The media invariably cheerleads for big acquisitions. They create headlines, after all. JB Hi-Fi’s acquisition of appliance retailer The Good Guys might make financial sense, but whether it’s strategically sensible is another thing entirely. Read on if you’d like to know the difference.
First, the details. JB Hi-Fi will pay $894m to buy the 101-store chain The Good Guys from the Muir family. A new debt facility of $500m and an equity raising of $394m at $26.20 a share – more on this later – will fund the transaction. The combined business will have more than $6bn in sales and almost $200m in net profit (see Table 1).
JB Hi-Fi will become the Australian market leader in consumer electronics and appliances, with Harvey Norman a close second. It’s already cleared The Good Guys acquisition with the ACCC during the prolonged courtship, so it’s a done deal.
Makes short-term financial sense
Strategically much more questionable
Store management transition a big risk
At the time of JB Hi-Fi’s 2016 results last month, managing director Richard Murray said the company would only pursue The Good Guys if it made ‘compelling financial sense’. Whenever you hear this, it’s usually code for ‘the transaction will be EPS accretive’.
As Table 1 shows, the transaction will increase JB Hi-Fi’s pro forma 2016 earnings per share by no less than 11.6% (169.5 cents divided by 151.9 cents). Whenever a particular transaction results in earnings per share rising, it’s called ‘EPS accretive’ (or ‘EPS positive’). Without demonstrating EPS accretion, a management team will usually find it much harder to justify an acquisition to the market.
|EBIT margin (%)||5.6||3.6||4.9|
|Source: Company acquisition presentation (page 20)|
EPS accretion is much easier to achieve when your share price is high – as JB Hi-Fi’s is – and interest rates are low. Had JB Hi-Fi needed to raise capital at $20 a share and borrow at 5%, for example, the EPS accretion would have been just 3.4%. But helped by the collapse of Dick Smith – and management’s impressive ability to negotiate an average interest rate of 3.1% on the $500m of new debt – the transaction looks financially compelling.
Buying The Good Guys make financial sense in other ways too. Perhaps most importantly, JB Hi-Fi will have greater buying power. Whereas once it sold Samsung laptops, now it will sell Samsung fridges too. JB Hi-Fi expects annual ‘synergies’ of $15m–20m after a three-year integration period, a figure that seems very conservative.
For all the financial benefits, though, we’re not convinced buying The Good Guys makes strategic sense. Crucial to understand is that a transaction that is EPS accretive in the short term is not necessarily value-accretive in the long term. Indeed, there are some warning signs The Good Guys could end up destroying value.
Selling appliances isn’t a great business. It’s highly competitive, with Harvey Norman a ferocious rival and consumers more comfortable with purchasing appliances online. That means margins are low – The Good Guys earned a pro forma operating margin of just 3.6% in 2016 (compared with JB Hi-Fi’s own 5.6% margin).
It’s also cyclical. Appliance sales benefit from strong housing markets, so it’s possible JB Hi-Fi is buying The Good Guys towards the end of a cyclical upswing. The fact The Good Guys has increased profit by 64% since 2014 lends weight to that theory. The $894m purchase price looks high next to the 2014 operating profit of $45m.
Most importantly of all, though, is that selling appliances in stores requires motivated salespeople. But there’s a big risk here because The Goods Guys’ business model has changed dramatically. Prior to 1 July 2016, more than half the stores were owned in joint venture arrangements with store management. This part-ownership arrangement ensured the store managers had an incentive to run their businesses well.
In preparation for the sale, the stores became fully owned by The Good Guys. Some former joint venture managers opted to leave entirely, while others agreed to stay on for 12 months as store manager employees. Even if handled well this management transition will be extremely disruptive. At worst, store managers ‘may not be sufficiently incentivised under their management agreements’ (as the Key Risks section of the acquisition presentation highlights).
No wonder JB Hi-Fi has forecast The Good Guys’ sales and earnings to be flat in 2017. With management in transition, even that might prove optimistic.
Then there’s the cultural mismatch. The younger, edgier JB Hi-Fi brand sits uneasily next to the daggy, old-fashioned Good Guys. In an attempt to minimise the risks, JB Hi-Fi will retain The Good Guys’ head office as well as its managing director. Keeping the businesses separate makes sense, at least during the transition period.
|Ratio||1 for 6.6 shares|
|Entitlement price ($)||26.20|
|Entitlements trading begins||16 Sep|
|Entitlement offer opens||21 Sep|
|Entitlements trading ends||23 Sep|
|Entitlement offer closes||30 Sep|
|New shares begin trading||12 Oct|
So what should shareholders do?
Well, we switched back to Hold in JB Hi-Fi: Result 2016 partly in anticipation of the market looking favourably upon the EPS accretion that The Good Guys acquisition would deliver. If management gets this acquisition right, earnings growth will be assured for a few years and EPS close to $2.00 a share is possible in 2018.
Offsetting that is our view that JB Hi-Fi has diluted the quality of its own business with an inferior one. The stock deserves a lower price-earnings ratio accordingly.
The retail entitlement offer – details are in Table 2 – opens on 21 September. We suggest you subscribe for your entitlement (assuming the share price is above the $26.20 issue price), but then sell down to no more than our maximum suggested weighting of 4%. This isn’t the time to be increasing your long-term exposure to JB Hi-Fi.
If you wish to sell your entitlement on market, trading begins on 16 September (when JB Hi-Fi shares will also come out of trading halt) and ends on 23 September. If you don’t sell or subscribe for your entitlement, they will be sold on your behalf and any funds remitted to you.
Now that The Good Guys transaction has been announced, it’s hard to be enthusiastic about it – whatever the EPS accretion. Our suspicion is that the market has already assumed the transaction will take place and, as a result, the reaction on Friday will probably be muted.
Of course, we’ve underestimated this business before and may be doing so again. However, appliance retailing is not what made JB Hi-Fi successful. Indeed, if anything it could be the company’s undoing. Subject to our 4% maximum suggested weighting, HOLD.