Another RadioShack Earnings Miss Ends Bull Case

| About: RadioShack Corporation (RSH)

I've made a few good calls here on Seeking Alpha but RadioShack (NYSE:RSH) definitely wasn't one of them. When the stock sold off in late October after a quarterly earnings miss, I pointed to the company's strong cash flow and doubled dividend, which at the time offered a 4.27% yield, as evidence for the bull case for RSH.

That dividend yield is now over 9 percent, as RSH closed Tuesday at $5.35 as of this writing. Shareholders have lost nearly 50% since third quarter earnings (there have been 62.5 cents of dividend payments per share), as the company followed up its Q3 miss with two more disappointments. Disappointing fourth quarter guidance knocked the stock down 30% in January; the finalized results fell short of estimates again, leading to an 8% drop. And, now, the first quarter results have caused another 10% fall. (See also earnings call transcript.)

As they have for most of the past few months, RSH's fundamentals still look reasonably solid. The stock now trades well below its $7/per share tangible book value. Free cash flow was about 13% of market cap in 2011, and positive again in Q1 at $36 million; both figures easily covered the quarterly dividend payout of about $12 million. Net debt still sits below $100 million; with positive free cash flow and an unused $450 million revolving credit line, a near-term bankruptcy seems unlikely at best.

Of course, the fundamentals don't tell the whole story with a struggling stock like RSH. The tangible book value is still slightly less than the company's inventory balance, putting liquidation value still well below the stock price. Q1 free cash flow was boosted by changes in net operating assets; removing that change and adding in $13 million of net interest expense, cash generation did not even cover the first quarter dividend. And the seemingly strong fundamentals are not a sign of an undervalued gem, but of a market that does not trust RadioShack or its management.

The problem with RadioShack, as I noted back in January, is that management's strategy of converting the company from an electronics retailer to a wireless reseller has been, simply put, a failure. The company blamed weak third quarter results on delayed results from its new partnership with Verizon (NYSE:VZ); fourth quarter earnings faced pressure from below-expected returns from sales of Sprint (NYSE:S) products, pressure that continued into the first quarter. CEO Jim Gooch has repeatedly emphasized the need for the Mobility segment to "mature"; yet segment sales fell 5.2% year-over-year in the first quarter. Given that wireless resales provide far lower margins than the company's legacy electronics and accessories products, RadioShack needs revenue growth in the Mobility segment simply to maintain earnings and cash flow. And as the company noted in its 10-Q, those margins face continued pressure from the movement into higher-quality phones. "Smartphones generally, and the Apple (NASDAQ:AAPL) iPhone in particular, carry a lower gross margin rate, given their higher average cost basis," the company wrote. Lower sales at lower margins cannot give investors confidence in RadioShack's ability to return to its previous earnings levels.

The company has doubled down on its Mobility bet by installing nearly 1500 kiosks in Target (NYSE:TGT) stores. "Other" revenue in the first quarter, which included 610 new Target locations, grew 43% year-over-year, due primarily to the expanded footprint. But the number of kiosks grew 69% year-over-year. The company did not break out revenues in the segment -- which also includes sales in Mexico and through the company's website -- but the top-line growth does not immediately appear to support the company's kiosk strategy. Bear in mind that operating income in the segment increased by $17 million in 2011 (the company did not break out the net loss); the increase alone cost full-year EPS by 17 cents per share, pre-tax. CFO Dorvin Lively noted in Tuesday's conference call that "we are not yet achieving the level of profitability was expected" in the Target Mobile segment, showing that the initiative continues to falter.

As I argued in January, RadioShack is not simply being buffeted by the same difficulties facing Best Buy (NYSE:BBY), with whom it is often compared. Best Buy operates mega-stores and has seen secular trends hurt its margins. (Televisions are the best example; margins have essentially disappeared throughout the supply chain, hurting not only retailers and producers but component manufacturers such as Corning (NYSE:GLW).) RadioShack's legacy business was to operate far smaller, far cheaper stores loaded with high-margin accessories and store-branded products. It isn't competition from Amazon (NASDAQ:AMZN) or a change in consumer behavior that has caused RadioShack's recent struggles. It was a coordinated decision by management to enter the Mobility segment that has damaged the company's earnings power. First quarter earnings continue to show that this decision, so far, has been a failure.

