JB Hi Fi earnings update

JB Hi Fi released its FY11 result yesterday.  Given the shellacking retail has been taking in recent months, and the ongoing market ructions, we have been eagerly awaiting the results of our favourite retail stock.

Sales

Revenue increased 8.5% to just under $2.9 billion.  Consumer electronic sales (which represent 75% of total sales) grew by 4.1% whilst software sales (music, movies and games, accounting for 25% of sales) dropped by 9.1%.  A major contributor to this drop was a 16.8% decrease in games sales.

Despite the drop in games sales, JBH increased their market share – indicating their competitors did it even tougher in the games market for FY11.

Profits

NPAT dropped 7.5% to $109.7m, which looks like a bad result.  And it is – but not because of low sales or high costs.  JBH wrote off $24.7m of their Clive Anthony’s stores in a one-time restructuring charge.  At Empire we don’t consider this sort of thing an abnormal loss – JBH is reaping what they sowed when they over-paid for Clive Anthony’s in the first place.

However, removing the restructure cost increases NPAT by 13% – not bad.

JBH has converted or closed all but 5 of the Clive Anthony’s stores, so future earnings shouldn’t be marred by further write-offs.

Despite the drop in NPAT, the all-important return on equity (ROE) metric came in at 50% (not adjusted for franking credits), which compares favourably with the 51% of FY10.  The small drop in ROE is due to a 10% reduction in equity as a result of JBH’s share buyback (see below).

In terms of net margins, FY11 produced a 3.7% result (4.5% without the Clive Anthony’s restructure) which is just above the long term average of 3.5%, but below last year’s stellar 5.1% margin result.

Online Ventures

JBH is attempting to counter the online retail “threat” by allowing users to purchase items directly from their website.  In addition, JBH is starting a new service in FY12 called “JB Hi Fi NOW“ which basically allows subscribers to stream music directly to their PC or mobile.  There will be 8 million tracks to choose from over 100,000 artists initially, and users will have unlimited access.  This sounds like a direct confrontation to the iTunes business model, where users pay for individual tracks, and may end up a superior choice for Australian consumers slogged by the “Apple Tax” (an average single costs $A1.69 vs $US0.99)

Whilst these ventures are in their early stages (online sales are very small compared to total sales), at least JBH is looking to embrace the online retail revolution and even produce some new concepts.  We have no idea how successful JB Hi Fi NOW will be (comments anyone), but it’s good to see JBH management embracing the online-inevitable, rather than just complaining about it like their peers.

Buyback and debt increase

In March 2011 JBH bought back 9.9% of its shares (10.8m shares) at $173.6m, entirely funded through their debt facilities.  JBH’s leverage increased substantially as a result, with borrowings moving from $35m to $233m.  Despite this increase, JBH is still moderately geared compared to NPAT with borrowings totalling 2.1 times FY11 NPAT.  However, the net debt to equity ratio now stands at 135% due to the reduced equity base and increased leverage.

If the returns on the purchased shares are higher than the interest charged on its debt facility, then the buyback will be a net positive for JBH (this should be easy given JBH’s high ROE).  Nonetheless, JBH has increased its balance sheet risk profile with the large debt increase.  We would rather see buybacks internally funded with excess cashflows, but if JBH can maintain sales into the future then the buyback will be a positive for shareholders given they’ve just invested in a 50% ROE business with money borrowed at circa 7%.

Summary

JBH’s NPAT is down but it has been adversely affected by a large restructuring charge for its Clive Anthony’s stores. Stripping that away, NPAT continued to climb despite the tough retail environment.

Margins appear to be in line with historical averages indicating cost of business remains under control – a key element to their success.  However, risk has increased with a large increase in borrowings to fund a share buyback.  Further, the threat of a continued slump in the retail environment will cause their ROE to drop significantly, and the buyback will be seen as an ill-timed bout of exuberance.

At Empire we still like JBH and its business model, especially given the following:

  • In March 10% of JBH shares were bought back, thereby increasing the equity value of existing shares by 11%;
  • Since that time, JBH shares have dropped 30%;
  • JBH has managed to grow sales and add new stores to their portfolio in FY11;
  • We believe they are superior to their rivals on a number of metrics (see my article here);

Investing in JBH at the moment would not be for the faint-hearted. It is almost certain that future participants will not provide JBH with as high an earnings multiple as in the past.

