We think the combination of both a valuation and a momentum assessment of a company is the best way to identify those stocks that will attain superior risk-adjusted performance over time. We outline the benefits of a combined value-momentum approach in our academic white paper, which can be downloaded here.
In this article, we showcase how our process enabled us to avoid a significant value-trap in the likes of Radio Shack (RSH). Though at times we thought the firm was undervalued on the basis of our DCF process, at no point did our Valuentum Buying Index indicate that Radio Shack was attractive. It scored a 3 during most of its decline, where a 9 or 10 on our index would represent one of our best ideas. We attribute such discipline to a technical and momentum assessment of the firm, which was decidedly negative. We think stocks that exhibit both good value and good momentum are most interesting. The Valuentum Buying Index, which measures the attractiveness of value and momentum characteristics of stocks, continues to identify big winners on the basis of the performance of our Best Ideas portfolio.
With that said, let's take a look at Radio Shack.
Electronics retailer Radio Shack seems to be in the midst of a steady decline. The company was somewhat successfully mitigating the obsolescence of many of its core product offerings by selling mobile phones. Apple's (AAPL) iPhone has become among the most popular smartphones available, and it has proceeded to squeeze margins at Radio Shack, Best Buy (BBY) and even the phone carriers like Sprint (S), Verizon (VZ) and AT&T (T).
However, the firm does have a huge store footprint, currently trades below its tangible book value and its annual dividend yield is over 12.8%. Same-store sales in its most recent quarter fell 4.2%, and earnings per share fell from a profit of $0.30 to a loss of $0.08. The company recently fell below our fair value range of $4-$12, but we still do not think the firm offers a compelling investment opportunity. Again, this is based on its poor technical/momentum assessment.
Mobile Segment is Huge But Beyond Radio Shack's Control
According to Radio Shack's most recent annual report, 51.4% of its sales came from the mobile segment in 2011. That's up from 44.2% in 2010 and 33.8% in 2009. It looked like Radio Shack had found an interesting niche, as the company focused on generating commissions on plans from mobile carriers and offering a one-stop shop for post-paid wireless shopping.
This model worked in the early days of the smartphone; however, it appears that the industry could face some consolidation. Apple currently has at least 29% of the US smartphone market, according to NPD, and Android (GOOG) has 61% of the market according to this survey. Though we think these numbers are less than precise, since they do not track enterprise spending, we think it's reasonable to assume that these two operating systems control roughly 90% of the US smartphone market. Android may currently ship on numerous carriers, but we wouldn't be surprised if Google uses its acquisition of Motorola Mobility to vertically integrate its smartphone construction, much like Apple. We also think Microsoft (MSFT) may enter the arena and cut out Nokia (NOK), much like it has already eliminated HTC as a hardware provider. Regardless of how it exactly shakes out, we think there may ultimately be 3-5 major smartphone manufacturers with heightened bargaining power.
As a result, profitability in the supply chain could shift to the actual hardware providers, forcing the three major U.S. carriers to reduce commissions paid on activations to retailers like Radio Shack and Best Buy. Further, if consumers only want one or two phones, consumers may simply go directly to wireless carriers' retail outlets where differences lie mainly in network access and price. Even if Radio Shack is able to maintain its mobile business, the firm will undergo fierce competition from Best Buy Mobile and other carrier-agnostic stores like Wal-Mart (WMT). Though mobile segment sales fell 5.2% in the first quarter of 2012, we think that decline could be steeper in the coming quarters.
What About the Rest of Radio Shack?
Radio Shack does have two other segments-signature and consumer electronics. The signature segment includes music, video game, and other home entertainment accessories, as well as other technical and specialty products. Sales in this segment fell 4.7% in 2011 compared to 2010, yet sales in this segment managed to grow 0.7% in the first quarter of 2012. This segment posted $1.11 billion in sales in 2011, but that number has fallen from $1.38 billion in 2009.
Consumer electronics did not fare so well in the recent quarter, as sales tumbled 25%. The company attributed the decline to difficult industry conditions and Amazon (AMZN). Radio Shack's consumer electronics segment is composed of laptops, TVs, cameras, computers, and other products that competitors like Best Buy are struggling to sell thanks to poor pricing and slumping demand.
Though we think some of the firm's signature segment may have a place in the changing retail landscape, we aren't sure that Radio Shack's consumer electronics segment has much value. The firm sells several products, i.e. MP3 players and TVs that are already declining, and other mature products like laptops and alarm clocks. Radio Shack may sell nearly every electronic product under the sun, but most are commodities and can be bought at several other small stores like Walgreen (WAG) and CVS (CVS).
Is Radio Shack Worth More Dead Than Alive?
Legendary investor Benjamin Graham often remarked that companies he bought were, "worth more dead than alive." Assuming a company is trading below liquidation value leaves investors with a powerful margin of safety. With shares trading below tangible book value, we decided to see if that's the case.
As of its most recent quarter, the company has $566.4 million in cash, $236.6 million in accounts receivable, $730.1 million in inventories, and $131.1 million in other current assets. However, with all of the random things the company carries, we'll assume the inventory is slightly overstated, so we will value it at 60% of carrying value, which translates to $438 million. This is well below some now-defunct retailers like Linens n Things, which received 95% of its inventory value and Circuit City, which seems to have received nearly 100% of its inventory value. We'll also add in 60% of the company's net plant, property, and equipment, which equals $156.3 million.
We come-up with a conservative estimate of $1.518 billion of tangible value. In the firm's most recent 10-K filing, it shows all of its financial obligations (none are off balance sheet).
So Radio Shack could shut the doors today, but there would be a $350 million shortfall, using our conservative estimates for inventory. Since the company seems to agree, it continues to operate and pay out an ambitious dividend that equates to about $12 million per quarter, and about $50 million annually. The firm was able to generate just shy of $50 million in operating cash flow for the quarter. If the firm is able to generate $200 million annual operating cash flow, which isn't as much as it did in 2011, Radio Shack would be able to just barely pay for its $50 million in annual dividends, $70-90 million capital expenditures and $50-60 million in interest expenses.
However, we think the firm's ongoing cash flow from operations is fragile and that it could tumble at any point. As our Valuentum Buying Index has demonstrated for months now, we think Radio Shack very well could be value trap. Instead of simply a firm in transition, Radio Shack is probably in permanent decline and might not be able to survive. Expanding international operations in Asia and Mexico could be a good strategy for the firm to endure, but we think the long-term picture is pretty grim. Though the company does trade slightly below our fair value range, we aren't interested in Radio Shack at this time.