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RadioShack Corporation (NYSE:RSH)

Q1 2006 Earnings Conference Call

April 20th 2006, 4:45 PM EST

Executives

James Grant - Senior Director, Investor Relations

Claire Babrowski - President and acting CEO

David Barnes - CFO

Analysts

David Strasser - Banc of America Securities

Greg Melich - Morgan Stanley

Jim Costell - Cuyahoga Capital

Danielle Fox - Merrill Lynch

Mark Rowen - Prudential

Chris Horvers - Bear Stearns

Matthew Fassler - Goldman Sachs

Jeff Stein - KeyBanc

Alan Rifkin - Lehman Brothers

Presentation

Operator

Good day, everyone, and welcome to the RadioShack Corporation first quarter 2006 earnings conference call. As a reminder, today's conference is being recorded. For opening remarks and introductions, I would now like to turn the call over to Mr. James Grant, Senior Director of Investor Relations. Please go ahead, sir.

James Grant

Good morning. Today we will hear from Executive VP and CFO David Barnes on our financials, and President and acting CEO Claire Babrowski on our operations. Afterwards, they will take your questions.

By way of reminder, this conference call may include comments that are forward-looking statements involving risks and uncertainties, and are indicated by words such as anticipate, expect and other similar words or phrases. These forward-looking statements involve risks and uncertainties which may cause actual results to differ from our expectations. You're encouraged to read our 10-K and 10-Q filings with the SEC for a more complete discussion of the major risks and uncertainties that affect our business. Now I will turn it over to Claire.

Claire Babrowski

Thanks, James. Good morning, everybody. Before David walks you through our financials, I'd like to take just a moment to acknowledge upfront how disappointing this morning's published results are. We did indicate earlier this year in our annual investor conference that the first quarter would be relatively weak and that quarterly trends would be volatile, but these results are worse than we anticipated. We clearly have a lot more work to do to get this Company back to levels of profitability and growth that we all expect.

I would like you to know, though, the first quarter results do nothing to change our belief in the turnaround plan that we announced early this year. We continue to be confident we're making the right moves that will benefit RadioShack significantly over time. We are likely to have a couple of more challenging quarters before we start seeing the financial benefits of the plan. Nevertheless, we're making good progress on the operational components of the turnaround, and I will fill you in on that with a much more extensive discussion later.

So, for now, let me hand it over to David to bring you through the financial statements.

David Barnes

Thanks, Claire. Good morning, everyone. First quarter 2006 EPS were $0.06, down $0.28 versus Q1 of 2005. Write-downs in connection with the Company's turnaround plan related to fixed assets and inventory reduced the Company's pre-tax income by approximately $10 million.

Broadly speaking, the main drivers of our operating performance in the first quarter were as follows:

First, and most importantly, sales of wireless units in the core RadioShack chain were down significantly versus a year ago. In particular, sales of Cingular postpaid units were well below levels attained with our prior supplier in Q1 of 2005.

Second, we experienced revenue declines in certain highly profitable non-wireless product categories, including power. While sales were strong in some other categories -- notably satellite radio, MP3 players and related accessories -- these growth areas were not sufficient to offset declines in other non-wireless categories.

Third, higher staffing levels in our RadioShack stores contributed to higher spending. This high level of investment in customer service was not successful in driving increases in transactions and revenue as we had hoped.

These factors collectively led to poor overall financial performance for the quarter. While we're not at all pleased with our collective results, there were pockets of very strong performance which we are building on in the quarters ahead. We made progress during the quarter in implementing our turnaround plan, which we believe will generate sustained improvement in our business.

I'll take you through the Q1 P&L and other financial statements to elaborate on the drivers of first-quarter results. First, sales. Our total sales for the first quarter of $1.16 billion were up 3% versus sales of $1.123 billion in Q1 of 2005. Comparable store sales were down 1% for the first quarter of 2006.

Note that our revenues were noticeably impacted by P&L geography changes relating to our sales of prepaid wireless airtime, which reduced comp sales in the quarter by roughly 300 basis points. I'll say more about this change in a moment.

The total sales increase was driven in part by 9% sales growth in our wireless platform. However, the wireless growth was due to approximately 200 more wireless kiosks in the first quarter of 2006 compared with the first quarter of 2005. Changes to our Sprint agreement in the middle of last year, which increased per-unit revenue, but only modestly increased per-unit profit, also favorably impacted wireless sales to a smaller extent.

The bottom line is this: wireless units sales in our core RadioShack stores were down, driven by a double-digit unit decline in postpaid handsets. Several factors caused the decline in our postpaid wireless business.

  1. Consumer awareness of RadioShack as a destination for Cingular was below our goals. Partly as a result, our sales of upgrades were down significantly versus those of a year ago.
  2. As an organization, we are still getting up the learning curve on selling our new carrier's product line effectively.
  3. Regional dynamics posed a challenge for us. In markets where Cingular has a particularly strong market share, we've seen significant increases; but, these growth markets were not successful in offsetting the declines we experienced elsewhere.

Clearly, improving the performance of our wireless business is a major priority to improve sales and profitability for the balance of the year. We are implementing a broad range of initiatives to get our wireless business back on track, and I will discuss those with you in a few minutes.

