RadioShack (RSH) made two major announcements today that have investors and analysts scrambling to reassess their outlook for the company. CEO Julian Day will be leaving the company later this year at which time CFO James Gooch will be taking over as President and CEO. Additionally, preliminary 4Q results were announced that show sales in line, but EPS below expectations due to weaker than expected margins.
The latter is clearly disappointing news, but to some extent the market seemed to be already pricing in a miss. Further, some of the weakness appears to be due to temporary issues that will dissipate in the coming quarters. As for Julian Day's departure, it shouldn't be unexpected and is not necessarily a bad thing, in my opinion.
4Q Earnings Shortfall Disappointing, But Not a Disaster for Outlook
4Q EPS are expected to be $0.50-$0.54, which was below the consensus forecast at approximately $0.65. The issue was weaker gross margins and higher SG&A expenses, much of which I would argue is temporary.
Gross margins were down in part on weaker results from T-Mobile and the mix of handsets sold. Its not clear what drove this change from recent quarters and therefore its hard to say whether the company can make changes to restore margins here quickly or not. The other drag on gross margins came from clearance of seasonal items and transitioning to new products.
The former is likely a result of softer-than-expected industry sales trends versus the company's planned inventory purchases from about nine months ago. Clearance activity like this happens when business slows, but this is NOT indicative of on going gross margin trends.
Additionally, RadioShack is transitioning some product categories to refresh its home entertainment and personal electronics categories. This, too, is not likely an ongoing drag (meaning every quarter) as historically I believe the company has made these types of major product changes only once every 3-4 years.
SG&A was up in the quarter mainly due to infrastructure investment necessary for the new Target (TGT) kiosk business. The infrastructure investment is a step-up in the company's cost structure that occurs before revenue potential from the kiosks can be realized. Thus, the impact on profits from this investment will also dissipate from here as revenue from Target's kiosks build and the financial drag will likely be unnoticeable by the second half of 2011.
Sales, actually, were OK and slightly above expectations ($1.37 BN vs. $1.36 BN consensus forecast). Same store sales (SSS) were up 1%, which is a slowdown from the 6% for the first nine months. However, this weaker trend was expected due to the difficult comparison last year when SSS were up 6.1%. On a two-year basis, SSS accelerated to 7.2% from 5.2% the first nine months of the year. Given much weaker results from competitors like Best Buy (BBY) and HH Gregg (HGG), RadioShack's revenue shows the resilience of its model in difficult times and reinforces our belief that the company's focus on mobile devices and accessories should be very beneficial to revenue trends in 2011.
Departure of Day Is Not Necessarily a Bad Thing
The departure of Julian Day is not a total surprise given when he came to the company about four years ago he was expected to whip the company into financial shape and then either sell it or move on. Mr. Day accomplished the financial restructuring in stunning fashion, but then was unable to close the deal on a company sale last year. It makes sense that he should move on now.
While the timing certainly could have been better, I do not view Day's departure negatively because:
- RadioShack Needed A Change. Mr. Day was a cost-focused executive and exactly what the company needed four years ago, but he hasn't done much to build up the company again, in my opinion. Promoting CFO James Gooch, well-known to Wall Street, suggests continued financial discipline but also a new hand at the wheel that could make bolder changes.
- Selling the Company Just Became a Lot Easier. The departure of the CEO could mean renewed interests from a financial or strategic buyer as it would be easier for the company to come back to the negotiating table and accept the lower price it previously turned down. This is especially true with RSH's stock now down about a third from where it was trading during the well-publicized buyout negotiations last summer that apparently fell apart over the take-out price. For example, a $22/share deal would offer a 42% premium to the current price for shareholders and still be well below the mid-$20's price that private equity was reportedly interested in paying for RSH. $22 would only be 5.4x EBITDA, a big discount to recent retail buyouts of Gymboree at 6.8x and JCrew (JCG) at 8.6x. Thus, the silver lining in today's news is that a deal just became far easier to achieve given there is a price that could make everyone happy.
Outlook for 2011 Not as Ugly as Stock Action Today Suggests
Forgetting about the potential for positive change with a new CEO and how much easier it would be now to sell the company, the temporal nature of 4Q's margin issues and the decent sales results for the holidays still suggest 2011 will not be a bad year for RadioShack. The company's focus on the hot-selling mobile category and the transitioning of certain underperforming products in other categories suggest SSS should still be up about 2%-4% in 2011. Margin pressure should abate in 2Q and margins should be up in the 2H as the company cycles easier comparisons related to the Target build-out, product transitioning and heavy clearance activity that happened in 2010. The company's aggressive ongoing stock buyback will mean a substantially lower share count.
All of this adds up to a company that could, in a base case, earn $1.90 in 2011, suggesting a minimum of low teens EPS growth. Even if you assume a huge 33% discount to the market valuation for RSH's multiple, or 10x 2011 earnings, this still suggests the stock is worth $19, or 23% upside from the current price. So while today's earnings pre-announcement was disappointing, the sell-off looks far overdone.