Yet the company has shown no signs of abandoning its movement into the wireless space. Instead of perhaps re-evaluating the need to emphasize mobility products, RadioShack is hiring a new ad agency, and putting "an increased focus on mobility" in its advertising. Yet the high=margin "Signature" segment products -- tablet accessories, headphones, cords, cables, and the like -- saw a 0.7% revenue increase in the first quarter. They -- particularly RadioShack's store-branded products -- provide significantly higher margins and profits. Those products drove RadioShack's profitability for decades. And yet, facing its a surprising quarterly loss, and a stock at an all-time low, CEO Gooch shows no interest in returning to an emphasis on the Signature segment, or on re-branding the company as "helpful" or "useful" instead of just another voice in the crowded, competitive wireless segment.

On Tuesday's conference call, CEO Gooch was asked about the company's strategy by UBS' Michael Lasser. Lasser succinctly summed up the challenges facing the company, and asked what exactly they might do differently:

Michael Lasser - UBS

So if I could just clarify because one confusing element of the story is that with your mix going more towards mobility and especially lower margins smart phones. It's hard to envision what the ultimate margin profile of the business will look like because the strategy is continue to emphasize some of these shifts.

At the same time the cost structure doesn't seem to be supportive of the move towards an inherently lower gross margin profile.

Jim Gooch

Yes and I think as I said it's going to be important for us to chip away at all three components. So, you will see us on top line growth, we are going to need some top line growth and we think the mobility business will support that. At the same time even though we are under margin pressure from that mobility business we have many initiatives around signature initiatives around private label, initiatives around pricing. This should help to stabilize that margin going forward and then we continuing to aggressively go after SG&A reductions on a day in and day out basis.

As I look to balance this economic model going forward, I don't see it coming from one component. I think you will see us move all three components to get back to an economic model that we are happy with.

Gooch's answer is simply delusional. The Mobility business is not creating top-line growth; revenues fell 5% year-over-year in the quarter. Elsewhere in the call, Gooch mentions the removal of Sprint "comparables" as a tailwind for revenue growth (the first quarter of 2011 saw significant strength in Sprint products) but growth off a lower base is not substantial, long-term, revenue enhancement that can drive a business model based on lower margins. Smartphones have lower margins -- but also higher average selling prices (NASDAQ:ASPS). So, if net revenue is down 5%, the drop in unit sales is even higher, showing just how much the Mobility segment is struggling.

Secondly, the "initiatives" to support the Signature business are not mentioned anywhere in the company's earnings materials. The focus of the new ad campaign with the new ad agency is on the Mobility segment -- not the legacy Signature products. The idea that this neglected segment will somehow boost margin when the company is clearly not investing in Signature products is a pipe dream.

Thirdly, the company has shown some ability to control SG&A, but there's very little left to cut. When asked in the Q&A what specifically the company might do to lower its costs, Gooch had no answer. Ad spending will not drop, rents are unlikely to change, and lowering staff compensation will only hurt the company's already-faltering reputation. In short, none of Gooch's "three components" towards a return to profitability make any sense.

So, yes, RSH seems undervalued; yes, it's trading below book value; and no, it is not Circuit City and will almost definitely not face bankruptcy in the short term. But what is left for shareholders under this management strategy? The company already guided for "lower" net income in 2012 versus 2011's 70 cents; but the company made just 33 cents per share in the last three quarters of 2011. After three straight disastrous earnings reports, and an 8-cent per share loss in the first quarter, is RadioShack even going to turn a profit for 2012? It's not clear that it will. The prospect of a full-year loss will hurt the stock, and likely cause a dividend cut, which will drop the share price further.

By the numbers, RSH still looks like it may be undervalued, or have some merit as a turnaround play. But, under its current management and current strategy, it is headed towards a future where it must execute perfectly simply to maintain earnings at depressed levels. The new strategy, and the new emphasis on the Mobility segment, is flawed. Management doesn't see it; by now, investors should.

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