This is the third in a semi-regular series entitled “Powerball” ideas. ”Powerball” ideas are basically lottery tickets with a value basis. Most likely scenario, these ideas will crash and suffer huge permanent capital losses. However, if the ideas work out, you’ll likely make 4-5x your money, maybe more. It’s basically speculation with a value twist. Enjoy, and beware!
Radioshack (RSH) was the focus of a series of posts earlier in the year. It also proved to be, by far, the worst investment I’ve ever made. I underestimated both the difficulty of the consumer electronics retailing industry and the secular shift from physical retailing to online retailing (driven largely by Amazon, see this article for an excellent breakdown of Amazon and how their dominance is reducing prices for consumers by taking most of the profits out of retailing). I was fortunate to exit most of my investment with a huge loss at prices in the ~$12 range.
So, please, keep in mind that I’ve been there, done that before with RSH. Maybe my judgement’s tainted. Maybe I’m fixating on the prices I bought at six month’s ago. But when I look at Radioshack’s LEAPs today, I see an incredibly skewed risk / reward situation that fits perfectly with the “Powerball” idea theme.
I’m not going to go into a breakdown of Radioshack’s business, the trends, the potential for their kiosks to increase value, etc. You can see a pretty decent analysis of all that in my previous posts, or you can figure all of that out with a really quick look at yahoo! finance- their numbers over the past three years are excellent but in clear decline, and a quick look at the stock chart would show the market is forecasting the decline not only continuing, but gaining speed.
Instead, let’s start by talking about what the correct response to a dying industry is. I mentioned it briefly in my post on “asset versus franchise” value investing, but, in most cases, the correct way to deal with a permanent secular decline in your business is to effectively milk the business for its cash flows and eventually liquidate (basically, do the exact opposite of what last week’s powerball idea, RIMM, is doing). Now, this can be difficult for a retailer given all of their operating leases, the fact that inventory tends to be worth much, much less than it’s on the books for during a fire sale, and that employees tend to accrue much of the value in a liquidation for themselves (see this excellent post over at bronte capital for a breakdown of why a Sears (SHLD) liquidation always seemed unlikely to him).
And Radioshack has responded to the secular decline, from a corporate finance perspective (though certainly not a strategy perspective. Their “The Shack” campaign was a joke), in the perfect way. They’ve increased leverage drastically to utilize it as a tax shield. They’ve stopped opening new stores and reduced cap ex (with an exception of kiosk cap-ex) to basically maintenance levels. They’ve returned all of their cash to shareholders through repurchases and dividends. Honestly, if you had gone back five years ago with a knowledge of exactly how the future was going to play out, you would pretty much follow exactly the same script Radioshack did from a capital allocation perspective (though you might want to save the money from the buybacks in the $20s for a lower share price!!!!).
Which brings us to today’s price. Radioshack is now trading for a market cap of $950m, and EV basically equals market cap. Some will point out RSH paid out a big dividend that will make EV today a bit higher than market cap, but the company will draw down working capital through the quarter so EV = market cap is a pretty decent assumption. The company has TTM EBITDA of ~$355m, giving at an EV / EBITDA of ~2.7x. That’s tremendously cheap. Obviously, the stock market is predicting some pretty drastic declines in their future profitability.
Radioshack has already announced they will repurchase $200m worth of shares in the next 12 months. Given their history of huge share repurchases, ~$650m in cash with no debt due until 2016, and the fact that their debt has no covenants restricting them from share repurchase or dividends, I think it’s pretty likely they follow through. At today’s market cap, that’s more than 20% of the company! It’s tough to imagine that huge of a share repurchase wouldn’t provide some support to the stock price going forward.
Which brings us to the Powerball opportunity.
First, you could look at the company and say- “Good Lord this is cheap. If Radioshack’s future even resembles its past, the stock belongs much, much higher than today’s price, and those share repurchases are going to be hugely valuable. Even if the market is right and earnings decline, the share repurchases should support the stock price and the market could prove overly pessimistic with their forecasted earnings decline and the stock’s could be undervalued even in a declining cash flow scenario. At under 3x EBITDA, I’m not paying much to find out” Buying the company’s stock would be a bit risky, but would pay out pretty well in most of the less adverse scenarios. Of course, the earnings decline could be swift and serious and the company could eventually go the way of Circuit City, resulting in a zero. Personally, I think the Jan. 2013 $10.00 calls present an outstanding risk reward at their current price of ~$1.45. I mean, say the company’s EBITDA declines by 30%, down to ~250m. At 5x EBITDA, still a pretty cheap multiple, they’d be worth $1.25B, or a bit over $12.50 per share. That’s almost a double with serious, serious upside if either of those numbers turn out to be pretty conservative and assuming no value created by repurchases at today’s prices.
Alternatively, you could take advantage of the huge volatility baked into the stock and sell puts. The July 2012 $7 puts sell for ~$0.50. That’s below RSH’s BV of $8 per share and would put the market cap below ~$700m before you got exercised. With $200m in repurchases on the way and how cheaply the stock currently trades, it seems like it’d take some more incredibly bad news for the stock to flirt with those levels. The stock would have to drop below $6.50 for you to actually take a lose on the investment, which would imply a massive decline of more than 30%. Not impossible, but it’s just tough to see how much worse the news could get for RSH at these levels.
Again, as a reminder, this is a very risky idea (hence the “powerball”), but I think the risk reward of both ideas are pretty attractive at these levels.
Disclosure- Short RSH puts and long RSH calls, though both are very small positions.
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