Other drivers of our first quarter sales beyond wireless were as follows:

Sales in our services platform were down 56%, due primarily to changes in P&L geography relating to our sales of prepaid wireless airtime. In the past, we recorded the full value of airtime purchased by our customers as revenue, whereas this year we are only recognizing our markup in revenue.

The P&L geography change stems from the fact that under our new agreements with wireless carriers, we no longer have the risk of loss on purchased prepaid airtime minutes as we did in the past. This change has no impact on gross profit dollars or operating income, but did lower revenue by roughly $30 million. Excluding the P&L geography impact, sales of airtime were down slightly.

Another noteworthy driver of sales in the first quarter was the 8% decline in our power platform. This was primarily due to:

  1. Lower sales of general-purpose batteries, in part driven by comparisons with strong promotional activity a year ago, and lower sales of products needing batteries; and,
  2. lower sales of special-purpose batteries such as cordless phone batteries due to declining consumer demand.

We intend to improve our power results with a few different tactics:

  1. We've introduced a new unadvertised promotion in our stores now which is off to a good start.
  2. We'll be making store fixture changes with a power wall next month in most stores in order to make a bigger statement in power.
  3. Power is one of the categories that will gain display space as a result of our assortment move stemming from our turnaround plan.

Finally, with regard to sales, we did have some important bright spots. Sales growth of satellite radio was nearly double our expectations. Bluetooth accessories sales growth was significant too, up double-digit percentages. Headphones and digital music accessories were up materially, as we continue to effectively serve today's growing customer base that enjoys portable music.

Now on to gross margin. Our gross margin rate for the quarter was 48.3%, down 209 basis points from the prior year. The impairment of approximately $1 million worth of inventory related to the turnaround plan translated into 8 basis points worth of margin decline.

The gross margin rate was driven primarily by five other factors:

  1. A merchandise mix down to sales growth that was higher than company average in categories such as prepaid wireless handsets, MP3 players and satellite radio, which all carry lower gross margins than the company average.
  2. The economic change to our Sprint model made at the end of the second quarter of 2005, which increased per unit revenue, but only modestly increased per unit profit. The higher sales and higher cost of goods sold per unit resulted in incremental gross profit dollars, but reduced gross margin percentage.
  3. Gross margin declined due to more aggressive promotional activity than the prior year, in part driven by our efforts to liquidate inventory.
  4. We again experienced a greater sales contribution from non-core store channels, which tend to operate with lower gross margins than the core stores in the Company average. Specifically, the sales contribution from approximately 200 more kiosks year-over-year, and to a lesser extent, strong growth in our dealer channel, helped drive overall gross margin percentage lower.
  5. Partly offsetting the first four factors, gross margin percentage gains related to the changes in P&L geography from prepaid airtime, which I noted earlier.

Now on to SG&A. For the first quarter of 2006 SG&A expense was up $45 million, or 10%, to $496 million. SG&A as a percent of sales increased by 261 basis points to 42.7%. The SG&A increase was driven primarily by compensation at the store level. More specifically, for most of Q1 we continue to put more labor hours in our stores in an effort to improve conversion and drive tickets through our stores, a technique we began in the back half of last year.

In addition, we launched the new store-level compensation program which was designed to provide managers and associates with higher fixed compensation in lieu of variable compensation opportunities. The goal of the new compensation plan is to lower turnover by making our pay more competitive with other major retailers. While we believe this plan change will have a positive impact on sales and productivity in the long run, the change had a de-leveraging impact in the first quarter, given our relatively weak comp store sales results.

In addition to core store compensation, other meaningful drivers of SG&A included more kiosk operations year-over-year, which unfavorably increased compensation and rent; the sale leaseback of our corporate campus in the fourth quarter of 2005, which caused an increase in rent; and finally, the expensing of stock options.

Lastly on operating expenses, fixed asset impairment related to our turnaround plan totaled $8.9 million. We are confident that we are through the significant majority of our store fixed asset impairment costs for the year. The associated store lease costs will be recognized as we move through the second and third quarter.

Now to depreciation and amortization. D&A expense for the first quarter of 2006 was $32 million, up $2.5 million over the prior year. The increase was driven primarily by incremental investments in our stores, systems and kiosks; offset by no longer owning our corporate campus as a result of the sale leaseback last year.

Net interest for the first quarter of 2006 was an expense of $9.8 million, versus an expense of $7.9 million in the same period last year. Interest income decreased due primarily to lower cash balances versus the prior year. Interest expense increased due to the following two factors:

  1. Greater short-term borrowing levels.
  2. Higher short-term interest rates which unfavorably impact our floating interest rate exposure.

Now to other income. Other income was -$600,000 in the first quarter of 2006, as a result of the mark-to-market impact of our Sirius Satellite Radio warrants earned at the end of last year. In the first quarter of 2005, we generated $10 million in other income through the sale of the rights to the Tandy brand name in Australia.

Lastly on the income statement, taxes. First quarter 2006 taxes were $5 million, compared to $34 million in the first quarter of 2005. The lower taxes were driven by lower pre-tax income, as the provision for both 2006 and 2005 was 38%. We anticipate a full year tax rate of roughly 38%, although that rate could be lowered by donations of inventory we make associated with our turnaround plan.

