Store rollout risks unhappy ending to JB Hi-Fi's growth story

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 last year.

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 July 15 last year, the stock has fallen about 23 per cent, most of the damage occurring in the aftermath of the company's December 15 profit warning.

Brokers, many of whom had JB Hi-Fi as a "buy" before the profit warning, have since downgraded the company to "hold". That, though, doesn't go far enough. This is a poor situation, which is only likely to get worse.

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 November 30 last year thanks to new store openings, management forecast that earnings before interest and tax for the six months to December 31 will fall by about 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 such as CDs and DVDs towards lower-margin items such as computers and Apple products.

Finally, expanding television sales requires 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 this year. This action is exactly the wrong thing to do.

Investing capital into a declining business will, in the long run, only make things even more painful for shareholders. Even Gerry Harvey has realised this trend and has 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.