Radio Shack (RSH) has been one of the worst performing stocks in the market over the past two years. Shares traded above $20 as recently as October, 2010, but have since fallen as low as $2.36. With the stock hovering around the $2.50 level over the past week, I think Radio Shack is finally gaining merit as a speculative contrarian play. That said, this is a very risky stock, and so investors should be cautious if entering on the long side.
The core investment thesis in favor of Radio Shack is that the company's market cap of $250 million represents less than 40% of tangible book value. There is significant underlying value that shareholders should be able to realize even if the current management team is unable to return the company to profitability. On the flip side, Radio Shack has lost over $26 million year to date, and was also forced to suspend its dividend and share repurchase program. If losses accelerate and/or the company is forced to write down the value of existing assets, the underlying book value could be eroded quickly. This creates a risk that Radio Shack would become a value trap.
I have been quite critical of Radio Shack's performance over the past year. Radio Shack operates in a very challenging market niche, particularly for its mobility business (which represents over half of total company sales). Not only does Radio Shack compete with Best Buy (BBY), but it also competes with the retail outlets run by its carrier partners: principally Sprint (S), AT&T (T), and Verizon (VZ). However, Radio Shack has struggled far more than any of these other companies over the past year (although Best Buy has also had its share of problems). This suggests that mismanagement may be a culprit in Radio Shack's poor performance. While sales have been steady, gross margin has plummeted in recent quarters.
Management has blamed this principally on two factors: 1) the growing popularity of the iPhone (which has lower margins for Radio Shack); and 2) the rollout of the company's Target (TGT) mobile centers, which has caused a mix shift towards the lower-margin phone business. It's not clear that the company has any solution to these problem. While CEO Jim Gooch claimed that the company should be able to save $40-$50 million in SG&A costs next year, this may not be enough to return the company to profitability. Radio Shack needs sales improvement in order to leverage its operating costs. Management is taking steps to improve traffic and conversion, through a new marketing approach and a stronger focus on customer service. However, only time will tell if these initiatives bear fruit.
In light of Radio Shack's very real problems, why am I turning positive on the stock? As I mentioned above, Radio Shack trades significantly below tangible book value. The stock price implies that the market expects over half of Radio Shack's value will be destroyed. If the company stops destroying value soon enough, the stock will appreciate. This is a very low performance bar! There are three main reasons why I think Radio Shack will stop destroying value soon enough to justify a higher share price.
First, the company has a very low level of future commitments. Many retailers have substantial off-balance sheet lease commitments that prevent them from easily closing stores and/or liquidating. However, according to Radio Shack's most recent 10-K (see pp. 62-63), the company's lease commitments total less than $600 million, with nearly 75% of that amount due by 2014. Management reiterated on its Q2 earnings call that the company's average lease term is less than 4 years. This gives Radio Shack substantial flexibility to close underperforming stores, or even to liquidate the chain in an orderly fashion, if the company cannot generate sufficient profitability.
Second, I believe that most assets on Radio Shack's balance sheet could be converted to cash at a modest discount to book value. The company's inventories of over $800 million consists largely of products in the mobility category: e.g. smartphones, tablets, and accessories. Radio Shack should not have trouble clearing this inventory if it decided to close a significant number of stores. Property, plant, and equipment (totaling roughly $250 million) would be more difficult to convert to cash, but Radio Shack would trade at more than a 50% discount to book value even if the company wrote down half of this amount.
Third, while underperforming management is never a good thing, in this case it provides a small blessing. Given the company's history of negative earnings surprises over the past year, I think the current management team is on a short leash, vis-a-vis the company's Board of Directors. Members of the management team own an insignificant percentage of the company, and so nothing would prevent the Board from replacing the leadership team if results continue to deteriorate. Given the stock's depressed valuation relative to book value, I think that a change in management could give investors hope and result in a significant bounce for the stock. If the current Board moves too slowly on this front, an activist investor could potentially move in to force the action.
In sum, while Radio Shack has significant operational problems, the market is presently pricing in a tremendous amount of future value destruction. By contrast, I think the company will stop the damage sooner. Additionally, a large number of bears have been aggressively shorting the stock; in recent months, roughly 40% of the float has been sold short. This creates the possibility of a short squeeze if any positive news materializes. A modest catalyst could result in significant gains for Radio Shack shares. Once again, I would recommend caution, but I believe that Radio Shack's current price builds in an adequate margin of safety for a medium-long term investor.