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Radioshack $RSH bonds: is the huge yield worth it?

July 31, 2012 | About:

I’ve received several emails and comments recently asking for an update on Radioshack. As long time readers know, Radioshack was probably my first huge mistake (Some history- I recommended LEAPS here, and long the stock here) . And, I’m going to be honest in an upfront note on this article, because of my personal history w/ the stock, this post is a bit rambling… but I do think there are some good takeaways, so read on!

Anyway, in my original investment, I was blinded by RSH’s upside potential, strong historical earnings, and mean reversion potential and failed to recognize this simple fact: Amazon has completely changed the retailing and, specifically, consumer electronics retailing industry. That, combined with the fact that retailing is just a hard business, lead to a completely disastrous investment. As a full reminder to myself to pay attention to potential long term shifts in business models (and to be incredibly careful when investing in retail stocks), I continue to hold a very, very small amount of shares that are down almost 90% at this point (fortunately, I sold almost all of my holdings at a much higher level, when it became apparent to me that trends were too negative).

So, enough personal history. The question everyone has asked is if Radioshack makes a good investment at today’s prices. People seem to be especially attracted to the debt, which matures in 2019 and is trading in the mid 60s w/ a YTM of 15%+.

And, personally, I think the answer is no, neither the debt nor equity is attractive.

First, a lot of people point to Radioshack as a net-net. As my friend Nate points out here, Radioshack is not a net-net once operating leases are factored in. While I disagree with some of Nate’s conclusions (leases are not necessarily fully debt; my experience in bankruptcies have taught me they can be rejected at well below face value. And if you are going to count them as full debt, you need to add the value of PP&E back to the balance sheet), I do 100% agree with his main point- the balance sheet is not something you want to rely on here.

Speaking of balance sheets, a huge piece of it is made up of inventory. I have two problems with this:

  1. inventory is up over 15% year over year despite flat sales. That’s really, really poor inventory management.
  2. This is consumer electronics inventory. It’s constantly depreciating in value. If you don’t sell all of your iPhone inventory stock before the next iPhone comes out, you currently inventory is effectively marked down by 75%. This is simplifying it a bit (you will get some money back for returning to manufacturer), but Radioshack’s inventory is very, very sensitive to both timing and a potential fire sale.

Add it up and you get a retailer whose inventory needs to move extremely quickly to preserve value, but whose inventory turns are slowing drastically. Really not good.

Back to leases for a second- one of the reasons retailers in general are so hard to invest in is their operating leases give them huge leverage. A lease is a fixed cost. This means it shrinks as a percentage of sales when sales go up, but grows when sales go down.

For a retailer like Radioshack to turn around, it’s probably going to take a significant investment. Upgrade the stores, invest in new systems, experiment to find something that works, etc. Look at JCP- given the high operating leverage involved with retailing, making a turn around involves bleeding for a while. You need dry fire power to do that. Unfortunately, Radioshack blew through all of their cash buying back share in the high teens and low 20s. They have no dry fire power to work with to make the turn around.

So you’ve got a retailer with huge operating leverage, no dry fire power, no real asset protection, and declining trends.

Given all of that- I would look at radioshack as almost a super fueled rocket. Given how depressed the stock price is and how much potential operating leverage there is, if management works a miracle and turns the company around, the stock price would likely take off. In this case, both the equity and debt would do incredibly well.

But, if they can’t (and remember, at this point it would take a miracle for them to turn around!), the equity will go to zero.

How would the debt do?

Well, it does look attractive on a yield basis. But remember, in the event of a liquidation all of those off-balance sheet liabilities are going to eat into some of the assets, and the inventory will likely prove itself to be dramatically over-stated.

For perspective, Circuit City filed for bankruptcy w/ assets of $3.4B and liabilities of $2.3B. Every situation is unique, true… but unsecured debt holders (who were most of the liabilities) got between 10 and 30 cents on the dollar. You do not want to count on asset protection in a downside scenario as a debt holder.

There are really two possibilities with Radioshack. Downside scenario (extremely likely, btw) means equity is wiped out and debt takes a huge haircut. Upside scenario (unlikely, but possible) has the debt doing well while the equity takes off like a rocket ship.

Given that- why invest in the debt? You’re basically taking on the same risk as the equity but with much less upside.

And given the increasingly negative trends, the risks involved, and the question-ability of its assets, why invest in the equity at all? There are plenty of safer net-nets out there that offer similar upside but with less leverage and better asset protection!

Disclosure: Long a very small amount of RSH

Rating: 4.0/5 (5 votes)


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