Shares of RadioShack (NYSE:RSH) closed Friday down over 11 percent in response to a downgrade of its debt by Standard and Poor's on Thursday evening. S&P cut RadioShack's debt to 'CCC', defining the company as "currently vulnerable and dependent on favorable business, economic, and financial conditions to meet financial commitments." The ratings agency also warned that "a default could occur within 12 months," according to the Fort Worth Star-Telegram.
At first glance, the risks of a near-term default would seem premature. After recently paying off $214 million in convertible debt (a payment the company confirmed to several outlets), RadioShack should have about $250 million in cash and $386 million on a revolving credit facility. (Note: the $250 million includes $32 million in restricted cash pledged as part of an insurance policy; RadioShack can replace the cash with a line of credit at any time, which would be deducted from the credit facility.) Meanwhile, maturities of future debt are limited in the medium term:
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But, at the same time, there will be significant pressure on RadioShack's cash balance going forward. On the Q2 conference call, analyst Daniel Wewer noted that the company was guiding for capital expenditures of $40-$60 million in the second half of the year. Net interest expense for the first six months was $28.4 million; even considering the removal of the convertible debt, which only carried a coupon rate of 2.5%, interest expense should be about $25 million in the back half.
S&P also noted concerns about whether the company could create operating cash flow. Free cash flow for the first half of 2013 was sharply positive, at $51.3 million. But the gains came solely from a $104.6 million change in working capital, driven by a $82.5 million decrease in inventory. That will reverse ahead of the critical holiday season, when RadioShack will need to build up its inventory. Meanwhile, operating cash flow in the second half of last year (based on data from the 10-K and the most recent 10-Q) was negative $66 million; with revenue likely to be flat at best, another OCF loss seems likely for the back half of 2013.
So with $75 million expected in interest expense and capex, another $75 million perhaps needed for inventory, and OCF costing perhaps $50 million, RadioShack could use up $200 million of its $250 million in cash by year's end, if not more. The company could tap its revolver to ease the cash burn; but that will only drive up future interest expense, making the return to profitability that much easier. In addition, that decision would make vendor financing terms likely tighten.
In short, it's not difficult to see RadioShack entering into a death spiral despite what appears to be a currently reasonable liquidity profile. S&P isn't the only ratings agency to question its viability; meanwhile, RadioShack bond prices have fallen and its credit default swap prices have risen sharply. Despite a coupon rate of 6.75%, RadioShack's 2019 debt is trading at just 72 cents on the dollar, showing a clear risk of default; CDS prices show similar fears.
Even without a near-term default, it's not clear that the RadioShack turnaround story is worth buying into. It's worth pointing out that many investors have; the stock doubled from the first of January into mid-May before turning south and giving back about 40% of those May highs. Yet, even including Friday's losses, the stock is still up 21 percent year-to-date.
Some bulls have pointed to the company's book value as a reason for optimism. That book value after the end of Q2 still sits at $4.67 per share on a tangible basis, nearly double Friday's close of $2.57. But investors need to understand where that book value comes from. Largely, it comes from inventories, which sat at $825.8 million at the end of Q2, versus a tangible book value of $470.1 million. Writing down inventories at 50 percent erases 88 percent of that tangible book value; doing the same for property, plant, and equipment (the majority of which is fixtures, not real estate) would wipe out the remaining equity. It seems clear that in a hypothetical liquidation, there would be nothing remaining for equity holders, particularly since the revolving credit facility is backed by the company's assets (including that inventory and PP&E).
Book value will also be eroded in the near term by the company's turnaround strategy, which includes limiting the assortment of items required and removing inventory through promotions and clearance sales. This may help cash in the near term, but will reduce book value as inventory carried at a higher value is replaced by smaller amounts of cash on the balance sheet. Indeed, RSH's book value per share has steadily declined, according to the 10-K, dropping from $8.37 per share at the end of 2009 to $5.03 per share currently (including a small amount of goodwill remaining.) That decline seems set to continue.
In short, RadioShack simply must turn around its operating business, but it's far from clear that it will be able to, or at least be able to soon enough to avoid its potential liquidity crunch. While the company did surprise in Q2 with positive comparable sales, net sales are still declining due to fewer company locations. On the conference call, new CEO Joseph Magnacca noted the "five pillars" of the turnaround strategy. The problem for RadioShack, and its shareholders, is that none of the pillars look particularly solid:
1. Repositioning the brand.
Magnacca wants to provide a "clear and consistent message" around the theme "Let's Play." The new CEO appears to be finally turning away from the company's disastrous strategy to emphasize mobile phone sales, which would appear to be a positive. But changing the branding of a well-known store like RadioShack is difficult. The company did score some points in customer perception with a recent, semi-scandalous, ad campaign for headphones and speakers, but much more work is to be done. Can the company do it quickly enough?
It's also worth noting that neither the RadioShack website nor its current weekly circular feature the phrase "Let's Play" anywhere (save in the home page's title which appears on a browsing tab). All told, RadioShack has been through numerous re-brandings, all of which have led the company to its current, precarious position.
2. Revamping the product assortment.
As noted, the company is limiting its inventory assortment, dropping from above 4,000 distinct items to under 3,000. RadioShack is also looking to "localize" inventory based on demand and revamping its private label business by limiting the number of brands and improving their quality.
