Nathan Bell
January 24, 2012 – 2:16PM
The Age
JB Hi-Fi faces a gloomy retail market.
When the former chief executive of JB Hi-Fi, Richard Uechtritz, announced his retirement in February 2010, he held 1.5 million shares.
He then sold 500,000 shares in March before retiring in May. After a convenient “leave of absence” he rejoined the board in April 2011.
How many shares did he own at that point?
Absolutely none whatsoever. Actions, as they say, speak louder than words.
The decision to leave JB Hi-Fi last year – and sell all his stock – means he’s $11 million wealthier than if he had retired today.
JB Hi-Fi faces a fundamental threat to its business model, one that will only intensify with time. Since 15 July last year, the stock has fallen about 23 per cent, with most of the damage occurring in the aftermath of the company’s 15 December profit warning.
Brokers, many of whom had the company as a “buy” before the profit warning, have since downgraded to “hold.” That, though, doesn’t go far enough. This is a poor situation only likely to get worse.
No sanctuary
The profit downgrade revealed how the store rollout program is no longer insulating the company against a tough retail market.
While JB Hi-Fi branded store sales rose 7.8 per cent in the five months to 30 November 2011 thanks to new store openings, management forecast that earnings before interest and tax (EBIT) for the six months to 31 December will fall by around 5 per cent.
There’s only one way to interpret this fact: Margins are being squeezed. For a high-volume, low-margin retailer, there is no more serious threat.
The company claims the squeeze is because of competitor discounting but that’s far from the whole story.
First, new stores could be cannibalising existing ones (there are now three stores within five minutes walk of Intelligent Investor’s office in Sydney, including the perennially empty hardware-only shop at Westfield Sydney).
Second, there appears to be a shift in the sales mix from higher-margin items like CDs and DVDs towards lower-margin items such as computers and Apple products.
Finally, expanding television sales require extra staff (another downside to price deflation). All these factors are probably contributing to weakening margins.
Nevertheless, management is persisting with the store rollout – 16 will open in 2012. This action is exactly the wrong thing to do.
Dick Smith purchase?
Investing capital into a declining business will, in the long run, only make things more painful for shareholders. Even Gerry Harvey has realised this trend and stopped further store rollouts in Australia altogether.
The problem is that JB Hi-Fi has long marketed itself as a “growth story”. Changing a company’s sense of itself, especially when it’s committed to growth and already under pressure, is usually too much to ask.
Also lurking within the announcement was another potential red flag. JB Hi-Fi stated that “consolidation in the consumer electronics and home entertainment sector is inevitable”. Here, the “commitment to growth” red flag takes on a potentially blood-like hue.
This could – but may not – signal an intention to acquire Dick Smith from Woolworths, which is conducting a strategic review of its consumer electronics division. Consolidation might forestall the inevitable, but allocating capital to a declining industry won’t save it.
What appears to be the right course of action in the short term – opening stores and buying weaker competitors – is a perfect way to destroy shareholder funds. The question, then, is how bad could it get?
Retailers and businesses in general have a tremendous capacity for reinvention. But with JB Hi-Fi’s reliance on DVDs, CDs and computer game sales to drive traffic and sweetheart lease deals with landlords, this business is at even greater risk than Harvey Norman (which has its own set of slightly different problems).
On a forecast 2012 price/earnings ratio of 10, JB Hi-Fi looks cheap. But that’s because it’s a “value trap”. The decline is very likely just the start of a very steep descent.
This article contains general investment advice only (under AFSL 282288).
Subscribe to our free mailing list and always be the first to receive the latest news and updates.