Why I'm Shorting RadioShack

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At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I seek out and invest in the world's elite businesses. These include companies with the most valuable brands, best business models, strongest competitive advantages, superior products and services, and excellent management. They are the innovators, disruptors, and best of breed. These businesses are... Tier 1.

During my research of these elite enterprises, I also come across the imitators, the disrupted, and worst of breed. These industry laggards have broken business models and are steadily losing market share to stronger rivals. It is an unfortunate and vicious part of the global economy, but also a natural outcome of the forces that help our world move forward.

As investors, we can profit from these situations by selling short shares of these dying companies. And so I am shorting RadioShack (NYSE: RSH  ) .

The bear case
(Nasdaq: AMZN  ) has completely disrupted the business models of many traditional bricks- and-mortar companies, from bookstores such as Barnes & Noble (NYSE: BKS  ) and Borders to office supply stores such as OfficeMax (NYSE: OMX  ) and Office Depot. Amazon is competing ferociously as it brings its ultra-efficient distribution network and low prices to bear on its less innovative and overmatched foes. Nowhere is this more apparent than in the electronics retailing industry, where even former industry giant Best Buy (NYSE: BBY  ) has succumbed to Amazon's onslaught.

There are multiple reasons for his phenomenon. One is that traditional bricks-and-mortar companies' physical store bases work against them, as their higher overhead (building leases, sales staff, etc.) makes it impossible for them to compete with Amazon when it comes to prices. This has led to the "showroom effect," whereby customers visit physical locations, such as those provided by RadioShack, so they can touch and try out devices, but then purchase those products on Amazon -- sometimes by using their smartphones even as they're still in the store! This is a nasty trend for physical retailers, but it's also a completely rational behavior on the part of consumers.

A second reason is that Amazon has built a powerful brand that occupies tremendous consumer mindshare. After more than a decade of offering an unmatched selection of products, low prices, fast shipping, and excellent customer service, Amazon has become the first -- and last -- place to shop for many people.

And finally, though some see the movement toward more states charging sales taxes on online transactions as something that could lessen Amazon's price advantages over bricks-and-mortar stores, it is likely to have the effect of increasing its competitive positioning when it comes to convenience. As Amazon becomes less restricted in terms of where it can build distribution centers, it will become easier for the e-commerce giant to offer one-day and same-day delivery in more locations.

Simply stated, RadioShack, like many of its traditional retail brethren, is outmatched by Amazon's superior selection of products, lower prices, brand loyalty, and convenience factor. That is a recipe for disaster.

It gets worse
RadioShack is also seeing increased competition from Best Buy, its struggling but still stronger rival. Best Buy has announced that it is moving toward a smaller store format -- typically RadioShack's domain -- as it tries to lower its cost structure as a means to better compete with Amazon. So not only has RadioShack's model been disrupted by Amazon, it's also being challenged directly by a larger and more financially sound competitor.

And finally, RadioShack's CEO, James Gooch, abruptly left the company just this week. CFO Dorvin Lively will serve as interim CEO until a permanent replacement is found. This instability in RadioShack's senior leadership will not help the company in these difficult times.

The financials
The impact of this extremely difficult competitive landscape can be seen by RadioShack's declining margins:

For the Fiscal Period Ending…

12 Months
Dec. 31, 2009

12 Months
Dec. 31, 2010

12 Months
Dec. 31, 2011

June 30, 2012

Gross Margin 45.4% 44.4% 40.8% 37.7%
EBITDA Margin 11% 10.3% 6.3% 3%
EBIT Margin 8.8% 8.3% 4.4% 1.1%
Net Income Margin 5% 4.8% 1.6% (0.4%)

Source: S&P Capital IQ.

I expect this trend to continue to worsen, which I believe will ultimately lead to a sharply lower share price. RadioShack has a debt load of $679 million versus cash of $518 million, so I don't expect a short-term liquidity crisis, but as RadioShack's cash flow continues to decline it will become increasingly difficult to meet interest payments and reinvest in the business.

The primary risk I see with shorting RadioShack is the possibility of a private equity buyout. While it's difficult for me to understand why an investment firm would purchase a declining business such as RadioShack, stranger things have happened. If a company were to purchase RadioShack at a premium to current market prices, we could see a substantial loss on our investment, and our longer-term thesis will not have time to come to fruition. To account for this risk, I recommend sizing this position conservatively. And so on the next business day after this article is published, I will be selling short 100 shares of RadioShack, which will be approximately 1% of the Tier 1 portfolio.

The Foolish bottom line
I much more enjoy building long-term ownership positions in the world's most elite businesses and profiting alongside them as they help to lead the world forward. But as portfolio manager of Tier 1 investments, I appreciate the hedging advantages that a few well-placed short positions can offer. When the market declines, these shorts can serve to offset some of the losses on our long positions and serve as a ready source of cash that we can then use to buy Tier 1 enterprises at depressed prices. I believe that's a winning formula for long-term investment success. If you do as well, join us on Twitter @Tier1Investor.

Joe Tenebruso manages a Real-Money Portfolio for The Motley Fool and is an analyst on The Motley Fool's Stock Advisor, Supernova, and Fool One premium service teams. You can follow him on Twitter @Tier1Investor. Joe owns no shares in any company mentioned above.

The Motley Fool owns shares of Best Buy, RadioShack, and Motley Fool newsletter services have recommended buying shares of Motley Fool newsletter services have recommended writing puts on Barnes & Noble. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (5) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 28, 2012, at 9:53 PM, BenFE08 wrote:

    RSH's CEO "abruptly left" because he was fired for poor performance. Call it what it really is.

    The BOD directly OWNS this total debacle because they put financial people in charge of a retail company, and they put it squarely in the toilet. The total incompetence of Julian Day and Jim Gooch in NOT running this company is going to be the death of it.

    If the BOD had ANY common sense, they will get someone with proven retail skillsets and completely clean house of the x-Blockbuster failures that were brought into RSH by Day and Gooch. Put people in charge who KNOW retail.

  • Report this Comment On October 03, 2012, at 7:51 PM, Kobalt wrote:

    Joe, nice article. I was wondering; you are shorting at well under $5. Many brokers won't allow retail customers to short stocks under $5. Does your size, stature, etc. give you special dispensation? Are there retail brokers that allow this without the $5 rule?

  • Report this Comment On October 04, 2012, at 11:23 AM, TMFGuardian wrote:

    Thanks Kobalt!

    As for shorting stocks under $5, the Motley Fool uses Interactive Brokers for our Real Money Stock Picks program, of which Tier 1 Investments is a part. Our RadioShack short went through without a problem, so it appears that IB does allow customers to short stocks under $5. But I understand your question, because after a quick Google search, it does seem like many other brokers do not allow customers to short low-dollar stocks. Your best bet is probably to call the customer support number of any broker you're considering and confirm the restrictions they place on shorting stocks.

  • Report this Comment On October 09, 2012, at 11:57 PM, Kobalt wrote:

    Thanks Joe!

  • Report this Comment On October 10, 2012, at 12:40 AM, TMFRhino wrote:
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