Regarding free cash flow, we used $310 million of cash in the first quarter of 2006, versus a use of $105 million in the first quarter of 2005. This year's use of cash was driven by lower net income and changes in payables and inventory. Payable changes were driven in part by our wireless transition at the end of last year. For a reconciliation of free cash flow, a non-GAAP financial measure, visit the investor relations section of our corporate website and click on Company Presentations. Notwithstanding our operating performance in the quarter, we continue to project that we will achieve our 2006 free cash flow target of $50 million to $100 million.

Now on to the balance sheet. We ended the first quarter of 2006 with a cash position of $45 million versus $293 million a year ago. The decrease was due primarily to our capital structure changes made in the second half of 2005, when we used available cash plus the proceeds from a sale leaseback to conduct an overnight share repurchase.

First quarter 2006 inventory was $960 million, virtually flat versus the prior year. Certain factors related to wireless generated an overall increase in the inventory position: lower-than-projected wireless sales volume, more kiosks, and the Sprint model changes discussed earlier. In addition, certain non-wireless factors reduced our inventory position: the write-down of certain impaired inventory and better management of non-wireless categories.

For the trailing 12 months ended at first quarter, our cash conversion cycle was 105 days this year versus 101 days last year. Inventory turnover was 2.7X this year and 2.6X last year. As previously indicated, we did not repurchase any shares during the first quarter of 2006, and do not intend to in the future until we see lower volatility in our operating cash flow trends.

Before I conclude my remarks, I would like to add that the financial outlook for our turnaround plan for the full year remains virtually unchanged. We still anticipate $50 million to $90 million in store closure-related expenses, and the low end of that range appears more likely. Also, we anticipate full-year inventory write-downs of $5 million to $10 million relating to the removal of slow-moving items from our assortment.

That concludes my prepared remarks on the financial statements. We appreciate your interest in RadioShack and your attention today. Now I will turn it over to Claire.

Claire Babrowski

Thanks, David. I'd like to begin my remarks by going through what we've gotten done on the turnaround plan so far this year. As a reminder, the objectives of the plan are to:

  1. Increase average unit volume.
  2. To lower overhead costs.
  3. To grow profitable square footage.

We intend to achieve these goals by simultaneously removing unproductive assets and activities from our system, and leaning into areas that are profitable and growing.

On removing unproductive assets, let's start with store closures. During the first quarter we announced the closure of 480 under-performing stores across dozens of markets throughout the country. Decisions were made on a market-by-market basis. We are not exiting any market and there is no geographic concentration of closings. We've already closed 40 stores year-to-date, and are piloting our liquidation mechanics in 19 stores right now so that we can work out the bugs. Liquidations will start next month for the rest of the stores slated for closure and will be completed by about the end of August. Also worth noting, it's possible that we'll sell a small number of stores to our independent dealers.

Since our announcements, there have been quite a few questions about how these stores were identified and whether they are profitable. So, for some texture for you, the stores slated for closure tend to have four characteristics. They have generally weak financials, they are in poor real estate locations that are unlikely to revive, they have a better-than-average likelihood to transfer sales to a nearby sister store, and generally a less-than-desirable representation of the RadioShack brand.

As you might imagine, some of these calls were easy and some were not. Most stores are modestly profitable if you just strictly look at the store-level economics. But we believe the incremental and less quantifiable support costs associated with more district manager attention and higher employee turnover, for instance, actually make many of these stores unprofitable. Their closure, therefore, should be accretive to cash flow this year and to revenue growth rate and profitability over time.

As I mentioned, removing unproductive assets is only half the story; we're also leaning into profitable growth opportunities. During our investor conference, we overviewed a new active approach to maximizing transfer of sales, from stores that were closing to sister stores that are profitable and growing, where every dollar of top line revenue works harder for us on the bottom line. We applied this approach to some of the 40 stores that we've already closed this year and the early results are very positive, exceeding our initial assumptions.

Merchandise is another area with simultaneous removal and investment activities for us. In terms of unproductive inventory, late last year we identified thousands of SKUs that we want out of our stores before the fourth quarter of 2006, our golden quarter. I'm going to talk about these products more in a moment, but for now, the decision to liquidate this inventory resulted in a charge in the fourth quarter of 2005 and reduced profit in the first quarter of 2006 by $1 million. We anticipate more modest write-downs later this year.

As part of our initiative to liquidate poor-performing inventory, we launched a clearance sale at the start of April. The event will carry through to the end of August. What we don't sell by then we'll remove from our stores, setting the stage for a fourth quarter which should have a much more productive line-up of inventory than we started the year with.

This change will free up about 20% of our display space for more profitable products which have brighter revenue and margin dollar growth prospects. We have many different store layouts throughout the system, and each store is being given a plan for the redeployment of space freed up by the removal of the targeted SKUs, which will take place in phases starting next month.

The conversion may appear obvious or subtle depending on which stores you walk this summer. Nevertheless, it will be collectively very meaningful. We're using metrics such as sell through rates and percentage of end-of-life inventory in order to measure our progress. We'll update you on that progress in future conference calls. As I mentioned, we began the clearance sale less than three weeks ago, so it's a little too early to draw conclusions about the clearance progress at the moment.

