RealMoney Silver - Radio Shack's Stock Is an Even Better Deal Than Its Bonds

Radio Shack's Stock Is an Even Better Deal Than Its Bonds
By Bill Trent
RealMoney.com Contributor
3/10/2008 2:49 PM EDT

RadioShack (RSH) is a company investors love to hate, and it isn't hard to see why. It's stores are stocked full of electronic stuff such as wires, batteries, cables and other low-tech items that you forgot to pick up when you got the HDTV or game console at your local Circuit City (CC) or Best Buy (BBY) .

What's more, sales at the 4,400-odd company-owned stores fell 6.7% in the fourth quarter of 2007. That's actually a slight improvement from the 8.2 % drop that Radio Shack posted for the full-year. Comps might continue improving since Radio Shack has shuttered 525 underperforming stores over the last two years.

But shrinking the store base invites another problem for shareholders. Most investors tend to shy away from companies that aren't growing, and generally flee from those that are shrinking. Still, even shrinking companies are worth something, and investors can be rewarded if they pay the right price.

The valuation is certainly cheap, at 10-11 times earnings. My preferred measure, the free cash flow yield, is a downright juicy 14.3%. With that kind of cash flow yield, RSH could generate double-digit returns even if cash flow declined 4.3% per year. With five-year Treasuries yielding just 2.5%, the declines could be even larger and still earn investors the typical risk premium that would be expected for holding stocks.

With the question thus changed from whether RadioShack can ever grow again, to how much shrinkage is currently priced in, the analysis becomes a bit less sticky. For this, I think I'd accept a return in line with that of RadioShack debt - which reflects the company's relative risk and allows for a modest premium based on the more favorable tax treatment of equity returns.

Radio Shack's May 2011 note issue currently yields around 7.2%. RadioShack's equity should offer a premium to that yield as long as it can limit free cash flow declines to 7% per year, in line with the recent rate of decline.

Wireless exposure: is the worst over? RadioShack attributed the same-store sales weakness in 2007 to "a decline in postpaid wireless sales for our two main wireless carriers." Wireless sales account for a third of RadioShack's business and those two carriers are Sprint (S) and AT&T (T) . Sprint's performance has been pathetic, while AT&T is relatively weak in the Northeast, particularly RadioShack's largest market - New York City. The contracts with AT&T and Sprint don't expire until 2015 or later, so there isn't much hope for a carrier shake-up. On the other hand, Sprint is now performing so poorly that incremental further declines may cease to hurt.

Investors seem to be picking up on the potential value, as the rally following the latest earnings report has given the shares some fragile support. I think the company will eventually stem the bleeding to within my acceptable range, but given the state of the economy and particularly RadioShack's wireless exposure, probably not this year.

The doubt can be addressed by using a put-write strategy to enhance returns and further reduce the potential entry point. As I write this, April 15 puts are selling for $0.80 -- a 5.3% premium on cash risked for about six weeks. If the stock declines and the options are exercised, the effective entry price would be lowered to $14.20 -- a price that would boost the effective free-cash-flow yield to 17.8% and increase the margin of safety to permit an acceptable return even with annual free cash flow declines of nearly 10%.

That starts to look like a risk worth taking.