On May 9’s “Stop Trading”, Jim Cramer warned NOT to buy certain stocks. Which one did he call a “travesty”?

Citigroup (C - Annual Report), AIG (AIG) and Circuit City (CC). Three of the worst companies America has to offer, at least that’s how Jim Cramer sees it.

But it’s AIG that takes the cake. The world’s biggest insurer has become a “travesty,” according to Cramer.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned in this article.

Somehow I missed this early in the week. Hat tip to Todd Sullivan’s - ValuePlays:

Apparently on Monday there was heavy call buying in RadioShack (RSH) - ironically a day I was writing puts on the name. Rumor is that Dell (DELL) is kicking the tires. It would be an easy way to get into retail in a bigger way.

Here’s a video discussing the rumor.

Anyhoo - my original thesis was that RadioShack’s valuation is cheap, at ten or eleven 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.That and the fact that there seems to be solid technical support contributed to my writing put options at $15 each of the last two months.

Disclosure: At time of publication, William Trent has written put options against shares of Radioshack (RSH).

This article is a reprint of my March 10, 2008 RealMoney column

• I don’t expect RadioShack to grow.
• But it should be worth buying as long as they can limit their cash flow declines to 5% or so annually.
• Combined with a put-write strategy, it looks even better.

RadioShack (RSH) is a company investors love to hate, and it isn’t hard to see why. Stocked full of stuff you occasionally need but often find elsewhere, it represents the unsexy part of consumer technology – wires, batteries and cables that you forgot to pick up when you got the HDTV or game console at your local Circuit City (CC) or (more likely) Best Buy (BBY).

What’s more, RadioShack’s 4,400-odd company-owned stores, on average, sold 6.7% less stuff in the fourth quarter of 2007 than they did in 2006. This is an improvement from the full-year same-store decline of 8.2%, which is partly attributable to the fact that 525 stores have been closed since year-end 2005. Many of these, presumably, were the worst-performing ones. Having fewer of the really bad ones open for the last 12 months will contribute to improving same-store figures.

Now that the low-hanging fruit has been picked, investors need to figure out whether what remains is worth climbing what could be a rickety ladder. 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 ten or eleven 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.

RadioShack’s May 2011 note is currently yielding about 7%. To generate equity returns higher than this, RadioShack will have to limit its free cash flow declines to 8% per year – in other words, they can’t get any worse.

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 - Annual Report) and AT&T (T - Annual Report). 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 so bad that incremental further declines may cease to register.

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. Given the state of the economy and particularly RadioShack’s wireless exposure, I think the company will eventually stem the bleeding to within my acceptable range, but probably not this year.

As is often the case, though, I think 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 $15.00 puts are selling for $0.80 – a 5.3% premium on money that is 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 10%.

That starts to look like a risk worth taking.

Disclosures: William Trent has written put options against the shares of RadioShack (RSH)

According to the Census Bureau ADVANCE MONTHLY SALES FOR RETAIL AND FOOD SERVICES:

The U.S. Census Bureau announced today that advance estimates of U.S. retail and food services sales for August, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $377.6 billion, an increase of 0.3 percent (±0.7%)* from the previous month and 3.7 percent (±0.8%) above August 2006. Total sales for the June through August 2007 period were up 3.8 percent (±0.5%) from the same period a year ago. The June to July 2007 percent change was revised from 0.3 percent (± 0.7%)* to 0.5 percent (± 0.2%).

The 3.7% year/year gain is an improvement from 3.2% in July. Still, looking at the longer-term trend it is too early to call an improvement. Furthermore, with CPI running 2.4% year/year the real retail growth is still pretty light.

I’m sticking to my previous characterization: Good but deteriorating.

EconomicData

With back-to-school season upon us but little time to shop, we stock market nerds can get a heads-up on the latest fashions and trends simply by reviewing a few choice conference calls.

Consider, for example, American Eagle Outfitters (AEOS).

