Monday, July 30, 2012

RadioShack as a net-net?…well sort of

Tandy Computers, CB radios, satellite dishes, transistors, capacitors, and stereo systems; what do they all have in common?  They were standard inventory at RadioShack just a few years ago, well maybe decades ago.  RadioShack has been hitting the news recently as they've become the most recognized "net-net" struggling with a turnaround.

RadioShack is an American retail chain that started as an electronics outlet and morphed into a cell phone store.  The company has a storied history with a whole website devoted to old RadioShack catalogs, and plenty of retro commercials on YouTube.  I spent some time browsing the old catalogs, it's amazing how much better and cheaper things are now.  To RadioShack's credit they were early on the cell phone trend.  Here's a little comparison:

Then (1987)


Now


Interesting to note that the monthly price only dropped $10 over the last 25 years.

Is it a net-net?

The purpose of this post isn't to walk down memory lane, but to evaluate how attractive RadioShack is now that they're purported to be a net-net.  I use purported and net-net in quotes above because as you'll see below they don't quite qualify as a net-net as Benjamin Graham would define it.  Graham defined a net-net as net current assets minus all liabilities.  If an investor just focuses on the balance sheet RadioShack qualifies with current assets of $1741m and total liabilities of $1383m for a NCAV of $358m against a current market cap of $257m.  Seems great right?  RadioShack is trading at 71% of NCAV and cash flow positive, so what's the problem?

There was a very good reason Graham took liabilities at face value and discounted assets.  Liabilities have a way of torpedoing investments whereas companies are rarely evaluated on their assets alone.  The goal of determining NCAV is to calculate a price at which buying below gives a margin of safety.  If assets are included that can't be sold, or select liabilities ignored the investor is just fooling themselves into thinking an investment is safer than it actually might be.  To me this is the most serious error an investor can make, an underestimating risk.

I have my own spreadsheet that I use to calculate NCAV, I only use cash, receivables, and inventory against all liabilities.  Here is what it looked like for RadioShack using just the balance sheet from the latest 10-Q:


My numbers are slightly lower than the back of the envelope calculation above.  With a current price of $2.59 against my calculated NCAV of $1.63 RadioShack doesn't qualify as a net-net. If an investor moved on at this point it would be understandable, but I want to drill a bit deeper to highlight an second issue.

Many investors don't take liabilities seriously enough.  A net-net investor could be forgiven because after discounting assets and subtracting liabilities the value they have is very conservative.  The problem is some companies like RadioShack have liabilities that are off balance sheet, mainly leases and purchase commitments.

RadioShack's operating leases are non-cancellable, which means the lessor is going to get their money before a shareholder gets a dime.  Purchase commitments in RadioShack's case are contracts to purchase a certain amount of inventory over the next year.  They also have some marketing expenses grouped in with purchase commitments.  Purchase commitments are sometimes necessary for a company to lock in discounts on bulk inventory purchases.  It could also be necessary if the retailer is buying a specialty item where a custom production run is necessary.  The marketing expenses could be things like TV or radio advertising where blocks of time need to be purchased in advance.

If I re-do the net-net worksheet to include both the operating leases (discounted at 6%) and purchase commitments RadioShack fails to be categorized as a net-net.  Unless the company increases their inventory (which would be bad), their receivables (bad as well), or their cash it doesn't look like an investment in them on a net-net basis would have any margin of safety.




Can it turnaround?

I'm not an expert in turnarounds, but I did notice something while browsing through the old catalogs, RadioShack is no stranger to reinventing themselves.  In the 1940s the company billed itself as the largest distributor of amateur radio equipment.  In the 1950s and 1960s the stores started to carry more stereos and TV equipment.  In the 1960s RadioShack started to ride the CB radio trend feeding right back into the stereo craze of the 1970s.  In the 1980s RadioShack the store introduced computers, and VCRs.  The 1990s brought cordless phones, answering machines and pagers.  The company seems to have lost their way a bit in the early 2000s before stumbling back into the cell phone business.

I don't know if the transformations are in the company's DNA or if they were a forced necessity.  I would have more confidence investing in a company that's reinvented themselves multiple times over a company that's attempting it for the first time.  The big question to ask though is what's next for RadioShack?  What's the next big trend they can grab onto and ride to profitability?


Disclosure: No position


19 comments:

  1. Nate,

    On cell phone hardware versus cell phone service pricing over time: I think the culprit is regulations and the FCC.

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    1. Not sure I follow. The hardware cost came down over time as production improved and the parts became cheaper. The actual monthly price stayed about the same. I think it's the same because the companies determined that's what people are willing to pay.

      Consider paying for text messages, it's crazy. The text message is carried over the protocol the phone uses to check for service. There was enough empty space in that packet for a 165 character message, so an engineer stuck on in there and text messaging was born. If a phone is turned on and checking for service it can send and receive texts. The fact that companies are charging $15/30 etc a month for something that's intrinsic to how the phone works is highway robbery.

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  2. In a liquidation scenario do you know if the leases have a value, i.e. can they be sold (for a discount - of course)? The right to use a shop in attractive locations should have some value?

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    1. If the leases were in prime locations with limited availability subleasing is a way they could escape them. I'm not sure if they could resell the leases and turn this liability into an asset.

      My bigger concern is the RadioShack locations I've seen are not in ideal locations at all. I can think of three or four off the top of my head that are in second run strip malls that sit half empty.

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    2. I think leases are liabilities and assets but as far as the net-net worksheet is concerned they are fixed assets and therefore do not count in the net current asset value calculation or count at a very steep discount (in your worksheet Nate I'd use the same multiple as PPE). Meanwhile in accordance with Graham's principles the full value of the liability must be deducted from net current asset value.