Focused cost restructuring and overhead reductions are another key component of our turnaround plan. Strategically, we're looking to stop activities that don't hold the promise of contributing to our short and medium-term success, to improve the efficiency of activities where we're not competitive, and to outsource areas that are not core to our business.

We have already made some decisions that will lower our costs going forward. One example is that we've reduced our advertising spending rate by changing the media mix, favoring vehicles that build customer traffic. This move is expected to both increase the effectiveness of advertising and reduce full-year costs by approximately $30 million to $40 million versus last year.

Another component of cost restructuring relates to closing two regional distribution centers. We expect that our two facilities in South Carolina and Mississippi will cease operations around August or September, subject to a sublease negotiation on one of them. Details related to the sale of one facility and lease of the other are progressing on course.

We have completed a plan to reassign stores to different distribution centers once the two are taken offline, and in fact some stores have already made their transition. Today, the South Carolina and Mississippi facilities are sourcing their stores as effectively as ever, and all indicators suggest we will have a smooth transition, with no service disruptions late this summer.

Just to reiterate our comments at our February investor conference, we expect the distribution center consolidations will be income statement neutral and accretive to free cash flow in 2006. Over the coming weeks we will announce additional moves to streamline our overhead costs.

Achieving our business goals requires that we go beyond the turnaround plan and make improvements in the day-to-day work of running our business. Despite the setback on controlling store labor hours, we're progressing here as well. For example, we are improving our promotional period effectiveness by improving our in-stock positions. Our goal is to be fully in stock on everything that is featured throughout the entirety of promotional periods.

By the end of the first quarter, only about two out of every five promoted products actually met that standard of being in stock for the entire period. But four out of five of each promoted product was in stock for over 90% of the time period. This is more than double our levels of last year. We're making important progress and intend to achieve our service level goal by September.

We have a high level of urgency on improving our wireless trends. David talked to you about the challenges we are currently facing, and in fact improving our wireless business is the number one priority in our execution improvement. Some examples of the tactics that are included in our plan are accomplishing a balance of national and local approaches to wireless marketing, rather than the exclusively national approach we've taken in recent years. We will have more exclusive handset offerings during select time periods. We're in the position now to do overnight replenishment to enable greater product availability, but without an increase in system-wide inventory.

We have a complete field-level focus on wireless from all aspects of management attention, communication and follow-up, including targeted mystery shoppers. We have negotiated better price protection from our vendors to keep us competitive as market pricing changes, and we have a variety of special tactics specifically for mall stores, which are relative underperformers on wireless.

In addition to these tactics intended to drive phone and service package sales, we have others intended to increase sales of accessories. We have put our focus and our people power to work on this at every level, and we are very encouraged by what we see.

We are undertaking other day-to-day activities to get our costs in line. We have re-calibrated our field organization around labor usage. As a Company, we did not manage store labor hours well during the first quarter. We went into the year planning higher staffing levels to support higher sales and better customer service, and then we actually used more labor hours than we planned to begin with. Clearly, labor productivity was not acceptable, and we have taken aggressive action to correct it.

The last subject matter I'd like to cover before we take your questions relates to a large misconception that exists in much of the investment community today. Somehow the message has taken hold that as part of RadioShack's turnaround plan, we're turning our backs on high-margin categories like technical parts in favor of products which turn faster but have very thin margins; that we are, as many have said, looking to emulate big box retailers in our small box.

Nothing could be further from the truth, and that is categorically incorrect. So please, allow me to set the record straight. We have identified products that we do not want to stock anymore as of this September. That portfolio of products has a mixed basket of gross margins. It includes electronic organizers and translators, life-wise products, keyboard equipment, obsolete accessories, certain wire, and much, much more. Many of these SKUs were never high gross margin to begin with, though when first purchased years ago, some were.

The main point is that we have identified products that customers no longer demand in insufficient quantity to justify the space that those products occupy in our stores, and we're going to liquidate them to make room for another basket of products that customers do want and that they trust RadioShack to sell. This more productive basket of products includes Bluetooth and power and headphones, all of which have margins higher than our company average.

We'll also give more space to existing categories such as home networking, MP3 and HD radio, and it's important to note that we already have strong sales history and high credibility in each of these categories; obviously, not a sales history in HD radio, which is brand new.

What we are doing is getting broader and deeper in categories that we can sell more productively. We're transitioning from one mixed margin basket of goods to another, more productive, mixed margin basket of goods. Let me just reiterate that our assortment transition impacts less than 20% of the space in the store. Over 80% of the display space is not impacted. In particular, we retain our commitment to our technical products because they earned their place in the line-up. In fact, revenues of our technical platform were stable in the first quarter.

I really hope that clears up any confusion and confirms once and for all we are not abandoning high-margin categories. So, thanks, everybody, for your attention and your interest in RadioShack. This concludes our prepared remarks, and now David and I will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from David Strasser, Banc of America Securities.

David Strasser - Banc of America Securities

Looking at the gross margin of 48%, I guess it's related to your last comment -- but how defensible, as you look out, is that number? Into '07, is that a very defendable number? At some point, you have at times invested some of the gross margin back into sales. Is your thinking about it going forward -- can you talk about the strategy a little bit?

