Much has been written in the press about my RadioShack (NYSE:RSH) recommendation in June of last year.
At the time I recommended it, RadioShack had just replaced poor performing CEO David Edmondson with retail-turnaround guru Julian Day.
Mr. Day was just coming off a huge success, helping billionaire value investor Edward Lampert increase the operating performance of Sears Holding Corp (NASDAQ:SHLD) after the merger between Sears and K-Mart.
The plan was to work his turnaround magic at RadioShack, and from what I could see by looking at the financials - it was very doable:
The first thing that you’ll notice is that from 1998 to 2005, sales increased from $3.5 billion to $5 billion. Not too shabby at first glance.
But over the same period, gross margins declined from 52.1% to 46.7%. That meant that the company was paying manufacturers more money for the products they were retailing. This is a very hard thing to do in an environment where China is making all sorts of electronics cheaper.
Operating margins also trended downward the entire time, going from a high of 14.4% to 9.3% in 2005. That meant the company had higher selling, general and administrative costs than they should.
In a period where the company paid down 10% of their debt – and lowered its interest expense - operating margins should have been going higher instead of lower.
Last but not least, net profit margins sank from 6.8% to a dismal 4.2%. In a company that does $5 billion in sales, that means a decrease in net income of over $120 million.
As I studied all this information, it occurred to me that from 2000 to 2006, one person was running the company - David Edmondson. It was only after he came on board that RadioShack's numbers fell apart.
Naturally, the stock price soon followed, with the shares collapsing from the $35 range to the $16 range.
Retail Distributor Turnaround Plan 101
Mr. Day knew, as do all good managers, that his first priority was to "right-size" the income statement.
That meant he was going to have to study the most important metrics in retail: revenue per square foot, cost per square foot and profit per square foot.
To increase gross margins, Mr. Day had to look at which products were least profitable and replace them, using the space instead for products that were more profitable.
To increase operating margins, Mr. Day would have to lay off hundreds, if not thousands, of good and honest workers through store closings and general releases.
(I know there was uproar about this, but the reality is that many of the workers who were laid off shouldn’t have been there in the first place.)
Based on Mr. Day's past experiences, neither feat seemed too difficult to achieve.
Indeed, every percentage point that a $5 billion company like RadioShack increases its profit margins means an additional $50 million in profits, which is an extra 37 cents per share.
Ultimately, the goal was for net profit margins to advance from 4.2% back to 7.7%.
In 2005 alone, that would have meant RadioShack's profits would have been $333 million, or 56% higher than what they were. As a result, per share earnings would have soared from $1.43 to $2.23.
At 15 times earnings, the stock would be selling in the $30 - 40 range.
A Classic Fallen Angel Stock
Forget new store openings. Forget additional revenue growth. And forget any big promises for world domination.
Based solely on a rebound in profits, it was clear to me that RadioShack shares were a bargain at $16.25.
But soon after recommending the stock, Wall Street seemed to wake up to the fact that RadioShack's problems were fixable and that Julian Day was the right man for the job.
Within months, the shares started moving upward, hitting a high of $35 earlier this year. (We sold the stock at $29.31.)
Is RadioShack a Buy (Again) at Current Prices?
But here we are in mid-October, and RadioShack shares are selling for $20, or 42% below its peak price earlier this year.
In the meantime, Mr. Day just keeps knocking the cover off the ball operationally. Here are some highlights from second quarter earnings, released July 30th:
- RadioShack Corporation today announced net income of $47 million (or $0.34 per diluted share) for the second quarter of 2007 versus a net loss of $3 million or $0.02 per diluted share.
- Cash balances increased to $630 million at the end of the second quarter of 2007, an increase of $460 million versus second quarter of 2006. The increase was mainly driven by the growth in net income, as well as improvements in working capital management.
- Gross margin rate for the second quarter increased 330 basis points over last year, from 47.2% to 50.5%. The increased gross margin rate was a result of improved inventory management and a more profitable product mix.
- SG&A expenses declined by $106 million or 22% for the second quarter of 2007. This decrease reflects a continuing effort to improve our return on expense dollars, most notably on payroll, professional fees and advertising.
So, with such stellar performance, why has the stock taken such a beating?
It's because Wall Street was spooked by a same-store sales (stores open at least one year) decline of 8.9%. In addition, total company sales declined by 15%.
But the declines mentioned above aren't a surprise to anybody who has ever listened to Mr. Day speak, or read anything that he's written.
Indeed, they're the direct result of Mr. Day's stated focus on closing unprofitable stores (481 at last count) and replacing unprofitable products with profitable ones.
As a matter of fact, everything so far seems to be going exactly according to Mr. Day's plan.
Does that mean RadioShack is a buy at $20 per share today?
Only if you believe that Mr. Day can execute Phase II of Retail Distributor Turnaround Plan 101 - the profitable growth phase.
And based on his track record, I'd never bet against the man.