Sears & Radio Shack: Moody's Flunks Out at Lampert and Day University

"What we've got here . . . is a failure to communicate. Some men you just can't reach . . ."
- Strother Martin in "Cool Hand Luke."

Yesterday I was doing my reading on Seeking Alpha and came across Chad Brand's blog The Peridot Capitalist and his post pertaining to RadioShack (RSH). Since he was the first to recommend it as far as I know, I will direct you to his site when my posts reference them (got to give credit where it is due).

Moody's investment rating services recently downgraded the debt of The Shack, saying:

Moody's Investor Services downgraded RadioShack Corp.'s long-term senior unsecured rating and short-term commercial paper Monday on lackluster sales and operations. The ratings agency lowered the electronics retailer's senior unsecured rating to "Ba1" from "Baa3." The move means the company's senior unsecured rating is no longer investment grade. Moody's also cut RadioShack's commercial paper rating to "Not Prime" from "Prime-3.

After reading it, the first thing that came to my mind was Sears Holdings (SHLD); the similarities are stunning. In his annual shareholder missive, Chairman Eddie Lampert lamented:

We ended the year with more cash on hand than debt. On a combined basis (including Sears Canada) we have $4.0 billion of cash and only $2.8 billion of debt (excluding capital lease obligations of $0.8 billion). Domestically, our $3.3 billion of cash exceeds our debt balance of $2.3 billion (excluding $0.7 billion of capital lease obligations). Furthermore, approximately $350 million of the outstanding domestic debt represents borrowings by our Orchard Supply Hardware subsidiary, which is non-recourse to Sears Holdings. Despite the conservative nature of our capital structure and our improved profitability, the rating agencies have not upgraded us and continue to hold a non-investment grade rating on our debt. We believe Sears Holdings is an investment-grade company; the lack of response by the agencies is puzzling and is certainly something we continue to hope will change.

Luke: Yeah, well, sometimes nothin' can be a real cool hand.

Why is this a big deal? The downgrade, aside from being a negative in the eyes of potential investors, means that when Sears and Radioshack do borrow money, it will cost them more. What did Radioshack due to deserve the downgrade? They had lower sales (it should be noted this was inevitable to fix The Shack). When CEO Julian Day, an Eddie Lampert U. graduate, took over Radioshack, it was stuck in the dead-end loop of growing sales and decreasing profits.

In an attempt to "just get bigger," Radioshack fell into the "sales at all cost" mentality. It worked. Sales increased, but the unfortunate cost of those sales was decreased profits. This apparently is fine with Moody's as Radioshack had an "investment grade" rating on its debt (memo to Moody's: this is bad). Day recognized that this was an unsustainable business model, unprofitable locations had to be closed and the system wide discounting that was crushing margins and profits had to stop. The result of this would be lower sales initially, but if done properly, increased profits. It worked as 4th quarter profits jumped 55% (Day took over in June) and crushed "analyst" expectations. In almost a year now, Day has decreased debt at Radioshack by 30% and increased cash on hand by a whopping 110%. According to Moody's, this was bad?

Boss: Sorry, Luke. I'm just doing my job. You gotta appreciate that.

Luke: Nah - calling it your job don't make it right, Boss.

Both Sears and Radioshack have a business model that Moody's clearly just does not understand. Here is the really odd part: they both have the ability at this second, to write a check and pay off all their debt and, have plenty left over! How can any reasonable person consider this a negative? This is even more bizarre when you consider that when both Day and Lampert took over their prospective companies, neither had the ability to pay off even 1/2 their debt and Radioshack was then considered "investment grade." Let's pretend you are applying for a mortgage. You have $250,000 in the bank , no other debt and are asking for a mortgage of $175,000. What would you say to the loan officer if he claimed you were a "bad credit risk" because as a sales person you only made $95,000 vs the $100,000 you made the year before (Radioshack had a 5% sales decline in 2006 vs 2005)? Personally, I would resist my initial urge to assault them and then inquire as to what they had drank or smoked for breakfast that morning.

What is Moody's communicating to retailers? Sales are what count. Annoying things like profits, debt levels and cash levels are secondary. Lampert and Day are both saying by their actions that they have this cute little idea that profits and increasing shareholder value are what really count. Both Sears and Radioshack are in the best financial condition in years yet Moody's just can't seem to grasp (or refuses to) the Lampert U. concept. Thank god for us shareholders that Lampert and Day ignore Moody's and do not manage their businesses to appease them.

Maybe a "night in the box" will help Moody's see the light . . . Don't get it? Watch the movie.

SHLD 1-yr chart

RSH 1-yr chart

Comments

[p k]

great to see you have so much more insight than moodys, who receives direct, confidential financial information from the companies themselves. including promises of planned debt repayment. and who issues specific guidance to companies on what they want to see in order to upgrade debt - and degrading competitive position in the face of a mgmt team that is claiming to be an operator coupled with cratering sales that waits to unravel the coiled spring of deleverage is generally not one of the suggestions. and this coming from a wizard of oz sitting behind his giant screen of non-disclosure.

just the right time to upgrade the debt when all that cash flows out the door for equity in an acquisition and they layer on debt to the gills of 7x ebitda. oh yeah, and ongoing sales of the assets backing up that debt.

yeah, that is some paper i want to be holding.