Consumer discretionary

Once upon a time JB Hi-Fi was a category killer: its returns on equity were unassisted by debt and stratospheric and it was all reflected in a strong share price. But  something has changed. I wrote previously, and commented elsewhere, that JB Hi-Fi was maturing, that returns on equity were flattening and that the sun was setting on the ability of the business to reinvest profits at the very high returns of the past.  The impact of this of course is flatlining intrinsic values.  Indeed take a look at the Skaffold valuation line chart below.  You can see that even by 2014, JBH’s intrinsic values are expected to show no appreciation from 2009/2010.  Maturity.

That of course hasn’t prevented me from buying a few shares around$15.00.  Fortunately however we were quick to change our mind and even secured a small profit.

I wonder whether the first signs of business performance beginning to mature, is often the point when it becomes worth watching what directors do with their shares for some further insights?

JB Hi-Fi’s CEO, Richard Uechtritz, had been at the company for a decade prior to his retirement in 2010 and those watching his share dealings may have drawn a different conclusion to those being lulled by a bullish share price.

At the outset let me say there is no impropriety in a director selling their shares and none is suggested here.  Directors are free to sell shares within the bounds of their staff trading policy and are required to report their dealings to the market.

And it’s through these announcements that the investor can see what directors are doing with their shares.

On August 20, 2009, JB Hi-Fi’s CEO held 2 million shares and 627,000 options

and he exercised options to buy another 180,048 shares at $7.27. A week later, JB Hi-Fi’s CEO had sold all of shares he had just purchased the week before for an average price of $17.65.

Then, between September 2 and 3, 2009, another 500,000 shares were sold at an average price of $18.22.  By now JB Hi-Fi’s CEO held 1.5 million shares (down from 2 million on AUgust 20) and 447,267 options (down from 627,000).

Skaffold’s Valuation Line Evaluate screen for JBH reveals a maturing intrinsic value – little growth and lower IV in 2014 than 2010.

To alleviate the need to read thousands of annual reports, for every listed company, going back a decade try www.skaffold.com

Now back to our regular programming…

Between August 20 and September 3, there are just 13 days – call it two weeks.

Another 174,656 options were granted on 14 October 2009, and then, in early February 2010, JB Hi-Fi announced the retirement of its CEO.. Having sold 680,048 shares in the seven months before the announcement, JB Hi-Fi’s CEO sold another 500,000 shares during the first five days of March 2010 at an average price of $19.74 leaving him with 1 million shares and 621,923 options.

In his final director’s interest notice in May 2010, the retiring CEO of JB Hi-Fi listed his direct equity interest in the company at 1 million shares and the 621,923 options. For investors who are interested in gaining a possible inside track on the prospects and potential of a business, it may be useful to watch directors’ dealings in their shares.

Of course sometimes the selling can mean nothing at all but my observation is that watching the selling offers some insights. If motivated by urgency, a desire to lock in lofty share prices or grim expectations, information about director’s selling can be more useful than watching their buying.

In April 2011 (about a year later), Richard Uechtritz returned to JB Hi-Fi as a Non-executive director. Until his return, he didn’t have director’s obligations so he was not obliged to make public any of his private share dealings. Upon his return, however, he revealed that he owned only 421,000 options. In other words, he appears to have subsequently sold the one million shares he held at the time of his retirement.

JB Hi-Fi shares do not enjoy the lofty levels they once commanded and investors who tracked the sale of shares by its CEO may have been given a prompt to look deeper into the company,  its prospects or at least the impact of those prospects on its shares.  Of course it could all be happenstance, company CEO’s have no particular insights and their selling is purely a reflection of the need to diversify.  ANy subsequent share price declines may just be coincidental.

JB Hi-Fi’s latest results were less than spectacular and, while the company will continue to win in the race against its listed peers, the reality is its margins remain under increasing pressure, it’s losing share to the internet and its remaining store rollout plan is contributing to a maturing set of metrics. Oh, and the share price now? Just above $9.30.

So do you think you should keep an eye on director’s dealings?  What have been your observations?  Can you nominate some companies in which directors dealings having given you cause to pause…

Posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 9 May 2012.

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A 7% slump in sales for the first 3 quarters of 2012 has taken a predictable toll on the Harvey Norman share price – but will things turn around when the economy improves?  Roger Montgomery discusses his views in this Sydney Morning Herald article published on 4 May 2012.  Read here.

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What a difference a high Australian dollar (lots of people travelling and spending their money overseas and not here), a shift to online retailing, deflation, competitors going out of business, higher petrol prices and a more cautious consumer can make in the retail space in just nine months. And few companies are more exposed to all these influences than JB Hi-Fi.

