author of the monthly Buffett-Munger Best Bargains Newsletter. I can be reached at fvandenbroek AT gurufocus DOT com

Visit batbeer2's Website


Rating: 3.8/5 (16 votes)

Voters:

Comments

Davidash76
Davidash76 - 2 years ago
Batbeer2,

Nice write up. Everything makes sense. If you were to play devil's advocate with this stock and your write up, is there any other risks or negative factors you see that are worth noting?

The math you present (the convertible debt assessment was explained well), is similar to what you find on a whopper investments, oddball stocks, or other microcap NCAV/Graham sites that look for value with a margin of safety.

What could happen to punish stock even further. It seems at this rate, the cheaper the stock gets, the better of a bargain. What could potentially kill this, other than continued depressed earnings which at this point aren't particularly important since there is a 40% discount to NCAV... Are we essentially getting the business for free?
batbeer2
Batbeer2 premium member - 2 years ago
Hi Davidash76,

Thanks for the kind words.

Re risks:

As with any stock, there is an endless list of risks. Unexpected litigation and tax issues/bribery two name two. I mention only risks specific to the company. I guess in this business there is a lot of wheeling and dealing with handsets, contracts and commissions. The company may be vulnerable in that regard (think WMT/Mexico).

The fact that it has been profitable doesn't mean it will be. Deals like this, will wreak havoc with your quarterly numbers. If it happens in the Christmas quarter, you have a serious problem.

Having said that, yes, you are getting the operations for free. Unless management destroys value (they're not doing that now) it will work out. I could have made a SHLD type case for this one based on the value of the real estate. That is not my cup of tea.

IMHO the core asset of the business is the guy with a Shack shirt who is willing and able to explain to you what the best dataplan is. They can stick that guy behind a counter in someone else's shop and get rid of their own shops without taking a hit to their core business. This would be great for asset turnover and ROE even at lower margins.
pravchaw
Pravchaw premium member - 2 years ago
Great article - esp the convertible debt. The market seems to be spooked by what they perceive to happening to BBY. But BBY and RSH are different. The popularity of iphone/android has also crushed RSY as margins on smartphone given up by apple and samsung are much lower. Another catalyst could be the release of windows 8 phone and tablets.

On the positive side the company is profitable - has a great balance sheet and could be a buy out candidate from private equity of someone like BBY.

3rand
3rand - 2 years ago
The holder of the convertible debt instrument has the option either to convert to stock at the specified price or to be repaid the full value of the bond at maturity.

The choice is not made by the company which sold the bond.
batbeer2
Batbeer2 premium member - 2 years ago
Hi 3rand,

It is my understanding that the bonds come due in august 2013. At that point, they will be converted into 16 million shares or the cash value thereof.

Were I to own some of these bonds, I'd prefer the cash. With cash, I don't need to register the shares and worry about slowly unloading them on the market......

Either way, they're worth a lot less than their current GAAP book value.

Is there some provision that the bonds can be put to the company at their nominal value before August 2013?

@ Pravchaw

Thanks for the kind words.
aldandrea
Aldandrea - 2 years ago
I believe 3rand is correct.

I haven't owned convertible notes but am under the impression that the face value of the debt -- ie. the amount the company owes -- does not become less just because the stock price has declined. Nor does the issuing company have the right to make the decision when and if to convert the debt to shares. Only the holder/owner of the convertible note has the right to make the conversion decision and they obviously wouldn't convert if the stock isn't at or above the conversion price.

Convertibles offer the buyer an opportunity for upside if, and only if, the stock price rises above the conversion price specified in the offer. At the same time, the debt associated with a convertible note isn't tied in any way to the current stock price. If it was, convertible notes would be incredibly risky for investors because issuing firms could have a strong incentive to cause a stock price decline after issuing the notes so that they could cash their debt out at pennies on the dollar.

Based on this understanding, RSH's debt is not going to decrease because their stock price has declined. Can anyone confirm this?
pravchaw
Pravchaw premium member - 2 years ago
Thanks for clarifying 3rand & Aldandrea - I think this is consistent with the definition of convertible debt in wikepedia - "_In finance, a convertible note (or, if it has a maturity of greater than 10 years, a convertible debenture) is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a coupon rate lower than that of similar, non-convertible debt, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity.From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into newshares

Overall it appear that RSH willl have to pay out the $375 principal by rolling over the debt at a much higher interest rate.

pravchaw
Pravchaw premium member - 2 years ago
Looked further into the 10K. RSH sold _


Five year 2.5% unsecured convertible notes due in 2013 for
$375.0
Million.

2013 Convertible Notes: In August 2008, we sold $375 million aggregate principal amount of 2.50% convertible senior notes due August 1, 2013, (the “2013 Convertible Notes”) in a private offering to qualified institutional buyers. The 2013 Convertible Notes were issued at par and interest is payable semiannually, in arrears, on February 1 and August 1.

