Time to buy JB Hi-Fi

Yesterday the retail stocks of David Jones, Harvey Norman, Myers and JB Hi-Fi all took a hammering.  It was sparked by a David Jones earnings downgrade as well as an awful run of retail spending/consumer confidence data.  To summarise the blood letting: David Jones (DJS) plummeted 18.2% to $3.20; Myer (MYR) dropped 6.4% to $2.48; Harvey Norman (HVN) dropped 4.6% to $2.30.

Meanwhile, Empire’s favourite retail stock JB Hi-Fi (JBH) dropped 5.3% to $15.65.  Despite our recent Equities Spotlight article singing its praises, JBH fell with the rest of them – as did our portfolio value. Nonetheless, when one of your stocks drops as a value investor you have to ask yourself two questions:

  1. Is it still a great stock?
  2. Is it even better value now the price has dropped

Is JB Hi-Fi still a good stock?

Retail spending is down, the consumer is cautious and keeping their wallet shut Scotsman-style, our  federal politicians are engaged in savage hand-to-hand combat over a carbon tax, Greece is in a slow-motion implosion and the US congress is playing debt chicken with the world’s largest economy.  With such macro uncertainty it’s little wonder that investors are staying clear of those companies that sell discretionary goods.  However, great companies survive such environments and eventually emerge stronger as the economy rebounds.  We believe JB Hi Fi is one such stock.

Financials

An in-depth rundown of JBH can be found at the MB equities spotlight article here.  To summarise, JBH’s return on equity (ROE) has averaged 50% over the last 5 years, equity per share has increased 235% and borrowings are modest.  Its financials are great and management has decided to increase dividend payouts as they saturate the Australian market – indicating a good grasp of capital management.

Another promising sign is an increase in JBH net margins, indicating that costs are being well-control despite rapid growth.

The recent price drop hasn’t changed any of the above.  No doubt earnings will be impacted if consumers stay cautious and sales drop, however the underlying business will still retain a robust balance sheet with low debt.

Is it better than its peers?

Based on my favourite metric of ROE, JBH is well ahead of HVN, DJS and MYR – whose ROE range between 20% and 30%. From a quantitative viewpoint, I much prefer JBH’s business model of small, spartan stores crammed with high-demand electronic goods.  By contrast HVN, DJS and MYR typically have large floor spaces, more employees and are stocked with a greater variety of goods.  This opinion appears to be backed up by the following revenue metrics I’ve derived from the FY10 annual reports of each company:

  • Ratio of revenue to employee costs (i.e. labour)
  • Ratio or revenue to inventory costs (inventory as of FY10 years end)
  • Ratio of revenue to plant and equipment (net book value)

As we can see, JBH is streaks ahead on both labour and plant ratios, whilst it is on par when it comes to inventory.  This would appear to confirm my previous hypothesis – DJS, MYR and HVN all spend far more on labour and plant to produce one dollar of revenue compared to JBH.  This difference can’t be explained away by size, as JBH actually has higher revenues than both DJS and HVN.  The inventory levels don’t tell us as much, except possibly that MYR is very good at stock level management.

So JBH has better ROE and can generate more revenue from a smaller physical asset base.  This, combined with its increasing margins and higher ROE, tell me that it is indeed the superior retail company out of the group.

Is JBH good value now?

In my opinion, yes.  It’s one of the best listed retailers on the ASX and has just experienced a big price drop brought about by another company’s troubles.  In the previous JBH article The Prince valued its shares at $20.37, based on an 80% normalised ROE dropping to 70% over ten years.

Given the recent slew of retail data the 80% forecast ROE is probably too high (although the recent share buyback does complicate the forecast).  However, to justify the current price of $15.60 I’d need to drop the average ROE for the next 5 years to 63%.  That represents a drop in earnings of 20% from forecast, which would be a massive hit – although not unheard-of given DJS’ recent confession.  If JBH comes through the next earnings season with minimal downgrades, I’d wager the market will look more kindly upon its share price.  And given the strengths I outlined above, I think there’s a decent chance of that happening.

Which means right now, it’s bargain time on JBH shares.

Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has an interest in the business mentioned in this article (JB Hi Fi).  The author also owns shares in JBH personally.  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. they have a pretty good retail model, but i think it has been manipulted by commercial bankers to push the debt to the optimum ROI position, a down turn in sales, or failure to secure fastr moving stock could force pressure on the balance sheet. I think the buy back was unnessesary in this economic enviroment (when they effectively redrew on borrowings to pay it out)
    my 2c worth.

  2. Don’t forget too that over the next 5 years or so their media sales (music and movies) should decline as online / streaming takes over, esp. music. I don’t know what specific plans they have to meet these changing conditions. Of course gadget demand should be fine and dandy

    • They have plans to counter the potential loss in media sales.

      After having talked to a few JB Mangers it appears that sales are holding up. No spectacular growth however their belief is that they are picking up further business due to the “buy cheap” nature of their offering. Also they don’t have extensive and expensive infrastructure that the other do and are further refining that.

