What does JB Hi-Fi’s result and resignation mean?
I have just completed a phone interview with Ross Greenwood on his Money News program at radio station 2GB. He was interviewing me and Patrick Elliott, the Chairman of JB Hi-Fi following todays result. As you have all probably noticed, the half year result was excellent but JBH has traditionally exceed the market’s expectations for earnings and sales growth. Today’s interim FY10 profit was up 29% on sales growth of 19%, and while it was at the upper end of expectations – it didn’t exceed those expectations. Believe it or not, the result will be downward revisions to analysts future estimates.
The share price decline today – it was down 6.5% at one stage – to be down 5.1% at $19.07 per share, was partly the result of the ‘voting’ machine saying; “the growth is not going to be as high as we envisaged” but probably to a greater extent, it was due to the fact that Richard Uechtritz announced his retirement in “July/August”.
Having grown revenues in ten years from $145 million to $2.8 billion, the resignation of Richard is a blow to the company. But as my restaurant owner friend says; “revenue is vanity, profit is sanity” and the new CEO will be no slouch. Terry Smart joined JBH when Richard did, as part of the private equity funded management buy in. They’ve all made millions and plenty of Terry’s money remains invested.
The changeover reminds me of the retirement of one of Australia’s retailing legends, Barry Saunders, from the Reject Shop. He handed the reins over to Jerry Masters and Jerry continued to grow and expand The Reject Shop. Jerry was an outsider and arguably not the first choice. Terry is a JB Hi-Fi insider and remember my comments that the business boat you get into is far more important than who is rowing it. I think you will find that with 210 identified stores and 140 likely to be rolled out by the end of 2010, there is still plenty of room for growth. More over, Richard’s resignation is similar to The Reject Shop in one important way; neither Barry nor Richard departed to compete. Richard, like Barry will remain a consultant and Richard on the board.
But unfortunately, it is not growth that determines intrinsic value. Its the return on equity, the payout ratio and the equity itself that determines whether the value continues to rise. The big news on this front is that the dividend payout ratio continues to rise. Now at 60%, the increased dividend is a classic response by the board to a business that is generating cash faster than it can use it. But thats a shame because the company is generating 45% returns on its equity. I would much prefer they kept the money – prepay some leases and get a discount (get the contingent liabilities down) – than hand it to me as a dividend. The best I can do with it is perhaps 8% in a 5 year term deposit. Not bad, but not 45%.
The result of not employing as much retained earnings at 45% is that the intrinsic value declines. Its still going up but not as much. The conservative intrinsic value before this result was about $20.30. Now it is $19.30. The intrinsic value next year falls from $24.14 to $22.50 and the year after from $29-ish to $26-ish. So where previously we were looking at a rise to the $30 area for intrinsic value by 2012, it now seems the value will be at best $26.50.
The sole reason for the change to intrinsic value is the increase in the payout ratio. More dividends means less profits being retained in the business, earning more than 45%. Now don’t get me wrong, this is still an amazing business – one of the best and intrinsic value is still forecast to rise by a compounded 16.3% per annum over the next 2 years or so. To get really excited however, you now want a bigger discount to the current intrinsic value.
Posted by Roger Montgomery, 8 February 2010
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Stephen S
:
Hi Roger,
I recently visited the Belrose Supacenta where JB Hi Fi have a new store. At 10.30am mid week there were only 2 people in the store including me. I think JB Hi Fi are starting to open in some “B” grade locations. I a not a buyer of thier shares anymore.
admin
:
Hi Stephen,
Thanks for the report. Please keep the observations coming in.
admin
:
Back on the 18th of February, Paul wrote to me, referring to the short term change in price of JBH – something I have indicated I cannot predict – but a valid concern to many investors.
Paul wrote:
“Good Evening Roger,
I enjoyed your session on Sky Business channel last Thursday 11th Feb. Interesting and informative as always. I am a JB HiFi shareholder since October 2009 and must confess to being a little confused as to the value of this company. My purchase took into account your valuation on Eureka Report at that time as I was pleased to have what I believed to be a good safety margin. From memory I believe the value listed was $25.76,the same amount as shown in your Eureka Report Value Line article on Feb. 16. On looking through your blog today,I find many questions about this company. Where my problem lies is that in an article dated 8 Feb. you list the intrinsic value as $19.30,down from $20.30. I am sure there is a perfectly logical explanation for the difference between the two valuations it is just that I can’t see it.
