Description

RSH is a misunderstood turn-around story with a compelling risk/reward opportunity with a price target of ~$4.75 (+80% from $2.65 on 7/24/13) and downside of ~$2.00 (-24%). The upgrade cycle for mobile phones is set up to drive growth at RSH in the next two years.  RSH had to ride out the last two years as carriers elongated their contracts with consumers.  That period is now reaching its two year anniversary opening the door for renewed growth at RSH.  In addition, a new CEO with excellent merchandising experience from the drugstore industry recently joined the company.  Finally, the current valuation of 0.57x tangible book clearly incorporates recent business difficulties as well giving excellent downside protection.

Over the past 2 years, deteriorating EBITDA (48M pro forma in 2012 versus 252M in 2011 and +400M in 2007-2010) was driven by challenges in the wireless handset industry and consumer electronics, generally. With any retailer, declining same-store sales (SSS) and deteriorating Gross Margin (GM) % rapidly impact EBITDA and influence investor perceptions to suggest that a franchise is “going out of business”. Investors commonly overlook what actually drove the underperformance at RSH, namely the elongated Mobile Phone upgrade cycle and the margin but not dollar impact of higher-cost Smartphones. Higher Smartphone penetration came at comparable Gross Profit (GP) absolute dollars per unit, but lower GM %: ($100 GP on a $600 phone is lower GM % than $100 GP on a $300 phone, with the difference typically subsidized by the Wireless Carriers). As a result of the iPhone and other Smartphone launches, Carrier subsidies increased and the payback period extended, especially for Sprint’s 12-month upgrade policy. Instead of subsidizing $200 on a $300 phone over 2 years, Carriers were now subsidizing $400 on a $600 phone over 2 years. In 2H2011, Sprint announced a change to their upgrade policy to 24-months eligibility for trade-ins (from 12-months) and others Carrier soon followed. Immediately, RSH’s unit transactions decreased without the 12-month upgrade stimuli. Furthermore, due to supply chain problems in 2012, RSH was on iPhone allocation and both AAPL and Carriers would ensure their own inventory levels before providing stock to RSH. With new upgrade and product cycles (24-month lapping in 2H2013; 4G LTE promotions; Carrier competition) and initiatives around product assortments and whole-store selling, we believe RSH can achieve SSS momentum and EBITDA growth into 2015.   

• Smartphone Upgrade Cycle & New Product Launches: we believe pent-up demand for trade-ins from the 2H2011 change in contract terms and additional market penetration in both Smartphone and Prepaid wireless will drive Mobility back to pre-2011 Revenue and GP.

• SKU Rationalization, Private Branding & Re-merchandising: through 2H2HH2013, the company will reduce the SKU count to ~3,000 from ~4,000 today, localize product assortments, and reinvest inventory into new categories (electronic health / Fitbit). In addition, management has rationalized the number of private brands in the portfolio to focus on unique innovation (Bluetooth speakers) and better aligned sales commission incentives to whole-store selling versus previous push to Mobile only.  

• Limited Downside, Estimated ~$2.10: during the turn-around period over the next 2-3 quarters, management has indicated their intention to discount inventory to “create the room” for new categories. If we assume the 50M Net Loss in 2Q2013 persists for 4 quarters, this would be negative 200M downside to the current Book Value: so 470M Tangible Book Value (507M – 37M Goodwill) at 6/30/13 – 200M Net Loss = 270M pro forma Tangible Book Value assuming no improvement for 4 quarters. Without a clear turn-around, we believe 0.75X Tangible Price / Book is a reasonable stress multiple, so 270M x 0.75X = 203M Equity Value / 100M Shares = ~$2.00. Note that BBY traded to $12 in Dec 2012 or ~1.1X of Book Value.   We should also note that RSH is levered but is not in danger of tripping any covenants. 

Business Overview:

RSH is a retailer of consumer electronics goods and services through US company-owned RadioShack stores. As of 6/30/13, RSH operated 4,311 stores throughout the US located in strip centers, shopping malls, and individual locations. With a 90 year history, RSH has continually evolved to meet changing consumer preferences and has positioned itself as a destination retailer in convenient neighborhood locations for mobile products, home technology, and consumer electronics.

