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)

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.

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.

Early in April we noted the disparity between the market reactions to sales reports from Circuit City (CC) and Best Buy (BBY). We speculated that the market favored Circuit City’s poor performance because the worst appeared over and management was getting down to nuts and bolts. If that was indeed the impetus for the positive reaction, it proved premature.
Circuit City issued a press release yesterday adjusting its previously reported numbers for some accounting matters. Buried in the press release was this revision to the previously issued guidance:

For the month of April, the company experienced substantially below-plan sales, primarily related to the large flat panel and projection television categories. Due to this trend, the company now expects a loss from continuing operations before income taxes of $80 million to $90 million for the first quarter of fiscal 2008. In light of uncertainties in the current operating environment, the company is withdrawing its previously issued guidance for the first half of fiscal year 2008.

Assuming business trends improve and the transformation efforts are effective, the company forecasts fiscal 2008 earnings from continuing operations before income taxes (EBT) as a percentage of consolidated net sales at the low end of the company’s previously guided range of 1.4 percent to 1.8 percent. The company will continue to monitor general business trends as well as the effectiveness of its transformation efforts and expects to provide an updated fiscal 2008 forecast when it releases results for the first quarter of fiscal 2008 in June.

So the old “worst case” is the new “best case.” The question now becomes whether the weakness is indeed specific to Circuit City. Recall that Radio Shack’s (RSH) positive move on Monday resulted from better than expected cost savings.  The revenue performance was atrocious. Circuit City makes for a second awful report. If we see the same from Best Buy, those who have long been calling the death of the American Consumer may finally be proved right.

The headlines told one story today while the tape told another. The headlines said “Best Buy Profit Up While Circuit City Struggles“. Meanwhile Circuit City lost only a third of a percent for the day while Best Buy got trimmed by 2.5%. It would be entirely reasonable for investors to be confused, so we decided to turn to the original releases and the conference call transcripts to get the whole story.

To be clear, Best Buy had the best performance, with same store sales up 5.9% during the quarter even after allowing for the quarter’s extra week. Circuit City stores open in both periods sold less this year than last. Furthermore, while both chains saw their gross profit margins trimmed by nearly a percentage point, Best Buy’s were better to begin with. And Best Buy is bigger, selling more during the quarter than Circuit City managed for the whole fiscal year. But none of this helps to explain the stock movements. Though both calls started with the customary CEO homily, there was a stark difference in tone:

We view the world today as a large, open set of customer problems, wants, needs and desires, not all of which are confined to consumer electronics. So our business, broadly defined, is about meeting the needs and wants of customers. We believe that our current assets give us a better shot at solving customer problems than we’ve ever had before.

(Excerpt from the full BBY conference call transcript)

This rather broad and lofty goal contrasted with:

For the year overall, we did not give up our customers to our competition. We steadily increased our consumer electronics market share compared with last year, according to Trackline Data. We reached $1 billion in web originated sales, growing more than 50% for the year while making structural changes to become a true multichannel retailer. During the second half of the year, we successfully launched our FireDog brand, covering both PC services and home theater installation, and grew our services revenue by nearly 80% for the year. We opened 35 stores and built a pipeline for between 60 and 65 store openings for fiscal year ‘08. We freed up cash by reducing our domestic net-owned inventory by $88 million and we returned approximately $250 billion to our shareholders through stock repurchases and increasing our dividend.

(Excerpt from the full CC conference call transcript)

Could it be as easy as investors worrying Best Buy is getting too cocky? Circuit City recognized its shortcomings and talked nuts and bolts. Best Buy showed all too much recognition of its success, and talked pie in the sky. Furthermore, it looks like the Best Buy’s customer-centricity isn’t expected to do much for market share:

Total revenue is expected to grow 9% to $39 billion, including a 3% to 5% comp sales gain for the year.

(Excerpt from the full BBY conference call transcript)

So for the full year, we expect net sales growth of 5% to 8% driven by domestic comparable store sales growth of 3% to 5%

(Excerpt from the full CC conference call transcript)

With both expecting the same growth from existing stores, we’ll take the one focused on nuts-and-bolts margin improvement over the one focused on pie-in-the-sky customer-centricity any day. Particularly when management can back it up:

Dan Binder – Buckingham Research

I was wondering if you could just give us more color on what kind of labor model changes you’re doing and what gives you the confidence that you can do that in the next few quarters?

