3 Crucial Lessons Investors Should Learn From RadioShack's Collapse

By Markets Fool.com



Photo: Nicholas Eckhartvia Flickr.

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There are few things worse than losing money, especially in the stock market.

But it's in studying failed investments that we can learn about how to make future decisions. It's how we can develop our own "mental model," as Charlie Munger would call it, for identifying good and bad stocks.

RadioShack (NASDAQOTH: RSHC)is an excellent case for calibrating our mental models for retail. Here are the three most important lessons from its rapid failure.

1. Retail is winner-take-all by its nature
In its very best year of the last 10 years -- 2004 -- RadioShack would earn a profit margin of just 7%. Put a dollar in at the top, and only $0.07 would survive its various costs to come out as profit.

Precariously thin profit margins are the reason retail is almost always riskier than it appears. Sure, some companies like Costco or Wal-Mart post relatively stable, slow-growing earnings for years, even during recessions. For those that sell discretionary products, however, earnings tend to be much more volatile.

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In retail, operating leverage is massive. A small shift in sales results in a proportionately larger change in profit. For RadioShack, a 10% increase or decrease in sales would result in a roughly calculated 44% increase or decrease in operating profits in 2004 -- and this is in a year in which its profits were particularly lofty!

This is what makes retail deadly competitive at a local level. As a single store takes a greater slice of sales volume, its mostly fixed costs like rents, utilities, wages, and even advertising are spread among more sales dollars. Thus, prices can be reduced, and margins can be maintained. The store's competitors, losing sales volume to their lower-priced market leader, have to engage in a pricing war they cannot sustain, or raise prices to make up for slowing sales, thus alienating customers.

RadioShack thrived from these winner-take-all economics during its early years, when it was the only place for obscure electronic gadgets and gizmos. As just one of many places to buy a laptop, TV, or remote-controlled drone, however, it eventually failed for much the same reason.

Being an "also ran" in retail isakin to being a small boat in a lake filled with transport vessels -- they'll go wherever they want, but you can go only where you won't be capsized by their wake.

Lesson: Retail is a winner-take-all business by its very nature because the leaders have the luxury of being able to price products aggressively and maintain a desired level of profitability at the same time.

2. Financial statements do not tell all
In 2012, RadioShack had a bit of resurgence as a value stock. It was trading cheaply at an equity value that implied it could be liquidated and, depending on the share price on any given day, basically give shareholders their investment back. You could determine this by simply comparing its market cap to its tangible book value.

A familiar analysis went something like this. In 2012, RadioShack could:

  1. Cash in its current assets -- cash, inventories, receivables, etc. -- at their accounting value.
  2. Sell its non-current assets at just $0.50 on the dollar of their accounting value.
  3. Use the proceeds to pay off all of its liabilities.
  4. Return the excess cash to shareholders.

The case was made that your downside was at least limited -- there was some asset value protecting your investment. And thus it was pitched as a value stock time and time again. (Many pitches invariably highlighted its operating leverage -- if sales could grow just a few percentage points, profits could explode!)

But many who ran this analysis made the critical error of failing to dig into the weeds. RadioShack's true debt was understated on the balance sheet. It was on the hook for $577 million in "non-cancelable" operating leases for storefronts around the country.

Source: Radio Shack 2011 annual report.

Operating leases are not debt in the traditional sense, but they represent cash outflows that have to be made in the future. If you included these required future cash outflows in as debt -- and operating leases are treated as a debt in a liquidation scenario -- virtually all of its reasonable value in a liquidation event was spoken for. Shareholders, being last in line to collect, would receive practically nothing.

Operating leases also stymied potential for a turnaround. RadioShack couldn't cut and run, shrinking to a smaller footprint of its most profitable stores. Its leases were multi-year in duration, requiring cash outflows years into the future. But you'd never know this if you didn't get to the table tucked away in its footnotes.

Lesson: You wouldn't read a map without a legend; you shouldn't read financial statements without the footnotes.

3. The importance of having something different
Retailers largely exist to sell commodities to their customers. As such, there are only two sustainable models in the industry: Compete on cost, or compete on service. Competing on cost generally requires an advantage of scale -- buying power that begets the power to force the hand of suppliers. RadioShack had no advantage here.

In a time when people buy new electronics rather than repair them, selling obscure parts by the handful was no longer a working model. The CB radio, which once made up 30% of its sales, according to BusinessWeek, was now solidly in the "for truckers only" category. And consumers, who have slowly educated themselves about the importance of megahertz and megabytes, don't need someone to hold their hand to buy a laptop or cell phone.

Lesson: RadioShack had no ability to compete on price. And its customers didn't care to pay more for service -- even the most helpful of employees added little value to the sales process. Thus it was just a marginal player in a sea of better capitalized competitors with better prices and relatively similar service. That's a recipe for disaster any way you slice it.

The article 3 Crucial Lessons Investors Should Learn From RadioShack's Collapse originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.