Can you enlighten me please.”
Paul had a valid point. Aside from wanting to make sure I kept my valuations up to date, the fact is that Valuations change.
That evening I wrote to Paul:
“Hi Paul,
The estimates for earnings growth have been declining gradually but more importantly, the payout ratio has gone up 20% to 60%. This makes the value lower. On current estimates the value is still going up but doesn’t reach $27 until 2012. And the 2012 value was well over $30. Valuations change with a companys changing performance which is why a wide margin of safety is required. Happy to discuss further if you have more questions.”
But on reflection I realised there were other questions that Paul had and the answers from the next day served as an important warning to all investors…
“Hi Paul,
After re-reading your email today I realised your question had two parts. The first was as to the change in the valuation for JBH and I believe the second was about the incongruity of the Feb 10 article about JBH and the Feb 17 Table. It was referring to the former question. Regarding the latter question, now that we are almost at the end of reporting season, I will update the table with the latest valuations and JBH’s will correspond with the article about it the week before last.
Regarding a safety margin; leaving aside the essential component of diversification for a moment, I believe a 20-25 per cent safety margin is appropriate. A larger one was available when I purchased the shares for [Alan Kohler’s Eureka Report] Valueline Portfolio in June last year, hence the reason it was the largest position in the portfolio upon its commencement – $12,500 or 12.5% of the $100,000 portfolio.
A 25% margin of safety from the previous valuation corresponds to a price of about $19.40. If I had added the shares to the portfolio at that price and invested 12.5% it would be showing a profit of $380 odd dollars today. A 20% margin of safety corresponds to a price of $20.60 and had the same investment been made at that price, the position would currently be showing a loss of $364 or less than 4/10ths of 1% on the $100,000 portfolio. I also saw that October was a particularly broad-ranged month in terms of price with the low of $18.42 and high of $22.43 but it did provide the opportunity to buy (always seek advice) at a 25 percent discount. Todays price of circa $20.00 means that it is now trading at a small premium to the new, lower valuation.
I hope that helps tie in a few other concepts that are important to understand in addition to valuations – for example margins of safety, position size and diversification. Most importantly, long term valuations are not a prediction of short term shares prices. In the short term prices can and do vary considerably from intrinsic value and I don’t believe anyone can accurately predict these short term movements.
Greg
:
Hello Roger
Why do residential property sale stocks trade at substantial discounts to their NTA. AV Jennings, for example, has a share price of 49.5c when its NTA is $1.06. Other stocks in the industry have the same characteristics.
Thanks in advance
Greg
admin
:
Hi Greg,
Historically they have oscillated around their NTA. Just always have. A very simple strategy has been to buy them when they are at discounts, hope they don’t go broke and hold until the cycle turns 180 degrees selling them at a premium to NTA. Of course the assumption is that the NTA doesn’t decline meaningfully. If you go through the annual reports and calculate the NTA for each year and then have a look at the 52 week price range; you will get a good understanding of the length and frequency of the oscillations.
Damian
:
Roger,
I’ve mentioned before that I use the ninemsn share screener, click on “create your own search”, then specify the criteria.
http://money.ninemsn.com.au/shares-and-funds/share-screener.aspx
For example, you can select debt to equity 20%, consensus EPS growth >0, then look in more detail at the historical financials.
http://money.ninemsn.com.au/shares-and-funds/research-a-company/results.aspx?inforeq=historical&code=MMS
I’ve noticed that the return on equity figure for a particular stock in this research is usually less than the figure you have.
Do you think these shares screeners are a good way to get an initial selection of good stocks, or do you have another method?
Damian
:
That criteria above should have been debt to equity less than fifty percent, return on equity greater than twenty per cent, consenus EPS growth greater than zero.
admin
:
Thanks Damian,
I am sure the other visiting investors here will really appreciate the time you have taken to show us how you are obtaining the data. I have no objections to getting the data the way you have described. Its a great (and FREE) way to narrow the universe of stocks/companies to look at. The limitation of course is that it would be useful to know the pattern or behaviour of the data over time. Often the screeners can only look at the most recent year. The other limitation is that you may have hit on a year with an abnormal item that has been included in the number for a particular company and the data provider hasn’t stripped it out. In answer to your last question, I subscribe to a customised institutional data feed. Its expensive but it means that I can value all 1874 companies and do all the other analysis that I have to, in order to determine the quality and sustainability of a company’s performance. Its all in the book of course!
tim clare
:
Hi Roger,
Could you please post a Top 10 great Australian businesses that satisfy your requirements of sustainable competitive advantage, high ROE with little or no debt and great management who eat their own cooking. I would love to learn more from your selections, how to produce a wish list that can be fulfilled when prices become attractive.