Danny Clark

First of all, I talked about the 50 store pilot group in my comments where we went in last year and have done some standard operating procedure changes, new SOPs in those stores, a new operating model in those stores all the way from how we receive trucks to how merchandise goes out on the floor to how associates interact with customers. We ran that pilot for over six months because we wanted to make sure that we had sustainable results. We’ve had sustainable improvements in both conversion, customer service levels in those stores and associate engagement. So there’s been three very positive signals from those stores over time and across 50 stores in different markets around the country. That work will be scaling in the first half of this year so that will be in place in all of our locations.

(Excerpt from the full CC conference call transcript)

By contrast, rather than backing up their talk, Best Buy seems to be backing away:

Matt Fassler – Goldman Sachs

I just want to dig a little bit deeper into your capital allocation discussion. You talked about opportunistic buybacks. How do you think about those opportunities in terms of stock price, times of year and outlook? If you could also give us some color related to that as to the amount of cash that you like to keep on the balance sheet, just from an operating perspective.

Darren Jackson So maybe a different way of asking that question, we didn’t buy a lot of stock back in the fourth quarter.

(Excerpt from the full BBY conference call transcript)

“Opportunistic” buybacks are those that take advantage of a low stock price. By not buying back shares, Best Buy is implicitly saying their stock price is higher than they think it should be. One begins to understand why the tape told a different story from the headlines.

The Economic Calendar is fairly light, though two important reports book-end the week:

• On Monday is the ISM Manufacturing Index (Consensus 51.5). We’ll take the under.
• And on Friday comes the March employment report.  Consensus is for an addition of 135,000 jobs on the nearly meaningless headline number. Keep an eye out for our more meaningful (we hope) analysis.

The earnings calendar, which really starts to heat up next week, nonetheless offers three important reads into consumer/tech spending on Wednesday:

• Best Buy (BBY) is expected to earn $1.52 on $12.7 billion of revenue for the quarter. Next quarter’s consensus is for $0.54 and $8 billion in sales.
• Circuit City (CC) is expected to earn $0.63 on $4 billion in sales and guide toward a loss of $0.02 on $2.7 billion.
• Micron Technology (MU - Annual Report) is expected to earn a penny on $1.5 billion in revenue, and guide to essentially the same.

We already heard from Best Buy (BBY) and Circuit City (CC) that price competition on flat-panel television sets was hurting profit margins.

Holidaysales Blog – WSJ.com : ‘The Year of the LCD TV’

Consumers spent $8.75 billion on TVs, gadgets and other technology items from the week of Black Friday through the week ending Dec. 23, according to the NPD research group. “This was the year of the LCD TV,” NPD declared in a press release, reporting that $924 million of that total was spent on such TVs and that unit growth doubled from last year. The top-selling size of flat screen was 32-inch LCD and the average price of such models dropped to $796 from $1,354 during the 2005 season. The No. 2 spot went to 42-inch plasma.

So twice as many units at $796 equals total revenue of $1,592 compared with $1,354 last year. 18% growth doesn’t sound too shabby. The problem is, with gross margins of 23% over the last year it doesn’t take much of a drop in margins to wipe out 18% revenue growth. In fact, all it would take is for margins to drop just below 20% (three percentage points) for the profitability to show no growth at all.

Semiconductor Equipment and Materials International (SEMI) has released its latest semiconductor equipment bookings and billings data.

“North American semiconductor equipment bookings and billings have moderated in recent months, following a strong first half of 2006 and expected cyclic patterns,” said Stanley T. Myers, president and CEO of SEMI. “Though having slowed recently, bookings remain at levels well above those of the last slowdown in 2005.”

The slowdown in orders and billings is illustrated in the following chart.

What is particularly interesting is that billings have slowed ahead of bookings. The normal relationship is for bookings to lead billings – you can’t install equipment you haven’t ordered. The faster deceleration of billings growth shows how quickly orders are being pushed back or canceled.

According to a recent MarketWatch article:

Spending on chip-equipment, or machines used to make computer chips in consumer electronics, will slowdown in 2007 but there won’t be a “collapse in demand,” according to Gartner Inc., a technology research firm.

“Looking ahead to 2007, we believe the capital equipment industry will take a breather as manufacturers slow their rate of expansion to allow demand to catch up,” Gartner said in a statement Wednesday.

There is one little problem with Gartner’s forecast, however. Best Buy (BBY) and Circuit City (CCS) have shown that end demand is even cooler than many industry watchers believe. With a slowdown in consumer spending on electronics looking increasingly likely for 2007, the orders will likely be pushed back further still. In other words, don’t hold your breath waiting for the industry’s “breather” to end.

Disclosure: William Trent has a long position in SMH.