During the second quarter, our men’s business was strong, delivering a high single digit comp increase. Strength was broad-based across most major categories, including men’s shorts, knit-tops, and woven shirts. Our overall women’s comp declined slightly with strength in aerie, bare knit-tops, shorts, and dresses offset by declines in graphic tees and polos, skirts, and accessories….

We are now in the midst of the back-to-school season and are pleased with the customer response to our collection. Our new line of women’s knit tanks and tees is a major step forward from spring and summer and a better reflection of what on trend means for our customer.

We are also seeing ongoing momentum in denim. Building on our strong jeans business, this season we took our offering to a new level with a significant amount of fashion newness in our blue issue collection and within our fit systems. Both guys and girls are embracing new fits and responding positively to fashion elements.

(Excerpt from full AEOS conference call transcript)

Abercrombie and Fitch (ANF) saw some of the same trends.

the shorts business was very strong for the quarter, and I can also tell you that the trend in denim improved over the course of the quarter.

Now, what that means go forward, we really can’t comment on and again, overlaying that, our tops business has continued to be very strong across all categories — fashion knits, fleece, just continued to be very strong but I don’t want to get into commenting about the back half of the business.

(Excerpt from full ANF conference call transcript)

Footlocker (FL) comments on the shoe business.

There were also a number of external factors that contributed to our disappointing second quarter results, including the summer fashion trend of sandals, slides and flip flops, a continuing fashion shift to brown shoes, lack of newness in the athletic category, the back to school shift from July to August in certain important states like Florida and Texas. And while steps that we took in June and July adversely impacted our profits for the second quarter, our cash flow was strong, and I believe positions our business better for the back half of this year.

From a merchandising standpoint, the story for the quarter was mostly about clearance. With that said, the marquee category led by brand Jordan, Shox Running, some Nike Max Air products, Adidas Bounce, New Balance Zip and the high-end of ASICS continues to be a very important part of our business.

(Excerpt from full FL conference call transcript)

Finally, you’ve got to have some fun during back to school season. According to GameStop (GME):

The incredible acceptance of the Wii and DS Lite platforms, coupled with the emergence of what could almost be considered a new category – non-game games such as Guitar Hero, SingStar, Boogie, et cetera — has not only attracted more customers, but we are seeing an increasing number of young girls and women in our demographic as well.

(Excerpt from full GME conference call transcript)

So there you have it. The two-minute update on the latest fashions, courtesy of SEC Fair Disclosure regulations.

During earnings season it can be difficult sometimes to keep track of everything that is being said, as it is coming fast and furious. I decided to look over a few of the recent conference call transcripts to see what the technology companies and retailers with high consumer exposure are saying. Here are a few excerpts:

As we look at the quarter’s performance, we see our earnings were below our expectations yet our results appear to be better than others in our space.

(Excerpt from the full Best Buy (BBY) conference call transcript)

The volatility associated with the amount of change to the company combined with the unfavorable macro-economic environment make it difficult to project our annual performance at this time. In light of this we are withdrawing annual guidance for the time being.

(Excerpt from the full Circuit City (CC) conference call transcript)

Retail revenue grew 4% year-over-year. However, overall revenue fell 8.6% due to declines in professional and direct.

(Excerpt from the full Gateway (GTW) conference call transcript)

It all sounds rather bleak, and the companies assure us they are going to do something about it.

So that’s my lens on the quarter and if I leave you with one point, it’s this; we’re never satisfied with missing earnings. However, we know it does not reflect the core health of our business, the strength of our strategy, or our ability to execute through our people, or our optimism about the future. In addition, we remain very focused on driving long-term success through building and strengthening our customer relationships.

(Excerpt from the full Best Buy (BBY) conference call transcript)

Remember, at the same time we are structuring a more lean organization, we will be adding associates to Firedog, our multi-channel efforts, and to fund our new store openings and support growth in all of these areas. The end result is that we are positioned for our long-term strategy and profitable growth. Goals and commitments throughout the company are aligned to execute this strategy, and we have freed up capacity through simplifying our work, enabling us to focus on execution in the coming year.