Kind regards,
Tim.
PS: Looking forward to your book and news of your plans this year.
admin
:
Hi Tim,
Its the second great suggestion in this blog thread. Give me a few months. I will get around to it. For now, those of you subscribing to Alan Kohler’s Eureka Report can find my valueline portfolio there. Previous columns are also available on the blog here. Just click the MEDIA ROOM tab at the top of the home page and select OFF THE PRESS.
Scott
:
lol Roger mammoth is an understatement ;)
Rici Rici
:
Hi firstly, i have to thank you for your time in operating this blog.
For a retail investor like myself it is really great to receive insightful information that is not just ‘market noise’.
In regards to one of your comments above, you mentioned that there are hundreds of listed companies with decreasing intrinsic value.
Maybe you could write an article on these companies. Personally i would find it very valuable, especially when i’m inundated with broker recommendations (which dont really talk about intrinsic value). I would much prefer to know about companies with decreasing & increasing intrinsic values before i hear about whether a company is a buy/hold/sell.
admin
:
Hi ‘Rici’
Its a great suggestion and a mammoth task! Stay tuned though, I will let you know when I am able to assist.
Terry Trickey
:
I have a take on JB Hi-Fi Roger would like your comment on the below:
JBH has an excellent track record of increasing revenue, profits and dividends and it passed my filters.
Two main issues cause concern. The smaller concern was with the statement by the CEO in previous annual reports that the market for JBH could eventually support 160 large format stores. Much of the excellent growth enjoyed by JBH so far has been a result of the opening of additional large format stores. Members noted that JBH now had around 120 such stores and was opening up to 20 new stores per year. On this basis the best of the growth would seem to have already been achieved.
Of greater concern was that the CEO and other executives had been heavy sellers of their shares in the past two financial years, (perhaps as they too were concerned about the above). In fact, notwithstanding options they had received and which had vested, (which should have increased their individual shareholdings) their individual shareholdings in JBH had been rapidly reducing. Members felt that clearly management appeared to believe that money from other investors was preferable to their shares. This looked as though the CEO and other senior executives may be heading for the exits.
On Monday, less than a week after the analysis, the CEO announced his retirement, the Board announced his replacement and the share price dropped.
admin
:
Hi Terry,
Thanks for your insights. It is certainly the case that the Return on equity is flattening out and that the intrinsic value is now lower than it has been previously. Richard did make comments about the likelihood of slower growth in the future than the past. The selling of his shares – he owns significantly less than when the company first floated – is a normal pre-exit tactic which he has every right to engage in if it is properly disclosed. What really matters is if the value of the business is continuing to rise. It still is and at about 15% per annum for the next two years. I agree however and have said it already that with a population of just $22 million, there is only so much growth available in Australia. It is however Return on incremental Equity and not sales or earnings growth that determines the direction of the intrinsic value of a company so have a look at the additional profit being made on the additional capital being put in and left in as your guide to the future direction of intrinsic value. Thanks again for the insights Terry. Say g’day to Mark and Howard if you see them.
admin
:
I should also add that I think there are 108 large format stores and the plan is to open 15 per year. Happy to check that for you though. Its is almost 4am.
Scott
:
Roger do you have any thoughts on Woolies?
Seems to be alot of analysts liking it — is that my warning sign lol?
On a superficial basis has their growth peaked and are they begining to diworsify to find growth ? I think Peter Lynch said that usually leads to disaster ?
Thanks again for all the effort you put in to help us ;)
admin
:
Hi Scott
So far its been one of the few businesses to actually sustain very high rates of return on ever growing amounts of equity. You allude to an interesting fact about us analysts. Very few are good at predicting change. Until the return on equity starts to decline and the valuation with it, you would bet with the company than against it. I will have to have a look at the valuation following the half year results and get back to you. May take a few weeks though. Stay tuned.
