ValueLine: JB Hi-Fi's capital management review

PORTFOLIO POINT: The retailer's steep profit trajectory may be levelling out, given its chairman’s promise to review capital management.

Since JB Hi-Fi was floated in October 2003 at $1.55 a share and made its ASX debut at $2.25 a share, the company has been much revered by analysts and shareholders, who have been spellbound by its seeming ability to grow the business in almost any environment.

Last year in Eureka Report I wondered out loud whether this was coming to an end (click here). My observation at the time was that JB Hi-Fi appeared to be maturing and the negative implications that had for the company’s intrinsic value.

JB Hi-Fi’s result for the first half of 2011 saw the share price rise 1.8% on Monday and many may think the price move correctly reflects the substance of the announcements. But as I have mentioned in previous columns, investors should never take cues from short-term price movements.

What is important, however, was the chairman’s promise to conduct a review of possible capital management initiatives and announce the results of that review towards the end of May because its decision to buy back shares, return capital or increase the dividend payout ratio will all have a material impact on intrinsic value.

Think about it this way: If you have a dollar in a bank account earning 45% and that figure compounds at 45% year after year – then that account is worth far more than $1. If you can buy it for less than a dollar, you’re on to something very, very special.

If another account, also earning 45% per annum, requires you to take the interest you earn on the capital out every year then it is worth something less than the first account. That’s why the capital management policy of a company has an impact on its intrinsic value.

Now if JB Hi-Fi buys back shares (restricts the number of accounts that earn 45%) or lifts the dividend payout ratio (increases the amount of interest it pays out) then the intrinsic value of those bank accounts (shares) are going to be lower.

With that in mind let’s have a look at the half-year results.

Store growth alone will ensure solid growth in revenue and earnings and management have not been shy in mentioning this (unlike say, Myer, which has fallen 13.6% since Monday). But as the bank account analogy above demonstrated, while earnings might be on the increase, the value of the account can still decline.

JB Hi-Fi currently operates 153 stores (including 13 in New Zealand) and has a target of 210 stores. At an opening rate of 15 stores a year, that implies another 4.5 years of growth. The problem is, of course, that the management team was hardly likely to leave the most profitable stores until last.

When JB Hi-Fi has opened all 210 stores the plan is that 160 will be Tier-1 and 50 Tier-2. Of the 67 stores yet to open, 36 will be Tier-1 and 31 will be Tier-2.

Tier-1 stores cost $2.5 million to set up, while Tier-2 are 20% cheaper, at $2 million. But Tier-2 stores generate only 70% of the revenue of a Tier-1 store.

That suggests half of the remaining stores to open will have lower returns on equity. This compares unfavourably to the current picture of 124 maturing Tier-1 stores and just 19 Tier-2 stores.

-The ValueLine portfolio, as at February 8, 2011
Company	Purchase or June 30, 2010 price	Price today	Est value**	Margin of safety	Shares owned	Invested capital ($)	Capital value ($)	Dividends received	Total return	Divs
JB Hi-Fi	19.07	18.94	23.85	20.6%	845	$16,106	$15,997	$0.33	1.05%	$278.72
Cochlear	74.32	76.62	52.86	-44.9%	102	$7,574	$7,809	$1.05	4.51%	$107.01
CSL	32.58	36.98	29.16	-26.8%	163	$5,323	$6,042	$0.45	14.89%	$73.52
Woolworths	27.02	26.52	26.41	-0.4%	206	$5,554	$5,451	$0.62	0.44%	$127.44
Reece	24.20	22.71	20.29	-11.9%	236	$5,723	$5,371	$0.38	-4.59%	$89.86
Platinum Asset Mgt	4.68	4.85	4.74	-2.3%	854	$3,996	$4,142	$0.14	6.62%	$119.55
Matrix Engineering	3.42	7.82	6.02	-29.9%	2,047	$7,001	$16,008	$0.02	129.24%	$40.94
CommBank	48.64	54.91	50.55	-8.6%	215	$10,458	$11,806	$1.70	16.39%	$365.50
Cash						$50,267	$50,267	$1,542.45	3.07%	$0.00
Total Dividends										$1,202.55
Total Return ($) 2011						$112,003	$125,636		12.17%
Return on Invested ($) 2011						$61,736	$73,827		19.59%
XAO (pts) 2011						4324.8	4890		13.07%
Total Return ($) 2010									12.79%
Return on Invested ($) 2010									27.59%
XAO (pts) 2010									9.69%
* Latest Intrinsic value update December 1, 2010

Keeping all this in mind the growth, high margins and low net debt, along with the fact that suppliers pay for the inventory the company sells (inventory of $388 million is exceeded by outstanding invoices to creditors of $507 million) you can see why the company doesn’t need to keep $180 million sitting idly in the bank. That’s why some major decisions about capital management are likely to be on the horizon.

Returns on incremental equity however, not cash in the bank, is key.

JB Hi-Fi reports returns on total capital, which includes debt. However, because debt continues to fall, the company can report rising returns on total capital. I use return on equity, and on that measure, the numbers for the long-term appear to be levelling off.

Mature retail businesses don’t produce massive increases in intrinsic value. Over the past 13 years, Harvey Norman’s intrinsic value has increased by a bumpy 15.6% per annum. By way of contrast, JB Hi-Fi’s intrinsic value had increased by 85% per year over the past eight years.

Maturity can hit with a thud. Since 2008, owners have committed an additional $189 million dollars to the business, which has generated a company-forecast return on equity of 39%. The 45% returns of several years ago appear to be a thing of the past.

As I have said previously, I would rather be invested in JB Hi-Fi than in almost all other retailers – it is trading at a meaningful discount to intrinsic value – but Australian retailers don’t enjoy the multi-decade store rollout profiles of US peers, for example.

I estimate intrinsic value will rise by no more than 11% in the next three years and perhaps by even less.

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