Equity Spotlight: JB Hi-Fi

Following on from Q Continuum’s post on investing during sideways markets, today we shine the light on Australia’s best retail stock, JB Hi-Fi (JBH). Interestingly, this position is not shared with the current marketplace, as JBH remains the No.1 stock to sell short (i.e to profit on a fall in price), with over 14% of stock on short-seller’s books. Fairfax (FXJ) at 13%, Perpetual (PPT) at 6% and Wotif (WTF) at 4% are also experiencing heavy selling.

The Business

JB Hi-Fi (JBH) is a home entertainment retailer that dominates the sector. Products include portable music devices, games, music/movies, LCD/Plasma televisions and computers. JBH recently purchased the Clive Anthony’s retail group and announced a share buyback plan of up to 10% of shares on issue.

Financials

JBH has sustained a remarkable 63% average normalised Return on Equity (ROE) for the last five years. Previous to this year, it has done so using modest debt, evidenced by a high Return on Funds Employed and low debt-equity ratio.

There are some intangibles on the balance sheet, but they are minimised due to the business model of rolling out new stores based on free cashflow and reinvesting capital at high rates of return.

Notably, the proportion of profits reinvested in the business is reducing over time (see ROE chart) as the business model matures and market reach is almost completed. JBH recently announced a share buyback plan, more evidence of a slowdown as the business finds it harder to spinoff cashflow.

JBH Return on Equity


Future growth in the retail sector is reliant upon continued consumer spending and population growth, both of which are slowing. JBH is well placed, unlike its competitors, to weather these demographic and microeconomic factors due to its sound balance sheet and excellent use of working capital.

JBH recently purchased the Clive Anthony’s white-goods business, and has already started to incur losses from restructuring (mainly write down on intangibles).

JBH Equity per share (note change in last year due to buyback)


Book value has increased steadily over the years, from $79 million to $293 million, but this will change substantially due to the share buyback.

Management

Capital management has been prudent and sensible, with excellent incremental returns on equity and very sound business practices (particularly working capital). Small amounts of capital have been raised but have not diluted earnings or return on equity. Management have been forthright and forthcoming with reports, results and warnings. A very well managed business through good times and bad

Key Risks and Opportunities

  • Likely to expand and provide additional revenue using the same business model, albeit at slower rates
  • Excellent brand name recognition and loyal customers
  • High barrier to entry for competitors due to excellent working capital, economies of scale and low rent
  • Expansion funded by cashflow
  • Cautious consumer may weigh down on growth or stagnate revenue
  • Online competitors can provide even higher margins and low costs, particularly with strong AUD
  • Saturation of conventional retail market almost complete

Conclusion and Valuation

JBH has a substantial competitive advantage as it continues to dominate its retail electronic competitors. Nothing comes close in terms of business acumen, customer reach, capital management and substantial returns to shareholders.

It’s excellent brand loyalty, effective use of working capital, and robust business model creates a very good barrier to entry for new competitors, although the online internet consumer space is an unknown. This robustness was reflected during the GFC when the business continued to flourished and during the post-GFC “cautious consumer” phase. Due to these elements, Empire considers JBH a “Wonderful” company.

Valuation

JBH has had an average NROE of 63% over the last five years, but the important metric underlying this is the reinvestment ratio, which is declining. Coupled with the share buyback, the forward valuation methodology gets a little tricky, with an expectation that growth in earnings will likely moderate, whilst dividend payout will increase over time.

Empire currently values JBH at $20.37 a share, based on a increased dividend payout ratio (and reduced reinvestment ratio of 25%).

Normally, a 10% Margin of Safety would apply, but due to consumer spending risks, and the increased competitiveness of online retailing, Empire would apply a minimum 15-20% Margin of Safety, with a maximum buy price of $17.71

Disclosure: The author is a Director of a private investment company (Empire Investing), which has a long position and may consider future additional long positions in the business mentioned in this article. The article is not to be taken as investment advice and the views expressed are opinions only. Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.

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Comments

  1. Great read Prince…cheers.

    I wanted to short JB Hi Fi in mid 2010 becasue I figured that they are already selling with low margins on many goods and I cant see how they could adjust to a consumer slowdown (do they really have much capacity to slash prices futher without having pathetic margins?)

    I also think their growth has been on the back of the credit fuelled housing boom. So although there will always be people needing to upgrade or replace electronics…most of the Australian McMansions have already been kitted out with JB Hi Fi gear.

    Finally, I think the online challenge is more pressing than you give credit for. Also the burning of CDs and MP3 delivery etc is damaging… has to be hurting their music sales (I picked up a few $4 CDs the other day).

    • Spot on. Credit bubble collapse is likely to discourage discretionary spending. Think recession/depression.

  2. Goods points Starvos – no doubt JBH has some headwinds.

    Examining a breakdown of their sales by category would be interesting. While buying physical CDs and small electronics like MP3 players is easy (and cheap) on the net, buying larger consumer goods may be a bridge to far for most consumers. When it comes to TVs or whitegoods, the delivery cost is a killer and I think people like to see, measure, examine the good before purchase. So I think JBH will still sell plenty of TVs despite the net – it’s just the cautious consumer that will dampen those sales.

