- With RadioShack trading at a tiny fraction of sales and near book value, investors may be tempted to bet on a turnaround.
- Cost cutting is limited by a credit agreement that prevents RadioShack from closing more than 200 stores. Operating costs are now nearly half of the company's revenue.
- Sales are collapsing, and costs cannot be cut fast enough for RadioShack to avoid bankruptcy.
- Book value is plummeting, and the liquidation value is likely already negative due to large amounts of inventory. Equity investors will be wiped out in the event of bankruptcy.
Shares of troubled consumer electronics retailer RadioShack (NYSE:RSH) have plunged below $1 per share as bankruptcy increasingly looks like the only option. The business has deteriorated rapidly, and at this point a turnaround looks essentially impossible. There are some arguments floating around the web that suggest that RadioShack could have substantial upside if the company can start to turn things around, or even that equity investors may fare well in the event of a bankruptcy. Neither of these arguments hold up against scrutiny, however, and investing in RadioShack is akin to lighting your money on fire.
Argument #1 - RadioShack can cut costs and return to profitability
RadioShack can indeed cut costs, but the company is severely limited by the constraints of its credit agreement. Back in March, RadioShack announced that it would be closing 1,100 stores, around a quarter of its store base. This was great news for investors because it would greatly cut down on the number of unprofitable stores. The problem, however, is that RadioShack had to cancel those plans because its credit agreements prohibit it from closing more than 200 stores in a single year. Talks fell apart, and the company later announced that it would only be closing 200 stores in 2014.
This will greatly limit RadioShack's ability to cut costs. Costs could be slashed at existing stores, but once you start hurting the customer experience, sales are going to start falling even faster. In the first quarter, SG&A expense actually increased year-over-year, and operating expense as a percentage of revenue rose from 41.4% to 47.5%. RadioShack is spending nearly half of its revenue just operating its stores, and it has made very little progress bringing this number down. For the sake of comparison, big-box competitor Best Buy (NYSE:BBY) only spent 20.1% of revenue on operating expenses during its most recent quarter.
The only way for RadioShack to return to profitability is to dramatically increase sales. RadioShack needs double-digit comparable store sales increases right now. During the first quarter, comparable store sales declined by 14%. Reversing that trend this year is likely impossible.
What this means is that RadioShack is going to continue to lose tremendous quantities of money this year, drawing on its credit lines, until it eventually is forced to declare bankruptcy. Cost cuts cannot save RadioShack.
Argument #2 - RadioShack trades near book value, so equity investors may do fine in the event of bankruptcy.
RadioShack is indeed trading around its book value, and without looking deeper into RadioShack's balance sheet, it would appear that equity investors might not be completely wiped out in the event of bankruptcy. There are two problems with this.
First, the book value has been collapsing. At the end of 2012, the book value was $599 million. This fell to $206 million by the end of 2013, and it fell further to just $73 million at the end of the first quarter of this year. RadioShack recorded a net loss of $400 million in 2013, so it won't take long for the book value to turn negative.
Second, the majority of RadioShack's assets are in the form of inventory. At the end of the first quarter, RadioShack had $792 million in inventory, representing nearly 60% of the company's assets. In the event of bankruptcy and liquidation, this inventory would have to be sold off, likely at fire sale prices. Even a 10% discount would lead to a liquidation value for the company of zero, and a larger discount would mean that not only equity investors would be completely wiped out, but bondholders wouldn't fare that well either. There's a reason why the yield-to-maturity of RadioShack's outstanding bond due in 2019 is currently above 30%.
Let me be clear about what I'm saying. I'm not saying that RadioShack stock can't go up. It absolutely can. It could double tomorrow, for all I know. I have no idea what the stock will do in the short term, and speculators can and will make money guessing the direction of the share price. But RadioShack's business has fallen apart, and it does not have the time or the capital to repair it. Costs are out of control, and there has been little visible progress in bringing these down. The company is contractually obligated to leave unprofitable stores open, and sales are collapsing faster than the company can possibly cut costs. The company's liquidation value is almost certainly negative at this point, and equity investors are going to be wiped out in the event of bankruptcy. In short, investors, real investors that invest in businesses and not short-term fluctuations in stock prices, should stay away from RadioShack.
Disclosure: The author is long BBY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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