Why RadioShack’s Gross Margins Will Remain Stagnant

Despite being a prominent player in the retail business for over 90 years, RadioShack (NYSE:RSH) has been struggling recently to survive in the industry with rising competition from other physical retailers such as Best Buy (NYSE:BBY) and Wal-Mart (NYSE:WMT), online retail giant Amazon (NASDAQ:AMZN) and online auction sites like eBay (NASDAQ:EBAY). With stagnating top line growth, declining gross margins, high inventory levels, a string of debt maturities and eroding cash reserves, the company has posted net losses the last five quarters.

Radio Shack’s gross margins have declined from 45.4% in 2008 to 36.7% in 2012. A higher proportion of low margin products in its portfolio, price competition from other players in the market and high promotional and re-branding costs are the primary factors negatively impacting RadioShack’s bottom line. While the company’s turnaround efforts might help reignite its brand and re-accelerate growth, in turn positively impacting margins, we believe that RadioShack’s gross margins will remain stagnant for the rest of our review period.

In this article we discuss various factors that impact RadioShack’s gross margin growth.

See our full analysis for RadioShack

Factors That Put A Downward Pressure On Margins

1. Higher sales of lower margin wireless products

RadioShack has been betting big on shifting its focus to mobility devices like smartphones and tablets, an area which is expanding fast but offers comparatively lower margins. Its revenue contribution from the mobility division has risen from 44.2% in 2010 to 51.4% and 53.1% in 2011 and 2012, respectively.

The wireless segment is intensely competitive due to the presence of a large number of players including not only traditional rivals like Best Buy and Amazon, but also Apple Stores, AT&T and Verizon outlets. While smartphones such as iPhone contribute to higher sales due to their high prices, they yield very low margins for retailers such as RadioShack due to the intense competition in the market.

On the positive side, RadioShack is seeing stable margins in its high-margin signature business and improving margins in the consumer electronics business. Nevertheless, since RadioShack derives a majority of revenues from the wireless segment, we expect margins to remain under pressure. The wireless platform is the largest contributor to total revenues with a 51.5% share followed by signature and consumer electronics which in 2012 contributed 33.9% and 14.6% respectively.

2. Competitive pressure can limit growth

The entry of online retail giants such as Amazon has altered the landscape for the consumer electronics market. Retailers like Wal-Mart and Amazon are taking business away from pure-play consumer electronics stores by offering lucrative discounts. Showrooming, a phenomena where customers use physical stores to check out products and gain hands-on experience with gadgets but use online stores to make the purchase, has negatively impacted sales of traditional brick-and-mortar retailers.

Earlier this year, RoadioShack’s competitor Best Buy (NYSE:BBY) announced making its price-matching policy permanent, in order to put an end to showrooming. The company now matches the prices offered by select online retailers and other brick-and-mortar competitors across a wide range of products, irrespective of whether the customer makes the purchase from a store or online. We think that while Best Buy can afford to take a hit on margins for additional market share, RadioShack doesn’t have the resources to. RadioShack’s smaller footprint does not allow it to carry the breadth of products that would make it competitive vis-a-vis other brick-and-mortar retailers and online channels.

Price competition from other established players can restrict Radio Shack’s top line growth and if the company does end up offering lower prices it will have to take a hit on its gross margins.

Factors That Can Help Stabilize Gross Margins

1. Revamping of stores can re-accelerate top line growth in turn impacting gross margins

With a new CEO in place, RadioShack has been working on devising a new strategy to turnaround its business since the last few months. The main focus of its initiatives is on re-branding the chain and re-defining what it stands for. The company is making an effort to go after the younger demographic and the Do-It-Yourself (DIY) customer segment. In addition to making changes to its store inventory, appearance and signage, it is airing commercials aimed specifically to lure the younger audience.

The main goal of RadioShack’s re-branding initiative is to make its stores more shoppable by providing a satisfying experience to its customers. Though, it has been reporting disappointing results for quite a while and we have yet to see any significant gains from its turnaround strategy, RadioShack claims to be making strong progress on re-positioning its brand, revamping the product assortment and reinvigorating its stores.

As the company focuses on revamping its product assortment and re-position its brand, additional sales volumes can help stabilize margins. However, costs incurred for the re-branding initiative might impact margins in the short-term. Nevertheless, RadioShack hopes to achieve higher operational efficiency and improve its financial flexibility in the future with these initiatives. The company claims that it will take several quarters of strategic changes to improve its long term financial performance.

2. Efficient inventory management can help improve margins

RadioShack sources inventory both domestically and internationally. Its inventory levels are subject to a number of factors including technology advancements, reduced consumer spending and changes in consumer tastes. Efficient inventory management can help the company improve margins in the long run.

In Q2 2013, RadioShack worked towards removing duplicate inventory and unproductive inventory through promotions and clearance events. The company claims that it has identified those SKUs that drive demand in a given store’s trade zone so that it can customize the assortment and focus the inventory on products that generate the majority of its sales and profits.

Our price estimate of $2.87 for RadioShack is at discount of over 20% to the current market price.

Understand How a Company’s Products Impact its Stock Price at Trefis