From our numbers analysis, JBH looks good – based on historical performance.  Despite its impressive numbers, the share market community is not buying.  Share price has declined to the point analysts like Steven Hing of Zodiac Securities are getting value investors across Australia excited about a potential bargain at current prices.

So who is right here?  Steven Hing or market participants selling the shares?  Their expectation appears to be that consumer discretionary spending will continue to suffer.  When faced with the choice between food and a new electronic gadget, food wins out.  But will it actually come to that?

When looking behind the numbers of a share you found in an analyst recommendation, do not forget to follow-up on the clues the analysts often leave.

In last week’s sector scan column, Hing singled out JBH as a potential value play, but he also included several caveats.  

•    outlook for the Australian economy;

•    interest rates;

•    the Australian dollar; and

•    the consumer discretionary sector.

Note that all these considerations are external to the company.  Our first task is to convince ourselves the company itself can withstand changes in any of the above circumstances.  

As you may remember from previous columns, there are three principal sources for searching behind the numbers of any share company:

1.    Visit the company’s website and read annual reports and other items of interest.

2.    Learn what you do not know through online searches.

3.    Read company-specific news items and industry-related items through online searches.

For retailers, there are two additional sources:

•    Visiting retail locations

•    Opinions from friends, family, and business associates.

If you are interested in investing in JBH, you have the unique opportunity to see how the company actually does its business – in the stores.  Visit as many as you can at as many different times as you can.

You can also ask anyone you know if they have ever shopped at a JB Hi-Fi store or online and see what they think.  There are few other share investments where you have this opportunity.  First, you have to know what to look for and what to ask, and for that, we will begin our search on the company’s website.

The JBH home page has the look and feel of a real bargain town emporium, complete with flashing banners, colorful star-filled price points, and product after product after product.  It is actually difficult to find your way to the investor page for the annual reports.

To know what to look for in the report, you need to know a little about discount retailing in a “big box brick and mortar” business model.  If you do not, an Internet search will teach you the important basics.  

From Hing’s comments, we know JBH has expanded its store base.  The most important thing you need to know about discount retailing is margins are everything.  All companies make profit by selling a good or service for more than it costs them to offer the product.

Discount retailing puts enormous pressure on margins due to the lower pricing.  Anyone can make a profit with markups of 75% and above.  Discount retailers make up for the low price on the other end – with low cost.  If they cannot monitor their cost of doing business, they will not survive.  

The big box retailing landscape worldwide is littered with the corpses of bankrupt retailers whose principal source of profitability was adding new stores.  They were like conquerors planting new flags in every location they could find.  Meanwhile, profitability at existing stores – same-stores is the industry term – were meagre at best.  Eventually, companies like these run out of places to plant their flag or the money needed to fund new store expansion, or both.

Therefore, our first concern is how company management views those two issues.  We find our answer in the Directors Report section of the annual report.  

In today’s world, corporate executives in publicly held companies everywhere have their compensation packages tied into share price performance.  In theory, this makes perfect sense, but in practice, many executives base their decisions not on the long-term health of the company, but on the impact on short-term price performance.

Here are the indicators JBH management uses as indicators in assessing the performance of their business:

•    Absolute and comparable same-store sales growth;

•    Gross margin by store and product category;

•    Cost of doing business;

•    Store earnings before taxes and interest expense;

•    EBIT margin;

•    Earnings per share;

While many management teams would place earnings per share first, this team places it sixth.  Their principal concern is driving same-store sales followed by maintaining margins and monitoring the cost of doing business.  All this adds up to a very good sign that JBH management is looking at the right things for a big-box discount retailer.

From the report, we also learn the company is continuing to expand, planning to add 18 more stores in 2011 and continue adding approximately 13 – 15 stores per year through the next five years.

They plan to continue with a major initiative to focus on higher end margin items.  They grew gross margins to 21.8%, up slightly from 21.6% in 2009.  If you know retail or did your homework, you know that high-ticket items, like computers, usually yield lower margins.  Items like the connecting cables and assorted other lower-priced accessory items offer the opportunity for higher margins.

In many brick and mortar operations, sales associates fail to take advantage of the opportunity to ensure customers walk out with accessories they need, both now and in the future.  JBH has a training initiative underway with their associates to focus on accessory sales, a very good sign.

The training initiative is an example of how you can follow-up what you learn in the Directors Report in both a store visit and by talking to friends.  Many corporations brag about training initiatives in their annual reports, but there is often little evidence of it in the stores.

If you read the Fundamentals: By the Numbers – JB Hi-FI (JBH) column, you may remember we speculated that JBH’s low debt to equity ratio and high ROE was a result of their business model.  The Director’s Report confirmed this – they attribute these numbers to the business model, which lowers their need for capital, and hence, the need to borrow funds to operate.

The company internals look very promising, so now let us move on to the external circumstances.

You can use the Internet to search for expert opinions on the outlook for the Australian economy, interest rate rises, the Australian dollar, and consumer discretionary spending.

You will quickly learn that while the retailing sector is suffering, there are those who believe the outlook for the rest of the economy in Australia is bright.  

You will also learn there was a definite slowing in the first quarter (Q1) of 2011, perhaps due to natural disasters.  

You will further learn, if you did not already know, Australians are reducing household debt, which accounts in part for decreased spending and lowered consumer confidence.

The picture is less than crystal clear.  If Chinese demand for Australian raw materials slows, so will the Australian economy.  However, current efforts by the Chinese government to slow growth indicate high demand is still there.  No one knows for sure what will happen there or elsewhere in our economy.  However, history shows fortunes are often made in times of uncertainty.

>>Back to the newsletter to view other articles – June 13th 2011


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