  3. True Q – the breakdown would be interesting. I presume their best sales follow the latest trends. So when Wii was hot, so were the Wii sales and so with Iphone etc…

    The question is what will come next. By all reports the 3D TV fad never took off and people seem a lot more content streaming videos over their computers than buying box DVD sets and more gaming machines…
    I don’t know, but I think that JB Hi Fi are sitting pretty now the same way that Harvey Norman and house flippers were sitting pretty 2 years ago…they are a relic of a bygone era yet to realise what a depressed economy is really like.

    I wont be shorting them any time soon, partly due to Prince and him highlighting their favourable ROI and cash flow etc…I thought they would be built on a mountain of debt like Groves and hi ABC Childcare Centres

    • Not a calamity, JB could go broke through just a shift in consumer preference and habits…plus spending falling overall

      The change is consumer buying online, downloading over internet – NBN, internetTV.I think the days of buying a three of DVDs for $39 is over, that is down from $30 a dvd during the bubble years

      Gaming consoles, TVs, Cameras and Phones can all be purchased online and at competing retailers who could be better at providing specialist information.

      The small business Minisiter predicted the practical demise of retail bookstores in Australia. I cant see why many forms of retail will not be under threat during the credit deflation

  4. I was just having a look at JBH and noticed that they have a currently grossed up yield of 7%. That’s pretty impressive. Although it has to be said that is backwards looking and has potential to shift down due to a drop in retails sales. Conversely it could also increase due to the reduction in outstanding shares.

    I have personally been thinking of dipping some funds into a retail based investment as I have no exposure. Yet when you look around, you have Myer, which I think is overleveraged and I still think is overpriced. The Reject Shop has been smashed in recent months and I think has some validity as they still have potential growth, but I think that there business is based on selling low price lower quality goods which has much more potential to suffer in an economic slowdown. (Reason: people who still want to spend will rather save up for an item they really like such as an ipad, rather than buy cheap $5 items down at a cheap shop).

    I’m curious to know anyone’s thoughts on the effects of slower consumer spending on companies such as Myer and The Reject Shop. Who will succeed, who will just survive and who will fail.

    • Good question Adrian. We’ve always worked off the assumption that the likes of Reject Shop will still do well during a downturn because people will shift spending further down the value chain. It’d be an interesting study to do actually – examining a low-value listed retailer’s figures during a proper recession (as opposed to the GFC recession we forgot to have).

  5. Stavros, you raise some good points. I think there is still a lot of growth to come in the digital distribution age. Especially in Australia there have been environmental factors limiting the take-up (for example it’s only in the last 12-24 months that unlimited and 100Gb+ ADSL2 plans have become affordable).

    I don’t have much time for gaming these days, but I bought my first ever digital download game the other week (DNF) for $35 where the equivalent physical copy in JB is $79. As well as music and movies it’s my opinion games will also move to being predominantly digital distribution. Especially now we have consoles coming with built in HDDs.

    Q Continuum, I do agree though that whitegoods and electrical will remain predominantly store bought for the time being. I recently bought my first plasma and wouldn’t have done so without the opportunity to view instore.

    Can’t say that JBH is one that I would personally consider, but still enjoyed the break down The Prince, thanks!

    • They got some cheap stuff Bullion (disclosure – I spruik them becuase I like them and we own their shares!). I’d also shop their over Harvey Norman, Good Guys, Dick Smith or Retravision any day – cheaper prices, non-bollocks service and no CEO fighting against the inevitable.

      • I do like JBs more casual approach to service (not as in your face, but they still know their stuff). Nothing worse than getting hounded the way some of the other stores do and agree their prices are often the best although Harvey Normans has getting pretty aggressive with some of their sales. I bought a laptop a month back on one of JBs 10% off weekends and then next weekend HNs had a 30% off sale!

      • I was shopping for a tv recently, good guys beat jb’s sale price. Would not have thought to go to gg however a work colleague pointed me there after also getting a better deal than jb.

        I’m not convinced jb have moved with the times (not that gg has either), they seem like a retailing relic. Once the bogangood times are over then what?

  6. There is a business model that I haven’t seen yet, which may or may not work, but basically a retail business like JBH could own a shop (probably downsized in floorspace from current size, thus saving on rent) which effectively is a physical showroom.

    The customers go to browse, and then buy everything online – in store customers would do the same thing, but do it on a terminal (i.e no check out “chicks”) within the store.

    For the retailer, overheads are reduced to just providing a model of each good you want to sell in store, whilst your entire POS mechanism is online.

    Just a thought – there’s more to it, I’m a better speculator than I am a businessman, but maybe there’s something in it – particularly for companies like JBH which have an advantage in this space already.

    • Have seen Woolworths/BigW with these and hearing McDonalds is even starting to introduce them overseas. No reason it couldn’t work for larger purchases as well.

