JB Hi-Fi: Steep descent ahead

When the former chief executive of JB Hi-Fi, Richard Uechtritz, announced his retirement in February 2010, he held 1.5m 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 2011.

How many shares did he own at that point? Absolutely none whatsoever. Actions, as they say, speak louder than words.

The company’s chairman describes Uechtritz as one of Australia’s ‘most effective chief executives’ but he’s also a savvy share trader. The decision to leave JB Hi-Fi last year—and sell all his stock—means he’s $11m wealthier than if he had retired today.

Ill winds hit JB Hi-Fi, Myer and DJs on 15 Jul 11 (Sell – $15.65) described in detail the reasons for following Uechtritz’s lead. The company faces a fundamental threat to its business model, one that will only intensify with time (see Will the internet kill traditional retail—Pt 2 from 27 Jun 11).

Since 15 July 11, the stock has fallen 25%, with most of the damage occurring in the aftermath of the company’s 15 December profit warning. This is a poor situation only likely to get worse.

Rollout program

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% in the five months to 30 November 2011 thanks to new store openings, management forecast that earnings before interest and tax (EBIT) for the six months to 31 December will fall by around 5%.

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 due to competitor discounting but more worrying explanations exist. 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 like CDs and DVDs towards lower margin items such as computers and Apple products. Finally, growing television sales require 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 in 2012. This is exactly the wrong thing to do. Investing capital into a declining business will, in the long run, only make things more painful for shareholders. Even Gerry Harvey has realised this and 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?

Table 1 outlines a pessimistic rather than worst-case scenario. It assumes that sales to 2012 rise with store openings then gradually decline as the threat from online shopping intensifies. Gross margins continue to weaken as the sales mix shifts while costs are contained once management finally realises what lies ahead.

Weakening sales are poison for a low-margin retailer, as the table shows; from 2014 net profit begins a savage decline. In a situation like this, debt levels tend to blow out quickly and insolvency is a very real danger.

Table 2 is a more optimistic case assuming a mild retail recovery in 2013, with sales and margins bouncing back and cost growth contained. From 2014 the company manages to hold its own despite the structural threats and some weakening of gross margins. By 2016, though, sluggish sales growth means profit is hovering around 2012 levels. Either way, it ain’t pretty.

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).

Even if you believe the optimistic case is more likely—and there is a reasonable argument for it—there are very few reasons to own JB Hi-Fi shares. On a forecast 2012 PER of 9.7 it looks cheap but that’s because it’s a ‘value trap’.

The future for JB Hi-Fi looks very, very different from the past, which is why the recommendation remains a resolute SELL. This is very likely just the start of a very steep descent.