Damian
:
Roger,
Three stocks I own (and I know you also have been watching) are JBH, MMS and SXE. They have all recently fallen more than the market. JBH (because of results), MMS (possible govt changes), SXE (profit downgrade). This has got me thinking more about the merits of allocating a small percentage of a portfolio to the stock STW (the ASX200 ETF, http://au.finance.yahoo.com/q/apr?s=STW.AX) to remove the company and govt risk. Do you have any general thoughts about this ETF (of course, all investment decisions are entirely my own).
admin
:
Hi Damian,
Its important to remember that I purchased MMS and JBH at significantly lower prices and at big discounts to their intrinsic values. They have since rallied much more than the market. In JBH’s case, more than 100%. Recently and as you correctly observe, they have fallen by more than the market too. That does not concern me provided the intrinsic value of the company is higher and expected to rise at a good clip over the coming years, because it means I have an opportunity to buy more of a good thing at an attractive price. I accept however that not everyone can stomach the volatility and so an alternative, which also produces a lot less work, is to buy an index fund. The ETF’s such as the Street Tracks series are cheap in terms of fees and do a good job of providing exposure to the returns produced by the overall market. Buffett has also said that if you don’t want to do the analysis an index fund is the best alternative. As you note, seek advice before acting.
Scott
:
Roger, just to say thanks for your CSL pick. Seems to be a flight to safety during this market “correction” and health being one of the beneficiaries.
Could I ask what things you look at to determine whether the market is due for a correction. Your timing was impeccable.
admin
:
Hi Scott,
Thanks for the compliment. I have developed a model that aggregates the valuations of the top 200 companies and weights each of those valuations according to the respective company’s index weight. The result is an intrinsic value for the ASX 200 index. I should warn you however, the index may be, or example, 15% above my valuation but that does not mean it is going to fall. The index could move to 20% or 25% over priced and still not decline. Eventually prices follow values (as Ben Graham said; the market is a voting machine in the short term, but a weighing machine in the long term) but prices can stay well above or well below values for a long time.
Ross
:
Hi Roger,
What would JB’s theoretical intrinsic value be if it retained all profits instead of paying some of them out? If the dividend payout ratio increase as above can make such a difference to a share’s intrinsic value, why do companies that can generate such good returns on reinvested profits (such as JB) bother to pay out dividends at all?
admin
:
Hi Ross,
If JBH could re-employ all of its profits at the circa 40% returns it is generating now, its value would be over $35. Thats a pipe dream though because in reality, it couldn’t do that forever, which explains the second part of your question. The company is generating cash faster than it can ask its employees and contractors and landlords to employ the funds to open new stores. Because the profits also produces taxes and associated franking credits that have no value for the company, shareholders are handed back the funds. This is a disappointment of course because I would much rather JBH keep the money and earn 40% for me. As Chairman Patrick Elliott implied when we spoke on the phone however, this is a function of growth and the limited size of the Australian population. It happens eventually to all retailers. The best you can hope for is that once the stores have saturated the market, the board elects to stick to their knitting, continue to generate high returns but pay all of those earnings out as a dividend (becoming like a bond) rather than make some grand attempt to buy something offshore or diversify too far away from their core expertise (at the behest of some institutional shareholder) and blow up the returns.
Michael Sheehy
:
Roger,
In relation to
————————————————————————-
Reply
*
Posted by Cathy on February 9, 2010 at 8:50 am
Thank you Roger. Lesson learned on the importance of getting a discount on intrinsic value and the patience and insight needed to do that! I appreciate very much your wisdom on this topic.
——————————————————————–
I have a hard time discerning what the margin of safety should be in relation to the required return.
In other words should the discount I am looking for go up if the required return(rr) goes up(riskier company) or should I be looking for a standard percentage discount as rr is factored into the intrinsic calculation already.
For example if I am happy to get a 30% discount to intrinsic value on JB Hi-Fi where rr=13.3% should I be happy with 30% discount on MCMILLAN SHAKESPEARE where rr= 14.1% or should I be looking for a higher % discount to intrinsic value due to the higher risk.
Maybe the answer is to be found in the following wb quote.
