The Newest Dividend Growth Stock: RadioShack

| About: RadioShack Corporation (RSH)

RadioShack (NYSE:RSH) sold off sharply Wednesday -- dropping 12.1%, to close at $11.70 -- after reporting disappointing third quarter earnings after the close on Tuesday. Revenue figures of $1.03 billion just missed estimates, but earnings of 15 cents per share (excluding one-time charges) was well short of Wall Street consensus of 36 cents per share. Lower-than-expected sales in TV converter boxes, consumer electronics, and a soft September rollout of a new reseller agreement with Verizon (NYSE:VZ) all contributed to margin pressure and the bottom-line miss.

Lost in much of the gnashing of teeth over the stock's earnings miss was an interesting announcement, however: the company is doubling its dividend and adding a $200 million stock buyback program, with that authorization representing 17% of the current market capitalization. The dividend, formerly paid at 25 cents annually, will now be paid quarterly -- with the exception of the previously scheduled annual dividend, paid on December 15th, which will be paid at the increased 50 cent rate. Thus, from now through the end of November 2012, RSH shareholders will be in line for a full $1.00 in dividends per share, an 8.5% yield over 13 months.

The updated annual yield -- 4.27% at Wednesday's close -- isn't too shabby, either. The question is: why raise the dividend amidst an admittedly sluggish earnings report? The company noted that its transition from T-Mobile products to Verizon in its Mobility segment had fared poorly, and Verizon sales were slow. Consumer electronics sales were down 21% from the prior-year quarter, and accessories down 6%, leading to a decline of 4% in same-store sales versus the third quarter of 2010.

The store originally expected to open 40 stores in Mexico; the number is now "close to" 20, with the 40-store target now expected in the next 3-4 years. Even CEO Jim Gooch admitted on the company's conference call that the quarter was the start of a "transitional period". And yet, the dividend has been doubled, returning an additional $25 million annually to shareholders, with the $200MM buyback authorization expected to be completed within a year.

Analysts were asking the same question on the Q&A portion of the conference call -- twice, in fact. Here's CFO Dorvin Lively's answer to the first analyst:

Matthew Fassler – Goldman Sachs

Thanks a lot. One question and one follow-up, first on the question, your decision to raise your dividend, while it seems like a smart decision from the capital allocation perspective raises your commitments to shareholders in the time when the earnings seem to be a much less certain then it takes the payout ratio to a pretty high level. So, how do you all essentially think about the security of the dividend and your financial flexibility at a time when there is an accurate visibility in the business?

Dorvin Lively

I think Matt, and we’ve talked about this before. We’ve gone back and forth looking at dividend, looking at share repurchase, looking at internal external growth opportunities and how we’re going to utilize our capital. I think we’re – we feel that’s a significant increase without question doubling the dividend, providing some great return to shareholders. If you look at our cash flow and even though we’re in a transitional state from an operational performance, we still feel very strong about our cash flow. I think that’s evidence over those past nine months of generating over $200 million of cash flow even as our some of the operational performance as been a little bit challenged.

Fassler's point about the payout ratio is a good one. Based on trailing earnings of $1.09 per share ($1.34 excluding special items), the payout ratio is now 46%: high, but not unacceptable. Given that fourth quarter guidance is for lower earnings year-over-year, it's possible -- perhaps even likely -- that the payout ratio will climb above 50% in early 2012, after fiscal year earnings are announced. That's a level with which many income investors are uncomfortable. (Fassler, in fact, downgraded the stock to neutral on Wednesday, removing RSH from Goldman's "Conviction Buy" list.)

However, Lively's response is the correct one -- and pretty much sums up the bull case for Radio Shack: they generate significant amounts of cash, consistently. The new 50-cent dividend requires $50 million a year in payouts. Over the last eleven quarters, the company has generated over $350 million in levered cash flow (free cash flow less interest payments), despite a negative adjustment in working capital for inventory increases -- an annual run rate of over $120 million. As such, the payout seems secured by existing cash flow. If not, the company's $6.67 per share in cash should tide over any rough patches. (The company has an almost equivalent amount of debt, but seems intent on using much of that cash to repurchase stock, rather than debt.)

In my mind, the newly raised dividend cements the bull case for RSH. Yes, 2011 has been a struggle -- yet, as CFO Lively noted, the company still generated one-sixth of its market cap in free cash flow in the first three quarters.

Going forward, the agreement with Verizon will give "the Shack" sales deals with the top three US mobile carriers (the other two being AT&T (NYSE:T) and Sprint (NYSE:S)). Swapping Verizon for T-Mobile should restore growth in the mobility segment, perhaps back to the double-digit growth the company saw in 2010. The company needs this growth to overcome declines in the legacy electronics and accessories business. Yet, as tablets and home connectivity become more mainstream, RSH may benefit as a provider of components and add-ons to those new products, perhaps mitigating the company's struggles over the past year. And before this "transitional" period, earnings were consistent and solid, even through late 2008 and 2009, with cash flow lowered only by working capital adjustments (the reversal of which accounts for some of this year's strong cash generation).

In the meantime, much of the company's struggles are already priced in. Trailing P/E is just 11, with trailing price to levered cash flow in the single digits. With its solid cash generation, and a brand new yield over 4%, investors can wait for the company's partnership with Verizon, international expansion, and continued expense control to boost the bottom line, and hopefully the share price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.