Beginning in 2007/2008, the company recognized the convergence of “single-use” devices merging into Mobile Phones (phone to wall; weather radio; GPS; alarm; camera) and took proactive steps to address these structural changes in consumer electronics. RSH aggressively pursued “Mobility” as a core strategy and currently receives ~50% of Total Revenue from “Mobility” compared to ~25% before the strategic change. In addition, RSH operates 273 company-owned stores in Mexico and has a network of 982 dealer outlets with 3^rd parties (mainly in the US) often engaged in other retail operations that augment their businesses with RSH products, services, and branding. Previously the company operated kiosks at Sam’s Club and Target, but has since exited those channels. RSH primarily operates within 3 platforms:  

• Mobility (~50% of Revenue): postpaid and prepaid wireless, commissions and residual income, prepaid wireless airtime, tablets, and e-readers. As a % of Mobility, Sprint is the largest Carrier and Verizon, which replaced T-Mobile, is the smallest. Sprint has fewer retail locations compared to AT&T / Verizon and maintains a long-standing relationship with RSH.

• Signature (Highest Margins; Estimate ~20% of Revenue): home entertainment, accessories (wireless, computer, music), headphones, technical products, and services.

• Consumer Electronics (Margins Similar to Mobility; Estimate ~30% of Revenue): laptops, PCs, digital music players, GPS, cameras, digital TVs, and other consumer products. DIY electronics is also a niche area for RSH.   

Catalysts & Opportunities:

• New Upgrade Cycle Sparked by Smartphone Introductions & Carrier Terms / Competition: as discussed above, we believe the 24-month delay from the 2H2011 change in upgrade terms and both higher Smartphone and Prepaid market demand could drive traffic, improve SSS, and increase EBITDA. Furthermore, intense Carrier competition and confusing contract terms could also drive more people to seek the consultative nature of RSH Mobility offerings. T-Mobile recently launched their new upgrade plan “Jump” to more aggressively pursue customers, which was followed a week later by AT&T and Verizon announcing similar upgrade plans. T-Mobile has publicly called AT&T’s and Verizon’s programs “deceptive” and has made multiple attempts to clarify differences in their own terms versus competitors. This competition and marketing likely results in additional subsidies and/or customer confusion, which would benefit RSH. Note, however, that T-Mobile currently is not available at RSH.

• New CEO Who Will Drive Re-merchandising & Private Label Innovation: the CEO, Joe Magnacca, joined in Feb 2013 with a proven ability to understand categories and merchandising. Although his background is in drugstores (Walgreens, Duane Reade, Shoppers Drug Mart) there are similarities between highly-consultative pharmacies and Mobility, as well as front-end versus back-end consumer products. He’s had success with aggregation of products versus brand rationalization and changing strategies with vendors from transactions to relationships. Also, there are changes to the shopping experience such as less merchandise density, a more open feel, clear product displays, and more opportunity for customers to interact with products. We believe he provides the leadership and vision necessary to reposition the RSH retail concept to categories and merchandise most relevant to consumers today and in the future.    

Key Risks:

• Major Carrier Non-Renewals at Contract Expirations or Significant Changes to Carrier Subsidies & Contracts

• Wrong Product Assortment & Private Label Portfolio

• Competition @ Retail & Internet

Valuation & Assumptions:

• $4.75 Price Target: we believe 4.5X EBITDA, 10X EPS, and 8X Free Cash Flow are reasonable multiples for a company with stabilized earnings.

• 175M EBITDA: the next 2-3 quarters are transitional periods similar to 2Q2013 inventory discounting and re-merchandising, and therefore we use 2012 pro forma EBITDA of 48M as run-rate EBITDA, including all the negative impacts from Carrier contract changes and iPhone supply chain issues. We also assume RSH can achieve 20% growth in the Mobility platform by 2015 (i.e. it could be  a combination of growth in 2015 and 2015), which accounts for ~50% of Revenue, so ~340M of incremental Revenue in 2015 (3.4B current total Revenue x 50%from Mobility x 20% growth = 340M). Assuming a 37% contribution margin (RSH’s current margin), the 340M of Revenue equals 126M of additional EBITDA plus the 48M run-rate EBITDA = ~175M EBITDA in 2015. We assume flat Signature and Consumer Electronic Revenue and EBITDA contribution on the other 50% of RSH Revenue, with growth in Signature approximately offsetting declines in Consumer Electronics. Signature is growing low-single digits in 2012 and 1H2013 after -16% aggregate Revenue declines in 2010-2011. Consumer Electronics has stabilized to high-single digit declines in 2Q2013 after -29% aggregate Revenue decline in 2010-2012. Over the short-term there could be additional Revenue declines from Consumer Electronics; however, we believe by 2015 Consumer Electronics should stabilize at least at ~50% of 2009 Revenue.  

Catalyst