(Excerpt from the full Circuit City (CC) conference call transcript)

To summarize, we’ve made good progress in the second quarter both in terms of financial performance and in executing our strategy. But we fully recognize that much more remains to be done.

(Excerpt from the full Gateway (GTW) conference call transcript)

In part there was also optimism about the future:

For many people, the consumer electronics industry is the industry most closely associated with how human beings live their lives now and in the future. The solutions we provide are right at the center of how people work, play and live. As a result, the industry has grown steadily and sometimes dramatically for years. In fact, going back to spring of 2001, the industry has seen positive growth every single quarter until the first quarter of this fiscal year.

Does this mean that people are changing their minds, turning away from technology and entertainment products and solutions? We don’t think so. They simply hit the pause button. We believe it’s a timing issue — natural ebbs and flows of different aspects of our industry. Moreover, in the fourth quarter of last year, we may have fast-forwarded some of the business with terrific promotions.

But to be honest, we believe that what we are seeing also has a lot to do with macro economic factors like housing, interest rates, no relief at the price of gas, and in many other factors that give our customers cause for real concern right now. It’s a humbling reminder that no matter how tight a ship you run and no matter how confident you are of the course you are sailing, external conditions completely outside your control can still rock your boat.

(Excerpt from the full Best Buy (BBY) conference call transcript)

Which sounds good, at first, until you remember that running a tight ship and being confident of the course being sailed has helped other companies avoid having their boats rocked by the external conditions outside their control.

Revenue of $5.41 billion was the highest in a June quarter in the history of Apple and represented 24% growth over the prior June quarter sales. The revenue was fueled by record-breaking Mac sales and continued strong demand for iPods.

Operating margin for the quarter was stronger than expected at 19.2%, resulting from higher than expected revenue and the continued, very favorable commodity cost environment. We generated net income of $818 million, which was up 73% over the prior June quarter’s results, and translated to earnings per share of $0.92.

(Excerpt from full Apple (AAPL) conference call transcript)

Circuit City withdraws earnings forecast - Yahoo! News

Consumer electronics retailer Circuit City Stores Inc. (CC)  on Wednesday posted a quarterly loss that it called disappointing and withdrew its earnings forecast, citing a drop in television sales and an uncertain economic environment.

In other words, “how should we know what our sales will be?”

The company reported a loss of $54.6 million, or 33 cents a share, from net income of $6.4 million, or 4 cents per share, for the fiscal first quarter. Analysts, on average, had been expecting a loss of 32 cents a share, according to Reuters Estimates.

After Best Buy’s (BBY) report yesterday, the causes are not particularly surprising:

The company said its profit margins fell due to a drop in domestic sales of extended warranties and on increased sales of lower-margin personal computers.

Circuit City said total television comparable store sales decreased sharply, as a significant drop in projection and traditional tube televisions more than offset growth in flat-panel televisions.

Given that flat panel televisions cost several times as much as a traditional tube television, that must have been some drop-off. The positive way of looking at this is that people want the higher-end televisions and are simply holding off on all TV purchases until they can afford one. The negative way of looking at it is that it may take quite a while before that happens.

Best Buy Co., Inc. (BBY) today reported net earnings of $192 million, or $0.39 per diluted share, for its fiscal first quarter ended on June 2, 2007. The leading consumer electronics retailer’s earnings decreased 18 percent from $234 million, or $0.47 per diluted share, from the prior-year first quarter. Sales were ahead of estimates at $7.9 billion.
I had noted in my earnings preview that the estimates of $0.51 on $7.84 billion in sales have come down during the quarter but the stock hasn’t. Now that even the lowered estimates proved too optimistic, the shares are headed down as well.

