Some Minor Static at RadioShack


Standard & Poor's Ratings Services on Aug. 8 lowered its long-term ratings on RadioShack (RSH) to BBB+ from A-. The A-2 short-term rating on the company was affirmed. At the same time, the corporate-credit rating and senior unsecured ratings were removed from CreditWatch, where they were placed with negative implications on May 13. The outlook is stable.

The rating action follows the announcement that RadioShack's board had authorized an overnight repurchase of 20 million shares valued at about $500 million. The electronics retailer intends to fund this through a combination of existing cash balances, a sale-leaseback of its headquarters building, and internally generated cash.

STRATEGIC ALLIANCES. The downgrade reflects the expected decline in credit-protection measures due to the partly debt-financed shareholder-return initiative, as well as a somewhat more aggressive financial policy. The transactions result in a deterioration in credit protection measures to levels more consistent with the BBB+ rating.

The ratings on the Fort Worth (Tex.) outfit reflects the strong cash flow and profitability of its store network. This factor is partially mitigated by RadioShack's exposure to short consumer-electronic product cycles, its participation in a competitive retail and online environment, and management's use of share buybacks to boost shareholder returns. The retailer's chain of more than 5,100 RadioShack stores holds a dominant position in high-margin electronic parts and accessories.

Product initiatives and strategic alliances with Sprint (FON) and Verizon Wireless (VZ) for services and products have been key to generating incremental profit beyond RadioShack's core product offerings.

SHRUNKEN MARGINS. RadioShack will switch its alliance to Cingular (SBE

, BLS) from Verizon on Jan. 1, 2006. In exchange for providing vendors with wide distribution, the company benefits from shared advertising, fixture, and inventory costs, and from the residual income stream from service contracts. RadioShack typically receives a portion of the revenue paid by the consumer throughout the subscription period.

Historically, RadioShack has recorded consistently good results due to the stability of its accessory and battery business. Its operating performance improved in 2004 as a result of vendor, supply-chain, and strategic-pricing initiatives, improved mix, lower markdowns, cleaner inventory, and sales leverage.

However, margins have deteriorated over the past three quarters and are expected to be down again in calendar 2005 due to the deceleration of growth in the wireless business, a negative shift in the sales mix toward lower-margin offerings, and startup costs related to its expansion of wireless kiosks.

THE VERIZON FACTOR. Margins are expected to narrow slightly over the next few years as RadioShack aggressively grows its wireless kiosks. Wireless kiosks are a profitable business for RadioShack, but startup costs are high as it takes time to build volume.

Moreover, margins could be hurt by the decision to exit the Verizon alliance, as RadioShack loses all the residual income from that business. Although the recently signed contracts with Sprint and Cingular have more favorable terms than the existing Verizon business, management could be challenged to quickly ramp up activations to offset the immediate loss of income from Verizon.

Capital investments are expected to rise to between $200 million and $240 million in 2005, from the typical $125 million level, as a result of RadioShack's store-remodeling program. Store openings should continue to be modest, at about 20 net stores per year. Although capital spending is rising, Standard & Poor's expects RadioShack's free operating cash flow to be in the $240 million to $290 million range in 2005. RadioShack's return on capital is a healthy 29%.

LITTLE SLIP? Cash-flow protection measures are adequate for the rating category, and the company is moderately leveraged. RadioShack is expected to buy back an additional $125 million of stock in the second half of 2005 under its 15 million share repurchase program, financed primarily through internal cash flow.

Outlook: The outlook is stable. RadioShack's growth trend should continue to be good, given its focus on the parts, accessories, batteries, and wireless businesses. Common-stock buybacks are expected to be commensurate with management's commitment to a solid capital structure.

In the near term, RadioShack's operating profits could decline moderately if it's unable to offset the loss of residual income from Verizon due to RadioShack's termination of the contract. From Standard & Poor's Ratings Services


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