David Barnes

A couple of thoughts. First of all, I think you know our margin rate increased quite a bit in the '04 timeframe. So, these gross margin rates, while certainly below our goals and expectations, are not unprecedented by historical perspectives in times when RadioShack was profitable.

That said, clearly, Claire mentioned some of the initiatives we've got going on to cut our costs. We're not happy with where our costs are now. We're working on reinvigorating some of the sales of the higher gross margin categories, which on balance were very weak in the first quarter, while simultaneously lowering our costs.

As we look at our business, we don't have to have 50% to 52% gross margins to have a healthy business with growing profitability going forward. But clearly, we have to do some things and make some things happen that did not happen in the first quarter of this year.

David Strasser - Banc of America Securities

I want to ask one other question. Being in a bunch of stores recently, talking to salespeople about Cingular, one of the things that I heard was sort of a complaint about that there's a higher deposit on Cingular, which is impacting some of the sales in that area. I just kind of wanted to hear your take on that, and how legitimate of a complaint that is from the field.

Claire Babrowski

The actual data on what the credit analysis is and what deposit requirements might be on any given customer resides with the carriers; it does not sit with our stores. So, we don't have data to refute or confirm what you've heard. We've heard some of the same things from our stores, and so we've obviously done some discussion around it and tried to get into it. It appears as though, in terms of the number of customers who are asked to make some kind of deposit to purchase a Cingular package really is no different than what we've experienced with other carriers. However, it does appear that perhaps the average deposit requested for those who are asked for them might be slightly higher, but we don't have the data backup to make that.

So, interestingly, as we talk to our folks in the stores, in markets where Cingular is very strong and the cellular business is up, our store managers never mention that; and when prompted for the question, claim that it's not a problem at all. Where we do hear the comment is in markets that are not doing quite as well with Cingular. So it appears if it is a problem, it's spotty.

Operator

Our next question comes from Greg Melich, Morgan Stanley.

Greg Melich - Morgan Stanley

My question was about the mix of the kiosks, and I think it was mentioned a couple of different ways in your prepared remarks. I just want to make sure the kiosks are lower margin; that would be on both on an EBIT and gross level. Are those hurting the mall-based stores significantly? Because I think I heard someone mentioned that the mall-based stores weren't doing as well.

David Barnes

Let me talk about the margin first, and then Claire can talk about the impact on the mall stores. From a margin perspective, kiosks are lower than the company-operated RadioShack stores in total from a gross margin perspective. They're actually reasonably comparable with the wireless business in the RadioShack stores; the difference being, of course, that that's all they do.

From an EBIT margin perspective, as you've seen from our 10-K, we did not make money; we actually lost money in the kiosk business last year in our start-up mode. We've projected that we will be profitable this year, but we were not profitable in the first quarter.

Claire Babrowski

In terms of the kiosks and the competitive environment inside the malls that we experience, I think your question sounds specific to our kiosks. In general, the competitive environment in malls around wireless has changed relatively substantially in the last three or four years with the proliferation of wireless kiosks. So, we have to compete a little bit harder to be equally successful.

On a broad basis, our mall stores have been underperforming the system for sometime now, and that is not exclusive to wireless. Some of the changes we made in the our mall stores last year did a nice job of positively impacting the trends that we didn't like, but not with respect to wireless. So, we were able to change the trends in some other aspects of the business; but in fact, the wireless business appears to have just been slightly nicked by the choices we made around pulling things out of the windows, et cetera.

So, as I mentioned in my remarks, we've got a relatively substantial wireless recovery payment plan in place, with a specific focus around malls, assuming that some of the actions we took last year set us back a little bit, we need to not only undo that but move ourselves forward.

Greg Melich - Morgan Stanley

So, is it fair to say that if you look a couple of years out, you'd still expect to be in almost as many malls as you are today? Or is there such a change that not just your own kiosks, but everyone's kiosks are really driving the traffic out of your relatively high-rent stores, or where the rents are only going up, out to the middle of the mall? Do you expect three years from now to have mall stores to be the same or higher or lower?

Claire Babrowski

We haven't set any kind of expectation around that, but I can't imagine that the kiosk phenomenon would change our real estate strategy around malls. One of the things about the kinds of products that are growing in consumer appeal and demand is that they play very nicely to the mall environment. So, things like MP3 players and all the accessories that go with them, Bluetooth, et cetera, actually play very nicely to the profile of a mall customer. I can't imagine that our real estate strategy would change.

Additionally, when we did the analysis to understand if we should close some underperforming stores -- and if so, which ones -- one of the things that we found was that literally thousands of our stores are really well placed from all the criteria I mentioned about. The negative criteria by which we closed some is very positive for, I don't know, about 3,000 of the stores. Many, many of those are in malls. So, our most recent analysis of our real estate would say the mall stores are here to stay.

Operator

[Jim Costell], Cuyahoga Capital.

Jim Costell - Cuyahoga Capital

David, a very quick question on the accounts receivable. They're up quite a bit year-over-year, and you had mentioned that the dealer sales were up. Could you tell us about how much of the accounts receivable are from the dealers this year versus last?