Back in August 2011, the company reported the following in their annual report;

FY11 Sales $2.96b

FY11 NPAT $134.4m

FY11 NPAT Margin 4.5%

Based on these numbers as well as company guidance for sales growth in FY12 of 8% to $3.2b, the consensus analyst view at the time was for 11% FY12 NPAT growth to $150m.

Since that time however, shareholders have suffered three profit downgrades – in mid December, mid February and another this morning.

In this morning’s trading update, management have guided analysts to an estimated NPAT of $100-$105m on sales of $3.1b. Based on this latest announcement, 2012 numbers will look like this (assuming no further downgrades);

FY12 Sales $3.10b

FY12 NPAT $102.5m

FY12 NPAT Margin 3.3%

What’s clear from these numbers is that sales revenue is growing. No immediate issues there. And despite being below the initial 8% forecast, sales are now forecast to grow by 5%. The concern however is that LFL (like-for-like) sales are negative. For the nine months, sales of mature (older established stores) are down 1.3% which means without their current expansion plans, sales targets would not be met. It’s also the main reason their initial 8% sales growth target won’t be met.

But the main issue in forecasting what the business is worth is that despite this incremental sales growth, this is not CURRENTLY being converted to the bottom line. Based on management’s forecasts, NPAT margins will be 3.3% this year vs. 4.5% in the year prior, a 26.7% margin decline in just nine months. No businesses can increase intrinsic value in such an environment.

The tide that’s currently running against JBH is very strong, no plaudits for pointing that out. But when that tide turns, could JB Hi Fi be in an even better position than it was going into the non-resource-recession (a.k.a. the seven cylinder recession of 2012). There’s certainly the possibility and the key is working out when the economy turns and whether the structural changes occurring in retail are enough to adversely impact and offset the benefits of a cyclical turnaround.

Here’s what we are watching:

· Recently management including CEO Terry Smart and Chairman Patrick Elliot have been heavy sellers of their own personal holdings in JBH. What do they know? Why are they selling?

· The retail industry is experiencing a huge shake-up. Many retailers are doing it tough and many more are exciting the space. The Good Guys was being shopped around for a private sale recently with Blackstone rumoured to be the suitor. Later denied by them. Clive Peters (now owned by JBH) and WOW Sight and Sound have gone into receivership and JB’s largest competitor Dick Smith (owned by Woolies) is set to close 100 stores by 2014. Few electronic retailser are investing in growth. The night is darkest just before the dawn so we are looking for evidence that JB Hi Fi is capturing market share in such an environment, either by making acquisitions of distressed sub-scale business or by taking over leases in locations previously unavailable to them. In QLD it appears up to $250m in sales are up for grabs as competitors close. Dick Smiths had $1.5b in sales of which an optimistic analyst would say that JBH could pick up a substantial portion of.

· Currently electronic retailers are on the back foot evidenced by store closures and liquidation sales. These participants are forced sellers of excess stock putting HUGE downward pressure on retail prices and hence profit margins. In March alone, JBH experienced a 200 bps contraction in gross margins. I was silly enough to buy two C3-PO USB keys for my kids at Christmas for $40 each but picked up another two in Brisbane a few weeks ago for $18 at a closing down Dick Smiths (my new book will be called How to Go Broke Saving MoneyTM).

Margin compression of the magnitude reported recently is unprecedented for an operator of JBH’s buying power. So we are looking for signs that the worst is over in terms of competitors closing their doors, a sure sign margins will improve or cease falling precipitously.

· We are also watching closely JBH’s move into the online space. Growth has been excellent in this segment of the business (admittedly off a low base) with an average of 965,000 website visitors each week. That’s 50.2m views per annum – 2.4 times the population of Australia. The trick of course is to convert page views to sales.

· In prior years the business has benefited immensely from positive LFL sales and also an internally funded store-rollout strategy driving new sales and sales as stores matured. This was a tailwind for the business when the number of new stores being added divided by existing stores produced a high ratio. For example when the business only had 50 stores and another 15 were opened, the proportion of stores growing and adding to sales was 30%. At present the business has in excess of 150 stores and is opening 14-15 stores per annum – a ratio of just 10% in new growth. So when you have negative LFL sales in existing and maturing stores, this is a huge drag on business momentum. We are therefore watching for signs that LFL sales stabilise or turn positive so that the business gets its mojo back.

We think it can although we are convinced the very easy money from the store roll out stage of the business along with P/E expansion has been made. Businesses with a leading market position are able to survive traumatic periods in what is a highly cyclical business and are able to absorb the effects of margin compression. Provided they can capture high levels of market share amid the tumult and cement their position as the dominant player JBH might be well positioned for the next economic recovery. One might ask whether ‘Terry and Co’ will be there when that happens.

Skaffold.com Intrinsic Value 13 year chart.

by Roger Montgomery Posted in Consumer discretionary, Skaffold.