Each $1,000 of principal of the 2013 Convertible Notes was initially convertible, under certain circumstances, into 41.2414 shares of our common stock (or a total of approximately 15.5 million shares), which is the equivalent of $24.25 per share, subject to adjustment upon the occurrence of specified events set forth under terms of the 2013 Convertible Notes. Upon conversion, we would pay the holder the cash value of the applicable number of shares of our common stock, up to the principal amount of the note. Amounts in excess of the principal amount, if any (the “excess conversion value”), may be paid in cash or in stock, at our option. Holders may convert their 2013 Convertible Notes into common stock on the net settlement basis described above at any time from May 1, 2013, until the close of business on July 29, 2013, or if, and only if, one of the following conditions has been met:

·

During any calendar quarter, and only during such calendar quarter, in which the closing price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter exceeds 130% of the conversion price per share of common stock in effect on the last day of such preceding calendar quarter


·

During the five consecutive business days immediately after any 10 consecutive trading day period in which the average trading price per $1,000 principal amount of 2013 Convertible Notes was less than 98% of the product of the closing price of the common stock on such date and the conversion rate on such date


·

We make specified distributions to holders of our common stock or specified corporate transactions occur


The 2013 Convertible Notes were not convertible at the holders' option at any time during 2011 or 2010. In 2011, we paid an annual dividend of $0.50 per share. This was a $0.25 per share increase as compared to the annual dividend we paid at the time we issued the 2013 Convertible Notes. This dividend increase triggered an anti-dilutive provision relating to the convertible notes that changed the conversion rate of the notes (“Convertible Note Anti-Dilutive Provision”). As a result, at December 31, 2011, each $1,000 of principal of the 2013 Convertible Notes was convertible, under the circumstances previously discussed, into 42.0746 shares of our common stock, which is the equivalent of $23.77 per share. Accordingly, conversion of all of the 2013 Convertible Notes would result in the issuance of approximately 15.8 million shares of our common stock.

Holders who convert their 2013 Convertible Notes in connection with a change in control may be entitled to a make-whole premium in the form of an increase in the conversion rate. In addition, upon a change in control, liquidation, dissolution or delisting, the holders of the 2013 Convertible Notes may require us to repurchase for cash all or any portion of their 2013 Convertible Notes for 100% of the principal amount of the notes plus accrued and unpaid interest, if any. As of December 31, 2011, none of the conditions allowing holders of the 2013 Convertible Notes to convert or requiring us to repurchase the 2013 Convertible Notes had been met.

In connection with the issuance of the 2013 Convertible Notes, we entered into separate convertible note hedge transactions and separate warrant transactions with respect to our common stock to reduce the potential dilution upon conversion of the 2013 Convertible Notes (collectively referred to as the “Call Spread Transactions”). The convertible note hedges and warrants will generally have the effect of increasing the economic conversion price of the 2013 Convertible Notes to $35.88 per share of our common stock, representing a 100% conversion premium based on the closing price of our common stock on August 12, 2008. See Note 5 - “Stockholders’ Equity,” for more information on the Call Spread Transactions.
batbeer2
Batbeer2 premium member - 2 years ago
-
batbeer2
Batbeer2 premium member - 2 years ago
Ouch, I stand corrected.

When the bonds come due, the holder receives NO LESS THAN PAR VALUE. http://www.investopedia.com/articles/01/052301.asp#axzz1zOp2RS00

I withdraw this one form the contest. I'm sorry for this folks. Sloppy work on my part.

Thanks for pointing out my mistake.
Davidash76
Davidash76 - 2 years ago
Thanks for pointing this out. It's a great lesson learned. No shame in making it, I'm sure every great investor has confused the terms of different securities at times that have flawed a valuation one way or the other.

Nice post and responses all around. Very valuable.
aldandrea
Aldandrea - 2 years ago
Don't sweat it Batbeer2. I read everything that you write and very much appreciate your good analysis and writing.

It sure would be nice to be able to get a good read on RSH, huh? Such potential if they could just find a way to ignite demand.
batbeer2
Batbeer2 premium member - 2 years ago
Thanks for the kind words.

I'll try to dig up something better next time round.
rrurban
Rrurban premium member - 5 months ago

A convertible bond is a hybrid between a corporate bond and a warrant. Warrants are essentially call options with the only difference being a warrant is issued by the company whereas options are issued by the CBOE. Convertible bonds, like corporate bonds, are issued at par (typically $1000 per bond) and pay semi-annual coupon payments - with the exception of zero coupon convertibles in which case the bonds are OID (original issue discount) and no coupon payments are made, but the bond matures at par and the yield/interest is "implied" in the difference between par and OID.

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