Secondly, I take it that the rest of it are mostly from the cellular providers. Are there any accounts receivable left from Verizon, or have all the monies that Verizon owes you for residuals and so on and so forth been paid to you?

David Barnes

We're all cleaned up with Verizon. It is a mix. The accounts receivable is a mix of the carriers and the dealer stores. I don't have at my disposal at the moment exactly what the breakout is, but I can tell you it's extremely high quality, and our collection rates are very strong from both sources.

Jim Costell - Cuyahoga Capital

It's up $70-some million year-over-year. Is your perception that the overwhelming slug of that is from the dealers?

David Barnes

More of it is wireless than dealers.

Jim Costell - Cuyahoga Capital

Why would that be?

David Barnes

In total, our wireless business is bigger, including the kiosks.

Operator

Our next question comes from Danielle Fox, Merrill Lynch.

Danielle Fox - Merrill Lynch

I was wondering if you could talk a little bit more about the expenses. You went into some detail about what hurt SG&A, but I'm trying to get a sense of what's permanent versus what's temporary, and a ranking. You mentioned compensation and labor, and then also a drag from kiosks, the headquarters sale leaseback, and then the options. So, do any of those items begin to moderate or go away over time? I know you're working on the labor issue, but I'm wondering about some of the other items as well.

David Barnes

Let me talk about just a couple of them in no particular order. The kiosk one, obviously, won't decline, although the rate of growth will decline, if that makes sense. It won't decline in absolute dollars, but as we lap the addition of more kiosks. And what we are striving to do is to leverage that SG&A and become profitable this year. That remains our goal.

We have some other areas where costs are up that are, I guess you would say, relatively permanent, but in some cases don't really change the fundamental economics of our business. That would include stock option expense and the sale leaseback of our corporate campus, which had an offsetting impact on depreciation and interest expense.

Other than those factors, the biggest, certainly, was labor cost in the stores. And obviously, as Claire mentioned, we need to do a better job managing that cost line item. And we anticipate that that will become more favorable for the balance of the year. Then we have our general initiatives to reduce overhead costs, including the marketing initiatives that Claire mentioned, which marketing was not changed significantly in the first quarter. But we anticipate the trends will be favorable in the remainder of the year.

Danielle Fox - Merrill Lynch

One follow-up question. What are some of the key things that need to happen to get to that $50 million to $100 million in free cash flow by year end? Is that primarily a profit recovery, or is there a very big working capital component? What are some of the things that need to happen to get there?

David Barnes

First of all, let me observe that if you go back in the past, our business always uses cash in the first quarter -- nearly always -- as we pay down payables from the holiday season. And we have some unusual dynamics with accounts payable in particular that we expected coming into the year.

One big driver of our cash flow objective for the year is our turnaround plan. If you just think about the components, we're liquidating poor-performing inventory which we are really not selling in any significant quantity. That will generate cash.

We're closing stores and liquidating the inventory in those stores, and we're closing distribution centers and reducing the safety stock levels of inventory. We also came out of the first quarter with more wireless inventory than we had targeted, which was significantly caused by lower sales than we expected.

I would say that obviously, net income is one of the key drivers of cash flow. But the most critical drivers for the balance of the year will be execution of the turnaround plan, and just generally managing inventory well.

Operator

Our next question comes from Mark Rowen, Prudential.

Mark Rowen - Prudential

Claire, you said that your wireless business was weaker than you expected, and Cingular reported a very strong net add quarter the other day. So, I'm just wondering if what you're seeing is that the carriers, Sprint and Cingular, that you sell, are continuing to take share within their own channels. If that's the case, how do you sort of swim upstream against that, and if that's what you think is going on?

Claire Babrowski

I'm not completely -- when you say within their own channels, are you meaning their company-owned stores?

Mark Rowen - Prudential

Yes, right. Or by phone, or Internet, or however they might sell things.

Claire Babrowski

Honestly, we have not seen any impact on our wireless business that we would trace to what the carriers are doing in their own channels. The impacts that we've seen on our wireless business we are attributing to RadioShack, and what we have or haven't done.

In terms of the comments that Cingular made this week; actually they seemed quite pleased with the RadioShack business, and in the same week we're articulating that we're not pleased. This issue actually raised its head at our February investor conference, when we had the wireless panel with executives from both Cingular and Sprint here to talk about the wireless industry. At the time, Stan mentioned that Cingular was very pleased with RadioShack at a time when we were concerned.

Coming out of that meeting, we compared notes and found that the work we had done late last year with Cingular around forecasting the business in RadioShack, where we actually had agreed and aligned around what the annual numbers were, still stood. So, the annual targets that both companies had agreed on were still in place on both sides.

What happened then, though, is Cingular went back and did a month-to-month forecast that had much lower expectations in the first quarter and ramped up substantially towards the end of the year. RadioShack came back and did more of a level-set kind of a forecast. Obviously, first quarter is lower than fourth, but not in any way with the extremes.

When we look at our actual first quarter performance against the Cingular numbers and the RadioShack numbers in the forecast, we came in right in between. So, it puts us in a position where you've got two companies looking at the same business from their different points of view.

