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Last month, Radio Shack (NYSE:RSH) announced fairly dismal earnings, but attempted to sugar coat the news by announcing a new shareholder-friendly capital allocation policy. If Radio Shack manages to turn its business around, then shareholders may indeed reap substantial gains from this new policy. However, these new measures drastically escalate the company's risk profile, and it is much more likely that they will hurt shareholders in the long run. The centerpieces of the new capital allocation policy are a doubling of the dividend (raising its yield to about 4%) and a massive share repurchase plan, which will exceed the company's free cash flow.

As a result, the company will have to dip into current cash on hand or take on more debt to fund the stock buyback. Some argue that using debt to fund stock repurchases is a terrible idea under almost any circumstances. I would not quite agree with that position. If a company's stock price seems unusually depressed but the fundamentals look good, then it can be wise to repurchase stock now and pay off the debt with future cash flow. That's particularly true when a company can borrow money at interest rates approximating its dividend yield. Under those circumstances, the cash flow used for paying interest would be made up by the savings from having fewer outstanding shares (and thus lower dividend obligations).

There's a catch, though. The company needs to be confident about having that future free cash flow available to repay the initial debt. That makes debt-funded share repurchases a very dangerous strategy for declining companies. Unfortunately for shareholders, Radio Shack fits into this category. Radio Shack has pinned its hopes to the mobility segment: i.e. selling phones and plans from wireless carriers like AT&T (NYSE:T), Verizon (NYSE:VZ), and Sprint (NYSE:S). The company's other businesses are shrinking, and yet company executives recognize that the mobility strategy is thus far not gaining traction.

Drawing down cash or issuing debt to fund a share repurchase lowers a company's book value. Having a low price-to-book ratio is the ultimate backstop for investors in case business goes south. Investors can be reasonably confident that either through sale or liquidation, they can recover a company's book value if the business becomes unviable. In the past two years, Radio Shack's book value has dropped from $1.05 billion to less than $800 million, and the new repurchase plan will lower that number even further. This increases the downside risk for investors. It's also worth noting that Fitch lowered Radio Shack's credit rating on account of its weak results and new capital allocation policy.

In the end, this move will help the share price only if Radio Shack can stabilize profits (or better yet, reignite growth). Radio Shack's "signature" business will continue to shrink; there's not a lot of money to be made selling cables, converters, etc. Meanwhile, the entire Radio Shack mobility business seems suspect to me. My local Radio Shack is next door to the T-Mobile Store. Two doors down in the other direction is an AT&T authorized retailer. The Sprint store is a block away, and a Verizon dealer sits another block down the street. There's also a U.S. Cellular store about two blocks away. Given that each of the major carriers has a carrier-specific store nearby, why would the average Joe go to Radio Shack? Most people already know which carrier they want, and have no need for "honest broker" services from Radio Shack.

Furthermore, I expect to see Best Buy (NYSE:BBY) increase its expansion of Best Buy Mobile standalone stores, now that it has bought out its partner Carphone Warehouse. Given its scale, Best Buy has a lot more money to throw at this business than Radio Shack. Spending money on share repurchases at this point could further erode Radio Shack's ability to compete with Best Buy.

There are some good things happening at Radio Shack. In particular, I like its partnership with Target (NYSE:TGT) to run mobile kiosks in Target stores. But until Radio Shack shows that the underlying businesses are sound, there's no reason to own shares. The risk/reward profile here is not favorable. Radio Shack shares are currently selling just above $13, which is more than 20% ahead of the 52-week low reached last month. If you're still long, now is a good time to get out!

If you're interested in the short side, I would wait to see if the stock pops above $15, which would make a good entry point. At the current price, I prefer to stay on the sidelines.

Source: Radio Shack's 'Shareholder-Friendly' Practices Will Hurt In The Long Run