      • Haha, on the topic Woolworth/McDonalds, the 200 hardware chain Wooloworth is opening, apparently comes with a McDonald’s in each!!! To compete with Bunnings sausage sizzle ?? Either way, GG to our health. Back on topic..

    • David (a different one)

      Sounds like a good idea to me. I wouldn’t want to bet on people not buying TVs and whitegoods online in coming years. I bought a fridge online a few weeks ago (after looking at it in a store first!). Not much cheaper than store price but free and quick delivery and removal of old fridge. When every store sells the same whitegood and electronics models, why would you need to buy them in a physical store?

      • Spot-on david.
        Went to JBH the other day to by an LED TV. They were more expensive than Myers. Point was Myers didn’t have any units in stock so one was delivered from Melbourne. The saleperson “ordered” the unit on-line. 24hrs delivery with insurance to the door.
        I personally believe JBH’s days are numbered.

    • Lighter Fluid

      When I was into building PC’s from the ground up, some of the cheapest Australian online stores had one or two brick n’ mortar stores from which you could pick up the order, or have it posted out to you. The actual store front still operated like a traditional shop, but the focus for employees then becomes more one of specialized sales/ services/advice. I think this model is fairly common in the US – some of my favorite online cycling stores from the UK/US are run out the back of small single shop fronts.

      On the possible directions JB might take, I thought this was an interesting idea:

      http://www.current.com.au/2011/05/25/article/Its-alive-New-JB-Hi-Fi-concept-store-a-chance-to-experiment-says-CEO/BADYNAELJH.html

      JB is using the new Sydney store to trial a different store format – Not only do they make the suppliers warehouse their inventory for them, they are now getting them to provide in-store marketing pro-bono… JB you’ve done it again!

      This could be a good play, as often it’s the peripherals to the big ticket items that have the higher margins – displaying branded lines together could increase the *plus one* sales.

      That said, I’m better at analyzing enzyme kinetics than business strategies…

    • That is a really good idea Prince. Flight Centre toyed with the idea some time back, for some reason it wasn’t implemented. Most probably due to their highly incentivised staff taking all the clients.

      JBH will have to significantly increase it’s online presence to be able to take advantage of that. That said they are about to release a very interesting new online product. Part of it has pretty much been trumped by iCloud but replacing the clunky website experience it has at the moment will encourage more online sales.

    • Prince, would you agree that HVN is a better positioned candidate to expolit this strategy going forward given their existing property portfolio ( not a fan of HVN but my musings only)

    • This is actually in-action. I bought my fridge from BingLee a few years ago. I shopped around and couldn’t get a better price than a certain store. I then heard about Choice magazine’s ‘choice shopper’ service, where if you were a member ($15/qtr I think) you can give them a model number and they will shop around for you. The best price obtained beat my best price from BingLee (and other retailers I might add) by about $150. The fridge itself was actually shipped and installed direct from the BingLee warehouse.
      So whilst not an active business model, the lack of overheads (staff & franchising etc) enable a direct customer of the company via the warehouse such as me to obtain a better price than any of their stores.

  7. Hi Prince/Q,

    A question on valuations.

    Given that two of the companies that you have recently spotlighted are currently trading below your “maximum buy price”, doesn’t that suggest that your maximum buy price is set too high?

    Why would you recommend buying a company for X, when it you can readily purchase it for 90% of X, and if you’re really patient, possibly 80% of X?

    • The Maximum Buy Price (MBP) is the highest we would pay for a particular stock. The valuation is what we think its worth – we then adjust this using a Margin of Safety to get an appropriate discount to value.

      Obviously, anything lower than the MBP is worthy of purchase. But no-one knows if the price will fall further, or where the bottom is. We can only go off our calculation and if there is a buy signal, we buy. Our capital management model allows us to purchase more if the price drops further.

      Consequently, we recently purchased some JBH – and it was below the MBP as stated.

      • Right, but my point is that in 2 recent cases, you’ve allocated capital, and then the price has dropped further. This suggests to me that your “capital management model” may require tightening.

        If my model was to simply take your MBP, then subtract 10%, and buy at that price, are you sure that your model would outperform mine?

        • No one picks the exact bottom and sells at the exact top. It seems that you are almost implying that these guys should.

          You wait until you find a really good company trading a reasonable amount below what you think it is worth paying for in the long term and then you buy.

          Anyone who comes out and tells you they always buy and makes money is trying to rip you and everyone else off.

          • I’m not suggesting that they pick the exact top/bottom – just that it’s possible that they could get closer to it, given the recent anecdotal evidence. (buy at 37c, low of 22c (so far), and buy at 17.71, low of 16.02 (so far))

  8. Our buy price is just the limit above which we wouldn’t buy David. Basically it means we think they are trading at a good discount to value right now. The lower below our max price the better!

  9. I just read yesterday that JB Hi-Fi is the most shorted stock on the ASX with some 13.21% being shorted. We may at some stage see a short squeeze here if JB can come out with some impressive news to make the market jump. This could be very interesting to watch.