Mark Rowen - Prudential

The quarter was significantly weaker than you expected, and yet you left your free cash flow guidance unchanged at $50 million to $100 million. Does that mean that free cash flow in the quarter wasn't significantly worse than you expected? Or are you now at the low end of that range, where before you might have been at the upper end? Or did you just back-end load it? Can you just help us think about that?

David Barnes

The cash flow was weaker than we anticipated, but largely driven by working capital-related issues that, we believe, will work themselves out well before the end of the year. Obviously, profit was weaker than we had projected, but there are other offsetting things we're doing to get back to our cash flow goal, including you'll notice that capital spending was down versus prior year, and we're managing our capital resources carefully. Part of that is just a by-product of the turnaround plan and having our folks very focused on those initiatives. But we are managing our cash very carefully.

That said, we, of course, aim to improve our profit trends in the back half of the year with many of the initiatives that Claire talked about. That will help cash flow.

Claire Babrowski

David also mentioned that a piece of the inventory that we had at the end of the quarter was related to wireless, as a result of at least one thing I heard you mention, which was we were a little disappointed in one of the promotions we ran in March. We ordered big, expected big, and got kind of medium.

What I think maybe you didn't mention was we also had built inventory for two additional wireless promotions, one of which started on April 2, and the other which started on April 16. But that inventory was all in-house as of the 31st of March, which we are reporting. So, our ability to sell through that inventory will also help with the cash flow.

Operator

Our next question comes from Chris Horvers, Bear Stearns.

Chris Horvers - Bear Stearns

On your in-stock, it seems like you've made some improvement here pretty quick compared to last year. I was wondering what categories in particular drove that improvement? Can you talk to us about the availability of hot handsets, particularly for Cingular? Then I have a follow-up.

Claire Babrowski

Handsets have been a little spotty in the first quarter. We have had some weeks that were terrific and some weeks where we were a little bit short, which prompted us to move to one of the tactics that I mentioned in our wireless recovery plan, where at least for wireless phones that are hot and somewhat pricey, we are now in a position to do overnight replenishment to the stores. Which means we can have more of the phones in the distribution center and less in the stores. So, we don't end up with the hot and generally pricey handsets trapped in places where they're not selling, and then other stores who could sell through them who can't get them. It also allows us to achieve that more in-stock position without overall adding excessive inventory levels to the system.

So that's one of the tactics there. The rest is just basic business planning, blocking and tackling, getting between the merchants and the supply chain folks and the folks who do demand planning and replenishment and marketing; making sure that as we plan these things we're doing it in concert, in an organized focused way, with the goal in mind that if we're advertising something, we need to be in stock on it.

Chris Horvers - Bear Stearns

Do you think you had to, maybe year-over-year, put less traffic-driving categories items on the front of your circular?

Claire Babrowski

No, we haven't done that at all. We have had an instance where we have had to plan -- because as you guys well know, we place our orders well before the event occurs. So, due to lead time issues, there is one time period where the decision we've made is to concentrate that "hot" promotional item that was originally planned as the lead offer into a portion of the geography of the United States, where we have enough inventory for every store. That will be the hot offer in that part of the country, and we've created an alternative hot offer for other parts of the country, where we just won't have enough inventory to spread.

Chris Horvers - Bear Stearns

For David, on the gross margin in the power category, that seems to push your profitability around pretty strongly. If you continue to see the 5% to 10% decline in sales in that category year-over-year, does that put risk to that free cash flow guidance?

David Barnes

Our free cash flow projection is based on a broad variety of business assumptions, and certainly doing better in the power category, yes, is one of them. As Claire mentioned, we've already taken successful action on one piece of our power business, which is our general-purpose battery business. We've got an offer in the stores today that's really picked things up since late March when we rolled it out. Our challenge here is special-purpose batteries; some categories there's just a smaller market for those. But we can do better by improving our merchandising and display space in the stores, and Claire mentioned several of the things we're doing later this year which, we believe, will improve our trends. But clearly, power is our most profitable platform, and revenue trends there are important to our business.

Operator

Our next question comes from Matthew Fassler, Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot, good morning. I've got a couple of follow-up questions on the numbers. First of all, there's obviously some noise in SG&A due to the sale leaseback options, et cetera. What is the apples-to-apples increase in the expense number when you back out those non-comparable dollars?

David Barnes

We haven't gotten into details. Apples-to-apples will always be partly in the eye of the beholder. We did indicate at our investor conference that option expense would be roughly $12.5 million for the full year. And we, because of some executive departures, tracked a little higher than the run rate of that item.

With regard to the sale leaseback of the campus, again, the terms of that are in filings on that. It had a multifaceted impact; it's just not a simple answer, because it reduces depreciation, increases rent expense, and then it has an impact on shares outstanding and interest expense. So, by far the largest piece, the majority was increase in SG&A in our stores.

Matthew Fassler - Goldman Sachs

The second question, also following up on your prior comments, you talked about the impact that the wireless airtime, kind of the P&L geography shift -- prepaid wireless airtime that is -- had on the comp rate. What does that do to the gross margin rate? Because I would imagine that while it didn't impact gross margin dollars, it raised the reported gross margin from where it would have been.

David Barnes

Clearly, it raised it. The math is pretty simple. It had no impact on gross profit dollars, but lowered revenue by $30 million.