Given this structural change and the risks outlined above, we value JBH in the $18 to $18.20 per share range.

Remember you need to decide if you are an investor, trader or watcher. If you choose the former, EXPECT high price volatility and a lack of growth over the medium term, or even long term. Even a “Wonderful” company like JBH will continue to be sold down alongside poor compnies, despite strong results.

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.

Comments

  1. Is the wrap-up on sales correct?
    Revenue increased by 8.5%: consumer electronic(75% of sales) increased by 4.1%; software(25% of sales) decreased by 9.1%.

    • Hi Prince,

      My take on JB Hi Fi NOW.

      The difficulty of producing a quality online service should not be underestimated. Software projects are even more notorious than construction for going over time and over cost, but unlike construction a below standard or barely functional product is also a common outcome.

      It will take significant investment but also a quality development team (rare domestically) to see this through.
      I can see JB competing with Apple for a small share of the market if:
      1) They are a lot cheaper than iTunes
      2) They focus on a minimal feature set AND do it well

      Price is the only thing that will entice consumers into trying an alternative service and usability is the only thing that will keep them. It’ll be interesting to see if they are successful, but I have observed that boardrooms consistently underestimate the difficulty of developing consumer software (in-house somewhat easier). You don’t just pay someone and it gets done, these projects must be very carefully scoped and managed and of course JB does not have a lot of skill / experience with this. Odds are not on for a raging success, but management looks young (i.e. tech savvy) and has a good track record so who knows.

      • This JB hifi NOW appears to be similar to what Spotify offers in various European markets. If so, kudos for JB in spotting the trend (it’s starting to hurt Apple, and only the recalcitrance of the US music structures has kept it out of the US) and noting that Spotify isn’t bothering with the Australian market.

        If it works (and yes it is a big if) it has the potential to hurt Apple in two ways.
        1. Once we are untethered from iTunes, and the need to keep our music in the itunes format, there is not a lot to tie a consumer to the iPod. This means decisions about music players become a lot more cost driven. Don’t underestimate the iTunes change effect- it’s a real pain changing the format of your entire music library.
        2. General purchase of music from iTunes will drop.

        The music streaming thing seems to be on the agenda of a few companies (microsoft is thinking on this), and once they persuade the record companies, something will take off. Being the early entrant in the market may pay off

      • I’m with Ben – this is a very tough market to crack and JB isn’t/won’t be the first to try (and in my opinion fail).

        Let’s start with cross-platform digital rights management – how are JB going to develop that when no-one else has? They’re not a software company and I can’t see them negotiating contracts with record companies that allow distribution of unprotected music.

        I think Spotify will be here soon and Apple will start offering streaming services in the medium-term future.

        This is just a distraction for JB (or they’re just throwing it out for analysts) and will cost them heavily if they pursue the idea.

      • The other thing to be aware of is that record companies are part owners of Spotify so they are likely to be difficult when it comes to licensing music streaming.

  2. That’s right Bill. The 4.1% was a comparable stores figure, not total sales growth. Total sales growth was more like 13% but this doesn’t factor in opening of new stores. Hence the higher revenue. Eitherways, it’s a good sales result in the current environment

    • A courageous decision in the Yes Minister way.

      Sir Humphrey: There are four words you have to work into a proposal if you want a Minister to accept it.

      Sir Frank: Quick, simple, popular, cheap. And equally there are four words to be included in a proposal if you want it thrown out.

      Sir Humphrey: Complicated, lengthy, expensive, controversial. And if you want to be really sure that the Minister doesn’t accept it you must say the decision is courageous.

      Bernard: And that’s worse than controversial?

      Sir Humphrey: (laughs) Controversial only means this will lose you votes, courageous means this will lose you the election.

  3. JB Hi-Fi now will most likely perform poorly. Reason being is that iTunes has created a strong barrier to entering the music market due to the fact that almost everyone has an iPod, thus making them more inclined to iTunes.

    Furthermore, instead of listening to music through JB Hi-Fi “NOW”, consumers can just listen to tracks on YouTube. After all, both are eating up their monthly download, it just happens to be that one’s free while the other isn’t.