Value.able: JB's ill-wind

PORTFOLIO POINT: Under threat from the internet, the future of retail stocks such as JB Hi-Fi is far from clear.

It was an ill-wind that defined 1996. Dolly, the world’s first cloned mammal was born, an E. coli outbreak killed 6000 people in Japan, the Prince and Princess of Wales were divorced and Bill Clinton won a second term. In Australia, John Howard won his first term and Barrow Island bore witness to the strongest winds ever recorded on Earth. It seems ill-winds are continuing to buffet many, particularly consumer stocks and retailers like JB Hi-Fi.

Back on February 10, 2010, I wrote: “It happens eventually to all retailers and it will happen to JB Hi-Fi in the next five to seven years. The best you can hope for is that once the stores have saturated the market, directors stick to their knitting, and the company continues to generate high returns but pays out all of those earnings out as a dividend (becoming like a bond) rather than make some grand attempt to buy something offshore or diversify too far away from their core expertise (often at the behest of some institutional shareholder) and blow up the returns.”

Last year I wrote: “ Until then, there is solid growth and category dominance to achieve and I currently believe it will do both. The visible maturing of the business has, however, resulted in a de-rating – jargon for 'the hot air has come out of the story’.” Wind, it seems, has always been a part of JB Hi-Fi’s story.

That proud “Made In Australia” label we once emblazoned on everything from mowers to mops is fast being replaced with the less marketable “Manufactured offshore/Accessed Online”, label and while retailers can use the offshore manufacturers to their advantage they cannot compete with consumers who access online or travel overseas.

Outbound tourism isn’t showing any signs of abating and the migration to online shopping from retailers anywhere in the world, who throw in free global shipping, is a structural change that may never be reversed. Overseas online purchasing already exceeds $1 billion annually and is growing at 20–25%.

As a result, many retailers have seen their shares sliced and diced and julienned like a carrot in a kitchen Wiz-O-Matic. Earnings downgrades have subdued sentiment almost all retailers.

While consumer spending got off to a shaky start in 2011, thanks to floods and cyclones, it does not appear that a lack of natural disasters will help in 2012.

The bigger picture includes not only the trend to global online purchasing but also the fact that over the past eight years consumers have been making more purchases with their debit cards than their credit cards. Indeed average credit card balances have declined.

Savings are up, credit expansion is non-existent and Australian retailers have been on the receiving end of a “virtual” invasion of competitors from every corner of the globe. Online retail sales for 2011 (including travel purchases) were estimated to be just shy of 5% of Australian retail sales, and nearer 10% when food is excluded.

Overseas travel, as measured by departures, continues to rise. Last year, fully one-third of Australians travelled overseas and the impact on the $240 billion of total retail sales is about $5 billion, representing lost growth and at best a flat market.

The resultant lack of foot traffic is hitting David Jones, Myer and Harvey Norman harder than everyone else, but few are immune. In response, the big retailers are having to change their spots. Myer and David Jones have virtually exited white goods and have reduced electrical items heavily; don’t go there expecting any kind of range. Only JB Hi-Fi could possibly achieve sales growth with maturing new stores and a store rollout that is as strong as it has ever been: 30% small-format stores and 70% larger-format

But before we start getting ahead of ourselves, we have to remember that at best JB Hi-Fi is maturing like every other retailer before it, and at worst it may become irrelevant. Clearly Richard Uechtritz, who led the management buy-in back in 2000, was right to resign as CEO, sell almost all his shares and return as a non-executive director. Harvey Norman will lose market share to JB Hi-Fi – I have said that before – but, sadly, both will lose share to the internet.

Even sadder is the fact that once the teen target market of JB Hi-Fi realises that their cheap prices aren’t “always” all that cheap – and it won’t take long given their audience are the most conversant with everything online – the entire USP (unique selling proposition) and with it, the company’s competitive advantage goes out the door.

Perhaps it is no surprise that ahead of the company’s next update, almost 23% of the stock is sold short.

Before Christmas, while on a speaking tour of South Australia, I bought a GoPro waterproof sports video camera for my brother from a camera store in Adelaide. The store wanted $399 and after I asked the assistant whether that was his best price, he promptly knocked off 5%. I then typed “gopro digital camera best price” into my iPhone and showed the assistant the $260 price from an Australian online store. The price was matched, an apology offered and I walked out wondering how much longer this could last. As one analyst friend keeps telling me: “Their goes growth.”

I do appreciate that there are many shortcomings to buying online. Cameras from overseas have cheaper Chinese batteries and children’s clothing may not meet Australia’s high fire rating standards, but many consumers simply don’t care. Almost everything is seen as disposable or replaceable and so where it comes from is less of a consideration.

What is the intrinsic value of a mature business? It has to be a lot lower. Indeed, Skaffold.com’s valuation of JB Hi-Fi (trading today at $11.82) under a “same-old, same-old” scenario is now just $11.89 and although that valuation could rise, one needs to bear in mind that a lack of growth in profits usually corresponds to a lack of growth in intrinsic values.

That is the good news. But what is the intrinsic value of an irrelevant business? An ill-wind indeed.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.