Why JB Hi-Fi is topping the charts

PORTFOLIO POINT: JB Hi-Fi has a different business model to rivals Harvey Norman and Clive Peeters, one that has put it out in front.

The stockmarket and the government are both expecting a V-shaped recovery. I hope they are right but my view is that it is far more likely that growth over the next two or three years will be more restrained. And that’s backed up by the fact that ANZ chief executive Mike Smith is warning the market that interest rates will need to rise irrespective of what the Reserve Bank is going to do. In other words, as I have been writing in Eureka Report for some time, the global demands for loan funds is crowding the market.

Right now the stockmarket is hot and going higher, but if I am right then in the longer term winners will emerge – some companies will perform much better than others, even in the same industry. And so it will be a market where stock picking will become far more important than it has been in the decade before the crash. And that will lead to a much closer study of business models and the way certain strategies are being developed and financed. The level of risk being taken to achieve a reward will become far more important.

In this environment I thought it would be instructive to look at strategies of three appliance retailers: Clive Peeters, Harvey Norman and JB Hi-Fi. Each of these companies set out to gain important market share in the appliance and related markets but they are achieving very different results because their business models are incredibly different.

I was prompted to review to the three different strategies by the announcement this week that Clive Peeters, whose shares are suspended, had encountered accounting difficulties. I am sure there is an accounting irregularity, but the real problem is that Clive Peeters was simply not equipped to handle a downturn because it expanded too quickly, did not have enough capital; had borrowed too much money; and did not realise that lease obligations are a form of borrowing.

nClive Peeters
Price	P/E	Yield	EPS	Mkt cap	12-mth gain
17¢	13.1	8.2	1.3	$21.590m	-63.80%

Variations of the Clive Peeters model have been used by many failed retailers in the past, including Cox Bros, Mark Foy’s, Waltons, Anthony Hordern Mutual Store, Reid Murray and many others. Clive Peeters may still survive. Indeed, it would not have been put under pressure if the business had continued at its previous level of profitability.

But the sudden and sharp downturn in the early months of 2009 exposed its key weaknesses. Clive Peeters had five stores in September 2005 and had increased that number to 48 by December 2009. It borrowed $46 million including $16 million in short-term loans to fund its business. In addition, it has about $20 million in property lease obligations.

Essentially, the Clive Peeters business was undercapitalised, with intangible assets comprising $37 million or about 48% of the $79 million in Clive Peeters shareholders’ funds.

In the old days, as soon as demand fell, staff were shed, but by the time Clive Peeters hit problems it had 1500 staff and really couldn’t afford today’s level of retrenchment payments.

The models employed by Harvey Norman and JB Hi-Fi represent two attempts in today’s environment to overcome the retail crisis that has spooked traditional operators like Clive Peeters.

Gerry Harvey sold his first appliance business to Waltons and watched Waltons destroy it. So he started again but this time he developed the Harvey Norman model, which is totally different from Clive Peeters and indeed JB Hi-Fi. Gerry Harvey, instead of simply leasing property, went into the property ownership business. At the same time he split the business into a multitude of franchises, which meant Harvey Norman did not have a huge wage bill and had great flexibility in its labour force.

Over the years, Harvey Norman made big profits on its property. And its property ownership meant that in a severe down turn no landlord could pull the rug from under the business. Most of the stores Harvey Norman developed were on land separate from big shopping centres so the stores did not always have a natural traffic flow.

nHarvey Norman
Price	P/E	Yield	EPS	Mkt cap	12-mth gain
$3.17	15.2	3.7	21.4	$3.367b	-7.60%

As a result of the store locations, Gerry Harvey undertook substantial promotion to attract people to travel to his stores and in the process lifted the value of the real estate. Clive Peeters also often moved outside the big shopping centres for cheaper rents. Harvey Norman believed so strongly in the model that they took it to Eastern Europe and Ireland. The timing was a disaster. This has led the market to lower its rating on the Harvey Norman model, and the JB Hi-Fi model has attracted much greater support as a consequence.

In theory, JB Hi-Fi could have set up a model that followed Gerry Harvey, but chief executive Richard Uechtritz and his team chose a third model. On paper, its structure looked similar to Clive Peeters’ but there were significant differences that have made it work brilliantly. In common with Clive Peeters about half of JB Hi-Fi’s shareholders’ funds are in intangible assets and it has significant (albeit long-term) borrowings.

nJB Hi-Fi
Price	P/E	Yield	EPS	Mkt cap	12-mth gain
$16.40	20.8	1.9	77.1	$1.758b	25.30%

JB Hi-Fi has no property but unlike both Harvey Norman and Clive Peeters it went for the established shopping centres, including those owned by Westfield. It reasoned that if it used the established centres it would have a traffic flow past its store that would not require a high level of promotion. JB Hi-Fi’s advertising costs were much lower than Harvey Norman’s as a result.

Moreover, JB Hi-Fi found that the shopping centres and their passing trade were very beneficial to lower-ticket retail items, which acted like a magnet to attract customers. And so JB Hi-Fi’s annual turnover rose above the industry average and it received a huge boost from the Rudd government's stimulus handouts and as the company’s turnover kept rising, leading to even more new store openings.

But the JB Hi-Fi model is based on continued growth. Both JB Hi-Fi and Harvey Norman will benefit from the stronger Australian dollar, lowering the cost of Chinese imports. Right now Harvey Norman is not the most popular stock among the institutions because although its model protected it from the worst of the Australian downturn, it didn’t protect it from the downturn in its overseas operations. I am also not sure whether the management at Harvey Norman was sufficiently deep enough to handle such difficult conditions, especially in its 14-store operation in Ireland.

So here we have the high-risk model working well, in the case of JB Hi-Fi, but tripping up with Clive Peeters, while the lower-risk Harvey Norman model is being tripped up because of its overseas expansion. At this stage it looks as though the JB Hi-Fi model has come out in front and its shareholders have been rewarded. But the current growth is only as good as the ability of management to keep the model up to date.