The difference between the better than expected top line and the worse than expected bottom line, according to the company, was that:

The gross profit rate for the first quarter was 23.9 percent of revenue, a 150-basis-point decline compared with a gross profit rate of 25.4 percent of revenue for the prior-year first quarter. A significant contributor to the year-over-year decline was the inclusion of the China business acquired last June, which carries a significantly lower gross profit rate. Domestically, the increase of lower-margin products in the revenue mix — particularly notebook computers and gaming hardware — also added to the decline. An increase in the products completing model transitions in the home theater area (resulting in markdowns) and lower profitability of computer transactions were also factors in the year-over-year decline in the gross profit rate.

Investors are being asked to believe that the margin pressures were related to the product mix, but the mix didn’t appear to change much: Entertainment software was 17% of sales instead of 18%, while appliances were 8% instead of 7%. Consumer Electronics was 43% in both periods and Home Office was 32% in both. Investors should rightly ask whether the “increase in products completing model transitions… (resulting in markdowns)” was due to the timing of model transitions or whether it was simply because consumers were only willing to spend if they were getting a great deal.

If one does believe the “model transition” story, apparently the models are expected to keep transitioning for the rest of the year as well:

Based on the first-quarter results and trends in revenue mix that we expect to continue, we now anticipate earnings per diluted share of $2.95 to $3.15. This range represents an average increase of approximately 9 percent, compared with the 53-week period of last year. Our earnings guidance continues to assume an annual comparable store sales gain of 3 percent to 5 percent. It also projects a nominal increase in the fiscal year’s operating income rate. This guidance includes gross profit rate pressure, driven by the sales mix, offset by SG&A savings and expense leverage.

Sounds to me like weaker consumer spending on the most expensive discretionary items.

William Trent currently has a short position in put options related to Office Depot (ODP).

Earnings are due this week from:

• Best Buy (BBY) on Tuesday. The estimates of $0.51 on $7.84 billion in sales have come down during the quarter but the stock hasn’t.
• Circuit City (CC) on Wednesday. The estimates of a loss of $0.32 on $2.43 billion in sales have come down during the quarter along with the stock.
• FedEx (FDX - Annual Report) on Wednesday. Estimates are for $1.98 on $9.14 billion in sales. Since this is already at the lower end of management’s guidance, falling short would likely be very disappointing.

The Economic Calendar looks pretty light.

Our earnings preview for Garmin (GRMN - Annual Report) said it “shouldn’t need a big surprise to move the stock from this level.” Today the company reported earnings:

First Quarter 2007 Financial highlights:

– Total revenue of $492 million, up 53% from $322 million in first quarter 2006

– Earnings per share increased 60% to $0.64 from $0.40 in first quarter 2006; excluding foreign exchange, EPS increased 37% to $0.59 from $0.43 in the same quarter in 2006.

These results compared to consensus expectations of $0.59 on $499 million in sales. So the stock did indeed move on a not-big surprise, albeit one in the opposite direction from which we implied. The company did not change its prior guidance, saying:

We remain optimistic about the future success of our business and our ability to serve customers and distributors around the world. We anticipate overall revenue to exceed $2.5 billion in 2007, and earnings per share to exceed $2.70 assuming an effective tax rate of approximately 13 percent. We anticipate automotive/mobile revenues to grow faster in 2007 than we earlier anticipated, and continue to expect declining operating margins due to product mix and a continued transition toward mass market levels. We intend to provide a formal update to our fiscal 2007 financial expectations during the Q2 2007 earnings conference call.

Unfortunately, analysts were already ahead of those expectations, calling for $2.81 in EPS on $2.54 billion in sales. Without a significant surprise in Q1 or a significant surprise forecast for Q2, the estimates are starting to look a bit out on a limb.

Add this data point to the ones provided by Royal Caribbean (RCL), Plantronics (PLT), Radio Shack (RSH) and Circuit City (CC) that consumer spending may be slowing.