RSH : An undervalued retailer

I was hesitant about writing up my RSH position, since there is basically already a cacophony of positive value-oriented reviews out there, and I’m not sure I’ll be adding much. But in the end, I decided to stick to the discipline of writing up every one of my positions, so here goes.

Radio Shack needs no introduction. There is a Radio Shack within 5 miles of 94% of the US population. The stores are small, and the business model is to sell small electronics at ridiculously high markups, with a gross margin around 45%. They have done well through the recession, with revenues roughly flat for the last 3 years through the teeth of the recession. The TV converter box sales came just at the right time to offset the recession, plus the company under CEO Julian Day has made many right moves and closed down a slew of low-performing stores, dropping the store count from 6000+ to 4000+ over the past 5 years. Why then has the stock dropped dramatically in recent days? I think this is largely because of hedge funds dumping the stock after the rumored takeover for RSH failed to materialize, plus the combo of a recent downgrade by analyst Stephen Chick followed by the departure of highly regarded CEO Julian Day just made things worse. I’ll now examine a few of the bearish arguments.

The news of RSH’s death has been greatly exaggerated. A popular bear argument is that the world is shifting to laptops and smartphones/tablets, and no one would want to buy the TV and peripheral cables that has been so profitable for RSH. I agree with their premise, but disagree with their conclusion. For historical reasons, there has always been the perception of RSH being this musty electronics store where one goes to find that rare battery/cable/part. Perhaps it is natural to focus on the stuff that RSH carries which is not carried by other stores. Based on this perception, the impending death of RSH has been reported repeatedly through the years, yet RSH never actually dies. RSH began with radios, of course, and for a long period of time (spanning some 4 decades, from the 1940s to the 1980s), radios and hobbyist electronics parts was all RSH needed. As radio sales began a terminal decline in the 1980s, RSH latched onto the nascent desktop computer, which was also very profitable for a couple of decades. But the electric gods are fickle, and those sales also faded in time. But again, RSH was saved by a rise in the sales of gold-plated cables for Hi-Fi audio and video. And somewhere in there was an insanely profitable remote control car fad. And more recently, the GPS device fad was also very profitable. Every time some electronic device enters terminal decline, it becomes obvious to all that RSH will inevitably fail, yet another device always pops up in its place. In short, humans will always crave new electronic gadgets, so inventors will always come up new gadgets when the old ones stop being cool, and RSH will always be there to sell those new gadgets.

Smartphones, the fad du jour. To understand why RSH isn’t dead yet, it is important to understand what RSH actually sells today (a task not facilitated by RSH’s opaque sales grouping). Basically, most analysts think that approximately 66% of RSH sales are of wireless phones and associated accessories, and 33% is everything else. The problem with two-thirds of your sales stemming from phones is that when those sales are apparently threatened, a visceral fear reaction arises in all investors. I am referring here, of course, to the threat of the Verizon iPhone cannibalizing AT&T future iPhone sales (RSH sells AT&T phones in its stores, but not Verizon phones, although Verizon phones are available at Target kiosks run by RSH). Firstly, I would point out that when the Verizon iPhone news broke, AT&T stock fell 5%, whereas RSH stock fell 20% on the subsequent downgrade. Now if AT&T investors are not that worried about future lost iPhone sales, what does that tell you about the profits derived from selling iPhone? While RSH does not break out iPhone sales, it is well known in the industry that there is limited profit in selling iPhone and iPads for everyone except Apple. Next, let’s examine the volumes of recent smartphone purchases. It is anticipated that nearly all future mobile phones sales will be smartphones, and legacy mobile phones sales will approach nil, so let’s just look at smartphones in isolation. From June to November 2010, 41% of smartphones sold were Android phones, whereas 26% were iPhones. Despite the current hoopla in the press about the Verizon iPhone, it is actually expected that the iPhone market share will continue to slip behind Android as the smartphone category grows. This is a reasonable state of affairs just based on the DNA of the companies involved. Apple has always made beautiful things, sold them at premium price points, and kept the bulk of the profits thereby achieving fantastic profitability despite a small market share. Google has always gone after growth and scale, gives away software for free, shares revenue with partners, and achieved good profitability through scale. So, I believe that the loss of Verizon iPhone sales is a minor matter, and will be more than made up for by Android sales. Furthermore, Verizon iPhone demand currently outstrips supply, and basically the phone is being sold only through Verizon, Apple and Walmart stores. There would be no point in selling through other avenues, because there aren’t enough phones to cope with additional demand anyway. If Walmart was not such an important retail partner, they wouldn’t even have shipped the phone to Walmart. In due time, when the buzz dies down and the competition heats up, the value of showcasing the Verizon iPhone at as many retail locations as possible will become more apparent, and Verizon and RSH might well strike a deal to do just that. Until then, RSH still has AT&T’s iPhone to bring the foot traffic through the doors.