The company is -- finally -- returning to its roots as a purveyor of high-margin electronics accessories, and did show some success in that initiative last quarter. The company's so-called Signature segment saw comp sales rise 6.4 percent in the quarter, leading to the surprising comp gain for overall sales.
The problem is that Signature must overcome headwinds in Consumer Electronics -- an area the company is de-emphasizing, ceding that ground to Best Buy (NYSE:BBY) and others -- and in the Mobility segment (the sale of pre- and post-paid wireless contracts). Mobility sales also rose on a comparable basis, but those figures are somewhat misleading. Average selling prices (NASDAQ:ASPS) for mobile phones continue to rise, due to the increasing weighting of higher-end smartphones in mobile sales. So flat sales, and a 1.7 percent comparable gain, mask declining unit counts. Declining unit counts mean declining profits; this is why gross margin fell from 40.1% in Q2 2012 to 37.2% in Q2 2013 despite higher sales in the Signature segment.
All told, even success in revamping the new product assortment may not be enough to overcome the consistent margin headwinds posed by Mobility and the removal of profits in Consumer Electronics.
3. Reinvigorating the stores.
Magnacca pointed to new concept stores in the New York area as part of the "strategy for reinvigorating our store experience." Yet he admitted that only "a small percentage of our store portfolio in highly visible and in high-traffic locations" would be affected by the change. In other stores, inventory would be reduced, "which will create a cleaner and more open feel."
The problem is one of volume, and cost. RadioShack operates 4,311 stores in the US as of June 30th, according to the 10-Q; it simply does not have the cash balance, or the cash flow, to aggressively change the look of its locations. If the company committed $100 million -- money it simply cannot commit now -- to updating its stores, it would be able to spend barely $23,000 per location. That might be enough for small cosmetic changes, but it's hardly an overhaul.
The company is also spending a substantial amount of money on its e-commerce presence; in response to an analyst question on the conference call, Magnacca noted that the sharp increase in capex in the second half of the year was coming almost solely from IT initiatives. The company is spending $30-$50 million on infrastructure for its website and what the company called "continuous channel" marketing. That has shades of "omni-channel" retailing -- a popular buzzword in the retail sector -- but its value for RadioShack isn't clear. The Internet hasn't been friendly to RadioShack, who simply cannot compete on price with Amazon.com (NASDAQ:AMZN). (In fairness, who can?) Sending customers to the Internet, where price competition is only a click or two away, seems less effective than simply becoming "useful" or focusing on the company's long-neglected customer service. Either way, the substantial spending on e-commerce -- as much as 25 percent of the company's remaining unrestricted cash -- is clearly a gamble.
4. Operational efficiency.
Toward this end, the company has brought in turnaround specialist AlixPartners. But it's not clear how much room the company has to cut operating expenses. Even in 2015, the company has $108.7 million in rent commitments (according to the 10-K), more than half of its 2013 figure. RadioShack will not be able to dramatically cut its footprint for several years. There would seem to be little fat left to trim in terms of retail labor expense -- RadioShack associates, on average, make less than $8 per hour. And while SG&A fell modestly year-over-year in the first half, its cost as a percentage of revenue rose from 38.7% to 39.8%.
5. Financial flexibility
The company has again turned to an outsider, hiring Peter J. Solomon Company to "evaluate opportunities and strengthen our balance sheet." But with bond prices plunging and CDS spreads widening, it's hard to see what RadioShack can do in terms of raising capital. Certainly, any capital raise would likely be significantly dilutive to current shareholders, and engender a steep short-term decline in the share price.
For RSH shareholders, the problem is that a turnaround is the only way for the stock price to recover. The importance of inventories and PP&E to the balance sheet and the company's book value mean that RadioShack's liquidation value on the equity side is likely zero, or little above that. There have been often hopes for a takeover of the company, citing potential acquirers including Best Buy, Amazon, or even Google (NASDAQ:GOOG). With Google looking into a retail presence, a la Apple (NASDAQ:AAPL), might RadioShack locations provide a cheap and simple way for Google to sell Chromebooks and Google Glass?
But none of these rumors make any sense, for the simple fact that RadioShack simply has too many locations, and, as noted above, no way for an acquirer to immediately dispose of unwanted storefronts. Apple, for instance, operates 408 stores in 13 countries, according to its most recent 10-Q; RadioShack has more than ten times that many outlets in the U.S. alone. Similarly, Amazon does not need that many locations, and the physical presence would force the online retailer to pay sales taxes in every state and add overhead to the company's streamlined operations. As for Best Buy, it is already closing stores and reducing square footage; adding the entire RadioShack chain would more than triple the amount of stores it operated, a difficult proposition for a company undergoing a turnaround of its own.
Without real estate, without substantial capital to deploy, and without a sensible acquirer, RadioShack is left with only its turnaround plan to grow its current share price. But it's not clear that the plan has a significant chance of working; the defection of CFO (and former interim CEO) Dorvin Lively last month (to a privately held chain of $10 per month gyms, no less) after less than two years on the job certainly should raise doubts about insiders' view of the company. Default may not come immediately, but it could be closer than many realize. Even if RadioShack can stave off bankruptcy, it's hard to see any real catalyst to move it away from the precipice.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.