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Roger Montgomery discusses with Ticky Fullerton on ABC1’s ‘The Business’ how the ever-increasing climb of Apple’s share price is likely to come under pressure.  Watch here.

This edition of The Business was broadcast 4 April 2012.

by Roger Montgomery Posted in Consumer discretionary, Energy / Resources, Intrinsic Value, Investing Education, TV Appearances.

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PORTFOLIO POINT: Despite the headwinds facing retailers in Australia, Domino’s Pizza is growing and expanding its margins. But is that growth already be priced in?

Retailers in Australia are facing a perfect storm of weak consumer spending, online competition and a rising Australian dollar. But despite these headwinds, there’s one company that is not only expanding its physical footprint, but is becoming a serious force online. It’s also notching up double-digit growth in Europe, in spite of the economic climate, and breaking records to boot. You may be surprised to learn that this success story is in fact Domino’s Pizza Enterprises (ASX: DMP).

Domino’s Pizza listed on the Australian stock exchange in May 2005, and opened its 400th store in the same year. The company is the largest pizza chain in Australia and enjoys a growing presence in France – a country that, with the exception of the United States, consumes more pizza per head than anywhere else in the world – Belgium and the Netherlands, having bought existing operations in those countries in 2006 and becoming the largest Domino’s franchisee in the world. Domino’s Pizza now operates more than 889 stores, employs more than 16,500 people and, according to one report, makes more than 60 million pizzas per year. And all of this is run by a Lamborghini-driving CEO, who is as obsessed about Domino’s today as he was when he merged his 17-store franchise company into what is now Domino’s Pizza Enterprises.

The company’s online strategy has been a raging success, not only for pizza ordering but also for recruitment. When the company launched its iPhone App in 2009, it became the number one free app on the iTunes site within five days. Today, 40% of orders are made online and the company expects this to be 50% in the next six months, with a third of these orders to come from mobile devices.

Domino’s recently reported its half-year results and saw an improvement on almost every KPI. Same-store sales growth was strong, exceeding expectations in both Australia and Europe; margins improved and stall rollouts continued; the balance sheet strengthened, as did free cash flow; and, despite even lower debt, returns on equity increased. Domino’s concluded by upgrading its full-year 2012 guidance.

My friends at American Express should be able to confirm that while fashion retailing is one of the hardest gigs to be in, restaurants and cafes are one of the best. This is something Domino’s Pizza CEO Don Meij would know only too well. Despite challenging economic conditions, particularly in Victoria and New South Wales, same-store sales grew by almost 9% and total sales were up 11.2%. In Europe, where conditions are arguably much worse and youth unemployment is in the high double-digits, Domino’s recorded 12.6% total sales growth and 7.5% same-store sales growth. By the end of financial year 2012, another 60 to 70 stores will have been opened, net profit is expected to grow by 20% (despite adverse currency movements), and same-store sales growth is expected to be in the order of 5 to 7%.

In the last three years, earnings per share have doubled (no doubt the company has also taken market share from its peers, such as KFC) and despite a substantial decline in borrowings, return on equity has increased from 17% to 23% (see Skaffold.com screenshot below)Rising returns on equity, with little or no debt, is an indication of powerful business economics. Generally, as a company gets larger, its returns on equity stabilise or decline. Domino’s, however, enjoys an ability to raise prices and, some say, reduce pizza sizes without a detrimental impact on volume sales. This is, in my estimation, the most valuable competitive advantage it has. Granted, it’s a surprising conclusion to put forward for a franchisee (for a look at how things can go wrong for a franchisee company, look no further than Collins Foods).

Dominos displays declining debt (red columns), rising equity (grey columns), rising return on equity (blue line) and rising profits (green line).  Source:  Skaffold.com

Since 2004, Domino’s profits have increased 40.11% p.a. from $1.954 million to $20.7 million.  To generate this $18.759m increase in profit, shareholders have tipped in an additional $64.37 million of equity and left in earnings of $34.82 million.  In other words every additional dollar contributed and retained has returned around 19%.  During the period under review the company has also reduced its borrowings by $9.11 million from $24.65 million it held in 2004 to $15.54 million at the end of FY2011.

Analysts worry about the risks associated with growing a business in Europe in the present climate. Rising commodity input prices, including oil for delivery vehicles and wheat for flour, and the stronger Australian dollar are also points of concern. In the face of these perceived challenges, the company continues to grow and expand its margins. It also expects greater than 25% profit growth from Australia within three years. Clearly, Domino’s competitive advantages are proving those analysts who said Australia was ‘ex-growth’ wrong. And the company is also moving to electric delivery scooters to hedge against higher fuel prices.