Matthew Fassler - Goldman Sachs

We would just do the math on gross margin basis?

David Barnes

That's right. The math comes out to roughly 150 basis points positive.

Matthew Fassler - Goldman Sachs

My final question is for Claire. You're working on a turnaround plan that was devised when the Company was under other leadership, under David, ex-CEO. Obviously, you and David Barnes and others who are still with the Company were involved in formulating that plan. But that said, you didn't own it singularly when it was rolled out.

Are you taking a look at the strategic direction of the Company from your own perspective right now, and do you expect to change that plan significantly, or do you think it needs to be changed significantly from the plan that you all talked about a couple of months ago when you first launched it, but Dave Edmondson was still in the CEO seat?

Claire Babrowski

You know, one of the beautiful things about the solidity of the turnaround plan is that it is truly a plan that was developed by the senior management team in total. Obviously, one person has to lead an effort like that, because there's focused work that has to be done. But that person is a man named Gary Stone, who is the Senior Vice President of Real Estate for RadioShack.

The process we went through, and the involvement of every member of the senior team, and the commitment of every member of the senior team to the plan, not because it was imposed on us but because we helped develop it and believe it, remains as strong at the moment as it was when we developed it.

To extend the thought beyond the immediate turnaround plan, though, the answer to the other part of your question around strategy looking forward, the answer is yes. A few of the executives and I are quietly but assertively having a look at assumed success on the turnaround plan, and then what comes behind that.

We are in the process of developing a three-year financial plan for our board to have a look at at their meeting in May, and are also looking at the development of a 10-year roadmap that -- again, both ideas assume success in the turnaround plan, that the businesses stabilize and the financials are strong. Then, with an eye to, based on technology and consumer trends, where do we take this wonderful little jewel RadioShack next?

Matthew Fassler - Goldman Sachs

It does sound like for the moment you're culling out in areas like expenses just simply to tighten your belts to increase the prospects for success of that turnaround plan. Is that accurate?

Claire Babrowski

We are doing that, but that was part of the turnaround plan. The second goal of the turnaround plan was to rationalize our cost structure. The reason we weren't able to announce exactly what the tactics were in that in February is because we hadn't decided what they were yet.

Operator

Our next question comes from Jeff Stein, KeyBanc.

Jeff Stein - KeyBanc

You mentioned that customer response, or customer association between RadioShack and Cingular was below plan. How much was it below plan, how much do you think that played in the below-planned wireless sales, and how are you going to increase that association moving forward?

Claire Babrowski

Increasing awareness. The wireless recovery plan that we have in place encompasses our entire wireless business, not just the Cingular business. One of the opportunities we have is to increase general awareness that RadioShack is a destination for wireless at all. Again, obviously, there's millions of existing Cingular customers out there that when they would like an upgrade on their postpaid phone, or to top up their prepaid phone, we'd like them to know that RadioShack is where they could do that.

We have learned in the course of the first quarter that some of the marketing and media tactics that we used just don't get heard by the customers that we're trying to target. We've had the opportunity to look pretty granularly with some statistical validity at when we do X from a marketing and media point of view, what actually happens in terms of consumer response?

So all of that is part of the shift that we're making in our approach to advertising and marketing as we move forward. We're going to use vehicles that actually reach the people we're trying to target with a relatively high efficacy, as opposed to just a scatter shot approach to the market in general.

Jeff Stein - KeyBanc

A follow-up question. Can you talk about Sprint, Nextel sales relative to plan, within the lower wireless sales?

David Barnes

Our issue relative to our expectations was related to the ramp-up of the Cingular business. The Sprint business was at or better than our expectations.

James Grant

We'll have time from one more question.

Operator

Alan Rifkin, Lehman Brothers.

Alan Rifkin - Lehman Brothers

With respect to wireless, Dave, you mentioned that prepaid in particular really negatively impacted your comps. I was wondering if maybe you can tell us what your advertising plan is on prepaid specifically in the second quarter relative to last year?

David Barnes

First of all, prepaid was very strong; it was the postpaid business that was weak.

Alan Rifkin - Lehman Brothers

I'm sorry. Postpaid. What is your plan for postpaid relative to last year in the second quarter?

Claire Babrowski

Actually, some of the learnings that we've had in terms of how to shift our approach to marketing have to do with insights we have gained on the consumer about wireless in general. So, I would rather not broadcast our marketing plans to the competition.

Alan Rifkin - Lehman Brothers

Okay. Claire, you mentioned that the closures will be accretive to cash flow. Now that you've identified 480 stores of the potential 700, can you maybe provide an update as to what the accretiveness to earnings will be from those store closures?

David Barnes

Let me try to help there. The idea was not that it was accretive this year; in fact, of course, we have closure expenses, leases, fixed asset write-downs, most of which we recognized in the first quarter, and severance costs. The pop we get on an ongoing basis will of course depend on the sales transfer from the closed stores to the others. In any case, it will not be meaningfully positive until 2007 on an ongoing basis.

Operator

Thank you. That will conclude today's call. Thank you for joining us. Have a great day.

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Source: RadioShack Corporation Q1 2006 Earnings Conference Call Transcript (RSH)
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