NerdWallet Scoreboard: RadioShack is a Value Investment to Consider

Investing, Investments
  • Thesis: RadioShack (RSH) is trading far below the present value of its future cash flows.  While RadioShack will never become a stellar performer, RadioShack will continue performing much as it has so it is worth considering as a value investment.
  • Risks: RadioShack could see declining sales as more competitors are forced to copy its business model.
  • Catalysts: Holiday sales in 2012 could help reestablish a trend of positive free cash flows.
  • Recommendation:Buy RSH shares at or below $3.75 per share as a small, speculative position in your portfolio.
    • Price Target: The intrinsic value of the firm is estimated at $7.50 per share.
    • Downside: If the firm becomes chronically cash flow negative it would eventually liquidate.
  • Disclaimer: I am considering multiyear timeframes for intrinsic valuations and market valuations to converge. For shorter investment horizons you should look to other articles for advice. Any investment you make should be a small part of a larger diversified portfolio. Please consult your financial advisor for personalized financial advice. The author reserves the right to trade shares of RadioShack in the future.

RadioShack is a dinosaur of a company. It was founded in 1899, long before most of its present inventory was even invented. Today it primarily operates as a retail store chain that sells electronics. Its business is increasingly focused on mobile devices and mobile device accessories.

The company’s operations all relate it is core business. In addition to its 4,476 RadioShack stores, the company operates other retail formats. It operates 1,091 dealer outlets, 227 RadioShack de Mexico stores in Mexico, 1,496 locations operating under the Target Mobile brand in Target stores, and RadioShack.com.

Choosing Discounted Cash Flow Analysis

There are two reasons why a discounted cash flow (DCF) valuation analysis is appropriate for RadioShack:

1)    The lack of stable comparable firms leaves us little choice. It wouldn’t be appropriate to use the wildly different price multiples of Best Buy, Amazon, or GameStop. In particular, Best Buy as a comparable wouldn’t really make sense because its stock price is volatile and its business model is being retooled. Since we don’t have a good gauge from the market, we must use a model to estimate the firm’s intrinsic value.

2)    RadioShack stock’s boring financials and business model are appropriate for future projections. Since the firm engages primarily in electronics brick and mortar, there doesn’t seem to be much justification for a sudden change in the firm’s operations. Historically, the firm has been fairly quiet:

(Items in $ Millions)

2007-12

2008-12

2009-12

2010-12

2011-12

Net income

237

192

205

206

72

Net cash provided by operating activities

379

275

246

155

218

Investments in property, plant, and equipment

-45

-86

-81

-80

-82

Free cash flow to the firm

334

189

165

75

136

 

RadioShack Annual Cash Flow Highlights (Data from Morningstar)

It has been cash flow positive on an annual basis, and the drop in its net income in 2011 came in part from one-time items. In 2011, net income dropped precipitously based partly on RadioShack’s switch from T-Mobile to Verizon products. This accounted for $23.4 million paid to T-Mobile for ending this relationship and a $3.0 million write-down of inventory. Also in 2011, RadioShack shut down a Chinese manufacturing plant resulting in $7.5 million in severance pay, $1.5 million in foreign currency loss, and a $1.2 million inventory write-down.

We can also see how sales and gross profit have been stable on a quarterly basis:

(Items in $ Millions)

2011-09

2011-12

2012-03

2012-06

2012-09

Revenue

1032

1387

1008

953

1000

Cost of revenue

590

904

614

593

640

Gross profit

442

482

394

360

360

Sales, General and administrative

411

431

373

362

385

Operating income

11

30

2

-21

-59

Net income

0

12

-8

-21

-47

 

RadioShack Quarterly Income Highlights (Data from Morningstar)

There are no terrifying changes to gross profit. Net income may vacillate on a quarterly basis as different items are recognized on the income statement, so its dip into negative territory is not frightening, yet.

DCF Considerations

Discounted cash flow valuation is a favorite among professors and other finance geeks. They like the elegance of the model and its reliance on two basic financial concepts: the time value of money and risk premiums. The time value of money is the idea that money today is worth more than money tomorrow because money today could be invested and earn a return payable tomorrow. Hence, the date you receive money is as important to its value as the amount you receive. You compute the value of a future cash flow as follows:

Value Today = Future Value / (1+required return)^(number of years in the future)

If you project a stream of constant cash flows, you can calculate their value today as

Value Today = Future Value/(required return)

This is what we will use for RadioShack since fantastic growth seems unlikely.

Required return is the sum of the “risk free rate” and a risk premium for a stock. The risk free rate is the return you would get from an essentially riskless security such as a short-term treasury. Since I assume your stock investments will be held for multiple years, I will match the length of this holding to the maturity of the treasury. Today’s 10-year treasury rates are artificially low thanks to buying by the Federal Reserve, so our models will need different scenarios for increasing interest rates.

Risk premiums come from the connection between return and risk. Higher returns are demanded by rational investors for higher risks. Higher interest rates and steeper discounts should be priced into riskier investments. Inversely, safer investments should have lower interest rates and lower discounts.

For RadioShack, we will use the market risk premium as the stock’s risk premium. You are supposed to multiply the market risk premium by a firm’s “beta” value to get the firm’s risk premium. I am not going to because the beta for RadioShack is 0.7 but the beta for hardline retail stores is closer to 1.7.

If you think this seems like hocus pocus, you are right. It is impossible to know how any of these inputs will behave in the future. The problem with discounted cash flow analysis is that interest rates and risk premiums fluctuate wildly over time. Right now interest rates are very low while the risk premiums implied by stocks are very high. This could change.

DCF Modeling

We did a DCF model outside of this analysis and here were our conclusions.

We can create three very different scenarios for RadioShack shares based on varying the risk free rate, RadioShack’s risk premium, and free cash flow to the firm.

Scenarios

(Items in $ Millions)

Best

Mid

Worst

Free Cash Flow To Firm

180

127.5

75

Risk Free Rate

2.0%

3.5%

5.0%

Risk Premium

4.0%

5.0%

6.0%

Value of the Firm

3000.0

1500.0

681.8

Value of Debt

749.2

749.2

749.2

Value of Equity

2250.8

750.8

-67.4

Diluted Shares (Millions)

100.10

100.10

100.10

Value Per Share ($)

22.49

7.50

-0.67

RadioShack Discounted Cash Flow Analysis

The Best case scenario assumes that interest rates will stay low and that the firm’s risk premium will not jump up. It also assumes that the average free cash flow to the firm over the last five years will continue indefinitely. The result for RadioShack is a $22.50 per share intrinsic value, more than ten times its market price.

But don’t jump for joy just yet. The worst-case scenario is very sobering. If we assume that interest rates increase to historical levels and that the risk premium for the stock increases while free cash flows stabilize at their 2010 lows, then the shares are worthless because the value of the firm is worth less than the firm’s debt. This would mean that the business itself is worth its liquidation value.

RadioShack Risks

The threat of competition is a terrible risk for RadioShack. The firm will not survive if many new entrants open Kiosks and stores in malls across America to sell mobile device accessories and plans.

Conclusion

RadioShack is a speculative value investment. Consider investing a small amount of your holdings (1% or less) at a steep discount (50% or more) to the firm’s intrinsic value using a mid-range scenario.

Disclaimer:  The views and recommendations in this piece are held by the contributor alone and do not necessarily reflect the opinions of NerdWallet.