      In the UK at least leases can be sold as well as sublet. Whether anyone wants it, and at what price, is the question.

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  3. Assuming that RSH paid market price for the lease, the price of a bad location is already discounted. However, we do need to discount for second hand and recession level market prices. Anybody knows a reasonable factor to discount the leases with? I do think 100 % is a bit harsh...

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    1. balans,

      Your view is very common, people seem to view debt as a real liability whereas an operating lease is something less. I think this is why companies like operating leases, they appear off the balance sheet and investors don't view them the same as debt.

      I would argue that an operating lease is the same as debt. Consider this, RadioShack purchased outright all of their locations, and financed them 100%. What you're suggesting is that some locations are so premium that RSH will be able to sell their location at an appreciated rate. This might be true in some areas but less likely with leases. The reason is leases are renewed every so many years so the company will be paying market rates. If a shopping center is a very desirable location they might decide to raise rates. As I mentioned my issue is the RadioShack locations I looked at were not in desirable locations, I haven't done an exhaustive study. But if all of their locations are in crappy shopping centers in Pittsburgh, Cleveland and Cincinnati (cities I know) it seems strange to assume locations in other cities are in desirable shopping centers.

      I'm not trying to bash the company, but I do think leases are a real liability on par with debt, and I'm suspicious about any value locations have. I think rather the opposite would be true, the company might have trouble getting out of leases for lack of demand.

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  4. If cash has to outlaid in the future to cover any operating leases on locations that can't be subleased etc then its debt plain and simple.

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  5. Well, I think net-net investing is generally a form of protection against equity wipeout in bankruptcy. And, in view of that, lease liabilities are less harsh than than other forms of debt.

    Radioshack could file for bankruptcy and reject the leases; the lessor then files a claim for any unpaid rent at 100%, and future rents capped at 15% of the committed amount (or 1 year, whichever is more).

    To put a hard figure on it, for the purposes of RSH liquidation analysis, I'd value the leases at $195 million.

    But, in a liquidation analysis, I'd add in the legal and other costs of the bankruptcy process itself.

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    1. Red,

      Interesting, so leases would be at about 50% given a rejection in bankruptcy. The question I'd have is if RadioShack and rejected the leases in BK what are the chances shareholders would get anything? In my thinking leases are higher up on the capital structure than shareholders, so if anyone's going to get paid it's lessors over shareholders.

      As you say net-net investing is determining a margin of safety. That's why I included the purchase commitments, RSH has entered into a contract to buy those goods and do that marketing. Shareholders are lower on the pole than vendors.

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    2. RSH would reject the leases in order to try to recover something for equity. By rejecting the leases, they would shrink the unsecured debt claims by, in this case, 50% of the lease commitment. So, it's a positive for equity in that sense.

      I hasten to add that for a going concern valuation, leases are debt pure and simple, and usually understated too. Best thing is to capitalize nex year's commitment (or this year's rent) by 7x or 8x to get the true value of the debt-equivalent.

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    3. Their leases run down pretty quickly:

      Commitments by year (2011 10-k):
      2012: $195
      2013: $142
      2014: $100
      2015: $70
      2016: $38

      So this could allow them to slash their store base and thus cull less profitable stores. They're expanding in Mexico, they have the Target kiosk biz which is still ramping up...

      It's definitely speculative at this point, but given that in 4 years 80% of their leases will expire...

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  6. Just to add another thought: if some of the leased space is in undesirable locations, RSH may try to precipitate a bankruptcy specifically so that it could weed those particular leases out by claiming that they are "burdensome".

    RSH is on my BK watchlist for this reason. I suspect it will be cheaper then than it is now.

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    1. If they went BK and cleaned up the balance sheet eliminating some debt and leases this would become very interesting. I can see a clean equity stub coming out of a BK having a lot of potential.

      Thanks for the comment on the least multiplier as well.

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  7. RSH is such a classic value trap, I don't even have to look at the balance sheet or anything else to know that this is DOOMED. There are so many better companies and stocks out there, but value investors still get attracted to these bottomless capital sinks.

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  8. Well, too say I'm the smart guy in this case would be quite an overstatement, given my long position RSH, but there have been seven different insider buys files since the quarterly results. Maybe there is one puff left..

    Regards,

    Floris

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  9. Re-invention will be a requirement for them to survive. The problem is that previous management moves might hold less weight on today's.

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  10. If you deduct the purchase commitments, dont you need to add some inventory? Presumably they could resell whatever they committed to buy...even if they had to sell it at a 50% loss.

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  11. Interesting post on radio shack. It appears to still be in decent shape financialy not great shape but not really bad shape either. The thing that I do not get about this stock is why it trades at such a low price. The price to sales ratio or another way to define price to sales ratio is market cap its just under 300 million yet the company does over 4 billion in annual sales. They have cash or they show cash of 500+ on their balance sheet. I checked the company out on yahoo finance. Their a little leveraged. I think they have around 700 million in long term debt. But here's the thing with 500+ million of cash on their balance sheet its a really cheap stock. I would have to take a closer look in their financial statements to see if some of their long term debt Is comming due soon. It must be the case because the only way that a company that seems to still be in reasonably decent shape financially with 500+ Million siting on their balance sheet but has declined from 34 dollars just a little over five years ago to just 3 dollars today must have a potential problem refinancing its debt comming due. All that being said. You cannot beat this company as a great turnaround stock. I love to see a company thats really undervalued with lots of cash.

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