  3. I read somewhere that JB is the number 1 most shorted stock in the market. If they do come out with some good numbers at reporting time, this could potentially force a short squeeze. I am certainly keeping a keen eye on JB.

  4. I’m worried the next 5 years might not be as rosy for JBH as the last 5 years.

    Looking at their product lines:
    * CDs, DVDs, Blu-Ray disks and, by implication, a lot of home-theatre hardware are suffering the death of a thousand downloads. 25% of JBH’s floor space is stocked with products that will almost certainly decline over the next 5 years and may be obsolete in 10 years.
    * Sales of iPods, MP3/4 players and, to a lesser extent, Digital Cameras are declining as the multi-media capability of mobile phones improve.
    * PCs, Laptops, GPS & Car Stereo, Hi-Fi and Home Audio are all mature markets. No growth there.
    * Games consoles are going nowhere fast over the next couple of years. Neither Sony or Microsoft plan to launch a new model before 2015, leaving the WiiU as the only major console release in 2012.

    TV sales have boomed over the past 5 years as everyone upgraded to LCDs/Plasma screens. But, I don’t think there’s a lot of distance left to run on that round of upgrades. Unless: a) the sets purchased in the last 5 years break, en masse, causing a boom in replacements; or b) 3D TV sales accelerate, it’s hard to see TV sales growing at the same rate over the next 5 years.

    Mobile phones and tablets are two lines where there’s plenty of growth potential. My concern with mobile devices is whether or not the margin on hardware is sustainable. To me, it seems like the mobile market is undergoing the same shift as the PC market encountered in the early 90s: a platform agnostic operating system (Android) underpinning a commoditisation of hardware.

    Of course, this assessment is limited by my own imagination. JBH might make a fortune selling the iWhatever-Steve-Jobs-thinks-of-next.

    However, weigh against that the bearific macrobusiness.com.au outlook.
    • An Australian housing slump would mean fewer new households and fewer people needing to purchase new gear.
    • Chinese inflation and/or currency revaluation would squeeze margins.
    • Consumers shopping online will increasingly bypass bricks and mortar retailers.
    I’m worried the next 5 years might not be as rosy for JBH as the last 5 years.

    • That’s an excellent review of the risks Jafail.

      We (Q Continuum and I) do realise that the business model for JBH has switched from growth to maturity, which is reflected in their increasing dividend payout (i.e an inability to reinvest high cash earnings into new equity) and their recent share buyback.

      We still contend they are the best positioned in terms of responding to change, as opposed to the Harvey Normans etc out there.

      As Q said, the current price assumes a very significant cut in earnings – given managements very good working capital arrangements, the risk of a DJS style earnings cut – whilst there – is negligible, IMO.

      Congrats on the bub Q btw. When does she get her first copy of “Security Analysis”? 😀

  5. It’s one of the best listed retailers on the ASX and has just experienced a big price drop brought about by another company’s troubles.

    But it’s in retail and it was that sector which was crunched on wake up Thursday.
    I agree it can outperform discretionary retailers like Djs and Myer..so take a cautionary position and sell short those stocks against your JBH buy.
    I wont be surprised to see JBH $2 lower within weeks.

  6. Profit downgrade

    If JB comes out with a downgrade how late can they leave it (before being “too close” to reporting season)?
    Cheers
    D

  7. Howdy all, sorry for the lack of replies. My first child was born this morn so I’ve been a little snowed. Most of the responses touch on the challenges facing retail generally a f JBs products specifically. Can’t say I disagree – there are plenty of headwinds and their product space is in constant flux However, as products/fads come and go JB wi no dobt change their inventory to suit (who buys VCRs anymore?). As for earnings, to me the current price assumes a cut to earnings of at least 20% from the forecast, which I am betting is too conservative. If JB drops another couple of bucks in a few weeks time, I will be buying more again

  8. Thanks all. Mum and babe are doing great. Funny you mention that book Prince, I’m reading it right now – should form part of her bedtime story routine 🙂

    • Sorry Prince, but really Q forget reading ‘Security Analysis’ to your poor little girl (I tried ‘This time is Different’ and it didnt work). My boy loves (and accordingly so do I) ‘In the Night Garden’ on ABC 4 KIDS at 6.30 every night.

      Iggle Piggle rocks!

    • Q would say Capitalism Rocks!

      The little Prince/Princess (due October) will be reading Harry Potter (in stages), amongst the usual lightweight stuff from the likes of Mandelbrot, Taleb, Ineichen, Keen….etc

  9. Dave From Pakenham

    an ex growth retail franchise should trade no higher than 10-11 x earnings 1 year out.

    no way JBH hits median forecast 2012. so unless there are rate cuts here JBH could easily be down another dollar or two.

    who cares about high historical roe’s only tells how good it was and shows what could go wrong!