“I would rather be certain of a good result that hopeful of a great one.”
admin
:
Hi Michael,
The margin of safety is a case of ‘the bigger, the better’. You don’t need to change it for different discount rates. Indeed, Buffett talks about using the same discount rate – 10% after tax – across the board and demanding a very, very large margin of safety, perhaps 30%-50%.
Des Laffy
:
Hello Roger. I currently own shares in bradken. Todays result seems to have pleased the market. I would like to know your opinion of this stock and its intrinsic value today and for the future.Thank you. Des Laffy.
admin
:
Hi Des,
Bradken has been highly geared and a quick look over its accounts over the last few years reveals a company that is funding acquisitions through capital raisings and debt. Its a bit like a teengager with a credit card! The valuation is around the current price so there isn’t a margin of safety in the share price either. None of what I say of course means that I can predict the share price, which can do anything. All I can tell you is that the intrinsic value of the company is expected to rise over the next few years but the share price is not at a sufficient discount to that value, to justify the risk. Half year Return on Equity has just halved. Cash flow however has improved significantly in the half year results – a function of the fact that no acquisitions were made in the six months. A stronger Aussie dollar has also meant the value of US sales revenue is lower but so is the US denominated debt. Because no acquisitions were made this half, the better cash flow has meant a reduction in debt – both good things. The rally in the share price appears to be the result of the 54% improvement in cash flow. As I look long term at companies, I would need to be satisfied that the company has kicked its debt and equity funded acquisition habit.
Be sure to seek and receive independent professional advice before acting.
Joab
:
Hi Roger,
I am trying to understand the difference betwqeen required rate of return and margin of safety. Should required rate of return be based on what you can achieve/opporuntiny cost (e.g. 8% in a 5 year term deposit) or should there be an adjustment to include margin of safety? In your post about Westfield, you were suggesting discount rate of 12%.
It seems like the discount rate is adjusted depending on whether the intrinsic value calculation is conservative.
I am sure your book will explain this is more detail. Looking forward to it.
Cathy
:
Hi Roger,
As someone who only 2 weeks ago invested in JBH after a long period of research, checking out what you were saying about the stock, and waiting for the share price to reach the mid-low $20.00-mark, are there any lessons I can learn to avoid this situation in the future? Were there any clues that this could happen and the intrinsic value fall. After brokerage, I need the intrinsic value to rise at around $2 to be happy with this investment… Or is this just bad luck?
admin
:
Hi Cathy,
JB Hi-Fi’s valuation (based on current forecasts for earnings and dividends should continue to rise over the next few years. As I have always said, it is important to have a margin of safety when buying shares. That means buying at a discount to the current intrinsic value. Before the announcement the intrinsic value was just over $20. It sounds like you paid a price that was equivalent to intrinsic value. A margin of safety however means buying at a price below intrinsic value. I paid $8.50 and $9.00 for JBH. You will notice from my interviews that when I am asked the question; what do I like? I mention JBH because 1) Its value continues to rise at a good rate, 2) it has manageable debt (remembering of course the contingent lease liabilities) 3) very high rates of return on equity and 4) it is entrenching its competitive advantage and this is evident in the declining Gross profit margin but rising EBIT margin.
Its also useful to not bet the farm on one roll of the dice. I am not suggesting investing is like gambling. What I am advocating however is the purchase of shares below intrinsic value over a period of time. In the event that the prices decline further, a lower average entry price can be obtained. Of course, there are risks with this strategy as well, as it is entirely within the realm of possibilities that the price could rally strongly and leave behind the patient buyer.
Regarding your questions about a sign in advance that the intrinsic value would decline – there are few. And unless management said in a briefing that they were changing the payout ratio, there would be none. Importantly, however JBH’s intrinsic value is currently about $19 and rising at 16% per year for the next two years. Of course, this is not set in concrete either. The next set of results could be better or worse and will change the intrinsic value projections again. Importantly, the intrinsic value is still rising at a good clip. There are hundreds of companies whose intrinsic values are declining.
Cathy
:
Thank you Roger. Lesson learned on the importance of getting a discount on intrinsic value and the patience and insight needed to do that! I appreciate very much your wisdom on this topic.
JohnC
:
As you had written elsewhere, that 8% in a 5 year term deposit is also before-tax income vs a company’s return on equity which comes after-tax, so that term deposit becomes even more unattractive by comparison.
admin
:
Hi John,
absolutely!