The bull case for RSH. Smartphones and tablets are products that are almost tailor-made to maximize profitability for RSH. They are small, allowing RSH to offer a selection equivalent to that provided by larger stores such as Best Buy. And they are expensive, maximizing profit per area of retail space. In fact, they are so profitable that Best Buy is rolling out its own Best Buy Mobile kiosks to try and compete. And smartphones have a shorter useful life than a laptop. People drop phones, and their batteries have a life of only 2 years. In addition, RSH actually makes money off buying back old phones and reselling them after refurbishment. And we have not even touched on possible tablet sales and the looming tablet wars. In short, I believe that RSH is at the cusp of another huge fad which should prove very profitable.

Revenue prediction. There are two moving parts in RSH revenues. The 66% that comes from wireless phones and accessories is increasing dramatically, with phone sales jumping 40% in 2010 compared to 2009, but the 33% of other legacy electronics is facing decline. Much of the 40% increase is due to a one-time addition of T-mobile to the lineup, but analysts widely predict 15-20% increases in phone sales in 2011. The rate of decline is very steep in the personal electronics segment (consisting of digital MP3 players, digital cameras etc.), with up to a 20% decline, but the decline of other legacy products is much less steep, somewhere around 2-4% per year. Combined, the overall rate of decline in the legacy business segment is around 7.5%. A 15% increase in the phone segment and a 7.5% decrease in the legacy segment give a net increase of around 6% in revenues. It is likely that the loss of the Sam’s Club kiosks (450 kiosks bringing in 6% of revenues) will be more than compensated for by the rollout of Target kiosks (approximately 1400 kiosks, with exposure to a more affluent clientele), but let’s assume that it is a wash. The 2010 revenue is likely to come in at $4.4B, a 5% increase over 2009 revenues. It is reasonable to postulate that with a recovering economy and the introduction of new tablets and phones, another 5% increase in revenue is likely. So let’s postulate 2011 revenue of $4.6B, another 5% increase over 2010 levels. A 45% gross margin (the low end of the past 3 years) gives gross profit of $2.07B, reduced by operating expenses of $1.6B, net interest expense of $40M, and income taxes of $150M to give earnings of $280M. I know this estimate actually exceeds the most optimistic analyst estimate of around $225M by a large margin, but I truly do believe that the smartphone growth trends are that powerful. But feel free to assume another set of numbers. No matter how you slice it, I fail to see how RSH can come up with an earnings of less than $200M.

Valuation. RSH is a retailer with cyclical characteristics, and is prone to fads. More stable retailers, like WMT and TGT, currently trade at an earnings multiple of around 14. The closest correlate, BBY, trades at a multiple of 10. Let’s say that RSH is more volatile and less valuable than BBY, because of its smaller stores, and give it a multiple of 8. For simplicity, let’s further assume that RSH uses all cash on hand ($720M) to pay off all long-term debt (approx $680M), thereby saving $40M in interest expense annually, and bringing earnings to $320M. Applying a multiple of 8 to this will give $2.5B, or approximately $22 per share. This would be below the $24.50 conversion price of its $325M convertible notes due in 2013, and is more than 35% above the current share price.

Disclosure : I own shares in RSH.