Saturday, September 20, 2014

Radio Shack: What Could Have Been, And What Will Be

It's too bad about Radio Shack fading out. I remember going there when I was a kid, curious about the offerings and looking at things to tinker with. But it's not a good way to distribute cell phones or consumer electronics, and it will ultimately be for the best for the time and resources currently being wasted in the business to be repurposed.

Like most managements, they had absolutely no idea what to do when their business model started to falter. Companies with an unclear future should not have any debt, yet the company borrowed very expensive money over the past several years.

Let's assume I'd been in charge starting June 2012 (the stock was in the $4s), right after they paid their last dividend. Here's what I would have done:

  • swap the unsecured bonds for stock
  • sell additional equity to pay off the secured debt
  • cut capital expenditures to the bare minimum - no store redesigns
  • cut SG&A, starting with the seven vice presidents
  • cut marketing - no "super bowl" ads
I would not have tried to "pivot" to a new merchandise mix or business model. I don't think there is one that can work; they are the worst, highest cost provider of all of their different product segments.

I would have closed stores as they became unprofitable. I would've looked for opportunities to assign store leases that were in the money if the stores were only modestly profitable.

I would've been honest with investors that the business was in runoff mode. Liquidating stores would have generated cash. It's possible that the honest, pessimistic approach would have caused the stock to be cheap. If so I would have repurchased shares. If shares were expensive, I would have issued more and bought shares of banks trading at huge discounts to book value. Could've been a Berkshire.

Anyway, management basically did the opposite of my plan. So now there are only two possible scenarios, one of which is going to occur in short order: either they file for bankruptcy protection or they get a generous "rescue financing" that lends them more cash and would probably be tantamount to a bankruptcy in terms of the dilution (like the Molycorp financing, but worse). Even all the sell side people admit these are the only two scenarios.

The question is: how do the bonds and stock each move from their current prices in these scenarios?

In the bankruptcy scenario, the stock obviously trades way down, lower than the August low of 55 cents. It would easily fall 75% from the current price, I think, and would ultimately get zero. The bond price change is much tougher to ascertain. The bonds don't price in as much optimism as the equity does - they assume a significant amount more cash burn. I could see them reflexively trading down 10 points, or a 33% loss in value.

In the rescue scenario, the bonds get a big boost. Any money coming into the company is going to pay unsecured coupons for a while, and the bonds would trade down from the 20% current yield I think. Also, the rescue is basically pointless if the unsecureds don't get paid at maturity, so there would probably be some provision in the rescue package for taking care of the bondholders. Honestly, a rescue would be so needlessly good for the unsecureds that I can't really see it happening. If you wanted to invest in Radio Shack it would make a lot more sense to take it through bankruptcy so that you could reject store leases and haircut the unsecureds.

It's less clear what happens to the stock in the rescue scenario. (We live in such a bailout culture now.) The kneejerk response is that it's bullish because it keeps the company and equity alive. However, anyone making a rescue loan would be insane not to negotiate all of this upside for themselves by demanding tons of stock or warrants. And there would probably be a second round of dilution because you'd want to insist that the company do an exchange offer for the bonds so that cash wouldn't be wasted on interest payments. (That's why I said 'tantamount to a restructuring'.)

So in the two scenarios, which cover the vast majority of the probability space (otherwise you need a sales and cash flow recovery in the business), the bonds seem likely to outperform the stock.

One other important Radio Shack topic for today is the liquidation value of the inventory. Read this excellent post about how the liquidators Hilco/Gordon Bros do retail liquidations:
Knowing that there’s a possibility that the physical inventory count could come up slightly different from the ‘book’ numbers – apparently estimated at about to $350M as of last week’s purchase - Hilco/Gordon expressed their bid in a way that mathematically came to their $250M bid: ‘72% of inventory at cost’ ($250M/$350M). If there turned out to be more or less inventory for whatever reason, they could adjust the purchase on that basis

That ‘72% of cost’ rate was about what Hilco/Gordon paid for the Best Buy inventory; for Linens they paid about 95% of cost – suggesting perhaps a combination of (a) higher markup in the Linens inventory, and (b) an expectation that it would require less discounting to move it. Remembering that Gordon Bros has been around for a century, we can assume they have a pretty solid handle on their estimations.

With almost 400 stores Borders – like Linens N Things- is a big job. Earlier in this thread competitors in the industry – other liquidators – were identified as including SB (Schottenstein’s firm), Tiger, Hudson, Great American, and possibly Monarch (more a focus on distressed debt than actual liquidation).

For Linens, Hilco / Gordon enlisted pretty much the entire field of smaller ‘competitors’, farming out portions of the job to SB, Great American, Tiger and Hudson. For Borders, Hilco/Gordon brought all but Hudson back in for pieces (instead, Hudson’s founder returned to work at Gordon Bros). At the top levels, the industry is fairly incestuous – Hilco, Tiger, and Hudson were all founded by, or run by, Gordon Bros execs, and those firms get a fair portion of work from the pair.
Radio Shack inventory in general has high markups (34% gross margin), which is bullish for the liquidation realized values. And I would guess that a large dollar amount of inventory is newer stuff that could be liquidated above cost pretty easily.


glennchan said...

It's incredibly hard for a management team to liquidate a business or to put it into run-off. Everybody wants to dream the dream. Even the people who say they will put the business into run-off don't do it (e.g. SHLD).

The other problem is that the returns from such a strategy are theoretically limited. If you were really smart (or really good at taking control of companies) you'd do something more profitable.

2- Management knows that they are screwed. They know that the status quo won't work. That's why they take risks like superbowl ads, store remodellings, etc. Not changing is death... so in comparison, everything else seems better.

CP said...

I'm sure it is hard.

Also, CEO Joe Magnacca is a drugstore guy not a capital allocator: