Description

Summary:
Unparalleled distribution (94% US population lives within 5 minutes of a store), customer-friendly reputation, and high product margins provide Radioshack durable competitive advantages. If management is able to execute well on its new, more conservative five year plan, earnings should double from 2001’s $1.50 to $3.00 in 2006. At $28, RSH shares offer long-term investors a reasonable return with relatively little risk of permanent capital loss.

Business Description:
RadioShack Corporation sells consumer electronics through 5,109 Company-owned stores and a network of 2,090 dealer/franchise outlets located throughout the United States. Total revenues approximate $5 billion, cash flow from operations (3-yr average) is about $400 million, long-term debt is $571 million, and TEV is $5.9 billion.

Most customers go to RSH for a specific part, battery, or accessory, and leave also purchasing an additional product or service. Through its strategic partnerships with Sprint and Verizon, for example, RSH sells more wireless phones than all of its competitors combined. Stores are typically located in malls and strip centers, average 2,300 sq ft, and carry 3,600 private label and third-party branded products. Average ticket size is $30.

RadioShack competes in consumer electronics (22% ’00 sales) with Circuit City and Best Buy, and to a lesser extent department and specialty stores, such as Sears and The Home Depot. In wireless communications (28% ’00 sales), Sprint and Verizon compete directly with RadioShack through their own retail and online presence. Mass merchants such as Wal-Mart and Target, and other alternative channels of distribution such as mail order and e-commerce, compete with RadioShack on a more widespread basis.

Financial Characteristics:
Unlike its competitors that rely on sales growth and expense leverage to drive returns, RSH produces returns on invested capital well in excess of its cost of capital, even in a down year like 2001, because of its high product margins. Gross margins are almost double its competitors at 48% (LTM 9/01). This number should hold steady at the very least as the company increases its emphasis on the high-margin parts, batteries and accessories segment (one of its two “anchors” going forward), reduces exposure to high-ticket audio/visual/computers, and grows its 100% gross margin “residuals” (income participation in wireless subscriber growth). For the next five years, I expect ROIC to average 16%-- relatively little change from recent performance.

With relatively fixed SG&A, good (and improving) capital efficiency, and disciplined capital spending, RSH generates substantial cash flow. Free cash flow projections for the next five years (after cap ex and dividends, assuming no improvement in working capital): 2001: $450-500; 2002: $265; 2003: $290; 2004: $340; 2005: $370; 2006: $410 (cumulative cash generation of $1,670, or 30% market capitalization)

RSH’s leverage is modest by any measure, so cash flow is available to continue the aggressive share repurchase program. The company’s net investment (adjusted for stock option proceeds) in treasury stock in the prior five years was just over $1.5 billion. Only 7.5 million shares have been purchased on the company’s current 25 million authorization (expanded by 15 million shares in December, ’01).

Shift in strategy and a soft economy cause share price weakness:
Riding the digital/wireless wave of the last five years, RSH increased sales almost 50% between 1996 and 2000. Although the company sacrificed gross margin along the way, higher sales leveraged 8% SG&A growth and EPS exploded 25% annually. With all the enthusiasm, RSH shares got hot—increasing nearly eight-fold from a split-adjusted $10 to $78. With sales of home satellite systems, personal computers, home connectivity, etc. collapsing in 2001, the shares began a long slide to the low $20’s (post-Sept 11). Earnings for 2001 are expected at $1.50, down from $1.84 in 2000.

Expecting less robust consumer electronics spending and slower adoption of broadband services, management recently presented a new five year plan that downplays growth, focuses on two core “anchors”—parts batteries and accessories (“PB&A”) and wireless communications—and maximizes cash flow. Growth investors are disappointed with 4-5% annual growth targets, analysts are troubled by the shift in strategy, and others are taking a wait-and-see view of the new performance goals.

The more important of the two, PB&A, assumes 5-10% growth—slightly higher than recent performance. Management believes better assortment and availability plus improved store-level compensation incentives can increase sales of its highest margin category. In wireless, RSH’s goals of 10% growth trail the projected 10-15% industry growth outlook which seems reasonable given its leading market share and alliances with Sprint and Verizon.

Lower projected growth of non-anchor, lower margin categories should benefit gross margin 30-40 bp per annum due to mix shift. SG&A growth should be 2-3% based on already achieved fixed expense reductions, thus EBIT should grow 12-13% annually and EPS 12-15%, depending on share repurchases.

Management:
The prior five year’s success notwithstanding, I think the quality of management is only satisfactory. Len Roberts (CEO) arrived in 1996 and did an excellent job selling unproductive assets (Computer City), closing unprofitable stores (Incredible Universe), and building the Radioshack brand (renamed company from Tandy Corp). He is long on big ideas, catchy phrases, and hopelessly optimistic. I think the investment community receives him with some suspicion and handicaps his promises accordingly. On the positive side, he is hard-working, results-oriented, and very shareholder-friendly.

Offsetting my reservations regarding the CEO, RSH’s new CFO brings a great deal of competence, confidence, and integrity to the company. Mike Newman joined RSH in May ’01 having spent 18 years at GE and short stints at Hussman International and Intimate Brands (very short). He replaced long-time CFO Hughes who passed away the prior year. There is a perception that RSH’s reduced expectations/lowered guidance is the influence of the less promotional Newman, who seems intensely focused on improving capital efficiency and cash flow. Needless to say, his arrival was well received by return on capital-hungry investors.

Valuation:
RSH does a good job providing investors a good degree financial detail, transparency, and explanation regarding business and financial performance. The balance sheet, income and cash flow statements don’t require accounting gymnastics to analyze. Business strategy and financial guidance are available on their website.

Valuation is rather straightforward using management’s financial model and a narrow range of assumptions for growth, profitability, and capital efficiency.
Though I don’t believe it’s particularly enlightening given the currently depressed level of sales and margins, RSH shares currently trade at 1.2x LTM and 2000 revenues, 11x LTM and 9x 2000 EBIT, and 9x LTM and 8x 2000 EBITDA. These numbers are low compared to RSH’s historical metrics, competitors’ valuations, and companies its size with similar growth, profitability and economic characteristics.

On an earnings per share basis, my best-guess for RSH’s performance the next five years, based on management’s guidance, is for 2002: $1.65-1.70, 2003: $1.85-1.95, 2004: $2.15-2.25, 2005: $2.40-2.60, 2006: $2.70-3.00. Total shares outstanding can vary in 2006 by 20 million shares assuming 2% annual option dilution and repurchase assumptions.

It’s anyone’s guess what multiple of EBIT, EBITDA, or earnings investors will pay for RSH shares in 2005/2006 assuming the company’s performance tracks near to plan. Given its attractive and durable competitive advantages, reduced set of expectations, and financial flexibility owing to its substantial cash flow generation, I’m willing to risk a little multiple contraction, though I don’t expect it.

A crude DCF-derived estimate of intrinsic value is $38-48 per share (5% revenue growth, 12% EBIT margin, 9x ’06 EBIT for terminal value, 10% discount rate).

Risks:
The biggest impediment to RSH’s achieving its goals is increased competition/price sensitivity in its core PB&A category. Management believes that it can increases prices on selected items and grow market share (assortment, availability, and incentives) simultaneously. Product/pricing missteps can wreak havoc on a retailer with such a high fixed or semi-variable cost structure.

Catalyst

1. More favorable comp store trends cycling through easier comparisons as the economy improves and resulting earnings visibility.
2. Cash flow estimates assume no improvement in inventory turns which Newman believes he can increase from 2 to 4 in the next five years. Each turn equates to $200 million.