Domino is a high quality business – Source: Skaffold.com

I have not been able to buy Domino’s shares – as much as I would like to – because they have not been cheap enough for me. My valuation is based on the idea that I want to reduce my risks as much as possible by ensuring I obtain a bargain. DMP has simply never traded at a bargain price. But with a price close to $9.00 today, you could (admittedly with the benefit of hindsight) put forward the argument that the $2.65 the shares traded at in 2009 was every bit a bargain. The issue is simply the discount rate that I am willing to use to arrive at my valuation. If I use 8% to 9%, my valuation approximates the lower historical prices. But is 8-9% enough? I think not.

What would you pay for a business earning $25 million this year and $29 million next year, perhaps $35 million the year after that? If you said $300 million or $350 million, I’d label you a value investor, but today the market capitalisation is more than half a billion dollars. At that kind of multiple, I would guess the growth has been ‘priced in’. I would rather be certain of a modest return than hopeful of a great one, and at current prices – despite the obvious track record of the company and the very great skill of its management – I think buyers are being hopeful. Unless, of course, they know a takeover is imminent.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 March 2012.

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David Jones will spend between 70 and 80 million dollars to restructure its businesses – is this likely to boost its flagging share price?  Roger Montgomery provides his insights to the ABC’s David Taylor on this edition of the PM program, broadcast 21 March 2012.  Read/Listen here.

by Roger Montgomery Posted in Consumer discretionary, In the Press, Radio.

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We all know retail businesses are swimming against the tide. We have written about that subject here at the blog on many occasions and below is a brief list of more recent posts:

We are not investors in momentum or sentiment however this blog allows me to share our thoughts with you and we are noticing a shift in investor sentiment now. The stock market indices with exposure to resources are underperforming the indices without. The industrial indices are rising at a faster rate and falling at a slower rate than their resource-rich bretheren.  Today is a classic example, This tells us that a shift is afoot. If you have been reading this blog regularly, you will know that we are also not enthusiastic about Iron Ore prices and believe prices of $100 per tonne or less are possible in coming years.  On air, I have explained that is our reason for not purchasing BHP despite optimistic earnings forecasts by analysts.

I think the lower-iron-ore price story is catching on and quietly but surely investors are reducing their relative weighting to resource heavyweights.

With that in mind, it could be that most down-in-the-dumps retail sector that now holds a few gems. Next week we’ll explore the results of the reporting season but for today I thought we should revisit The Reject SHop following its half year results.

Here’s the list of recent posts covering retail stocks and the retail sector.

http://rogermontgomery.com/invest-in-kfc-or-just-eat-it/
http://rogermontgomery.com/is-it-just-harvey-norman-or-bricks-mortar-retailing-generally/
http://rogermontgomery.com/are-bargains-available-at-woolworths/
http://rogermontgomery.com/now-waving-drowning/
http://rogermontgomery.com/not-so-high-at-jb-hi-fi/
http://rogermontgomery.com/dumped-by-the-wave-of-fashion/

Way back in September 2009, I published my reason for selling The Reject Shop:

“I can’t stop thinking that the value of the business just cannot rise at a fast enough clip to justify the current price. I really don’t like trading things that I have bought but I don’t think the value of the business can continue to rise indefinitely. With a share price of $13.45 (intraday today) and a valuation of $11.27, the shares are 24% above their intrinsic value. This combination of factors tells me we are safer in cash.”

Like many value investors, I was a little premature and the price first rallied to more than $17.00.  Since then the price has steadily declined to $11.80 after hitting a low of $9.12.

More recently – in December – I wrote:

“The Reject Shop still enjoys its high brand awareness but, as is typical in many store roll out stories, as the offer matures the later sites are less profitable than the early sites.

This doesn’t fully explain the fact that during a period in the economy where one would expect a bargain offering to shine, it hasn’t. Eighty percent of Australians still know the brand but I believe consumer experience and mismanagement has done it some damage.

According to one report, 20% of the population believe the company offers rubbish – cheap Chinese junk that quickly breaks after use and fills our tips. It’s the very reputation China itself is trying, but frequently failing, to shake off.

The other reason for damage to the brand is confusion brought on by mismanagement. Several years ago the average unit price was about $9 and basket size was $11, but over the years one cannot help but have noticed many higher-priced items creeping into the stores.”

Value investors are often early to buy and early to sell but over the long run, being certain of a good return is safer than being hopeful of an exceptional one and so, when it comes to buying decisions a demonstrated record is often essential.

In TRS’s FY12 earnings guidance, the company noted “Significant expenditure on increasing brand awareness”.  This is a real shame because at the time the company float The Reject Shop enjoyed 90% brand recognition and thats why its store roll out was working so well – shoppers knew the company, the store and the offer even though they had never been into a store in their area.

The company has provided earnings guidance for the full year 2012 of $20.5 to $22 million and while some smart analysts will note this is a 53 week year – we don’t care about such arbitrary lines in the sand.  Our approach to investing is involves treating any purchase and ownership as if we owned the whole company.  In that light and over the long term it doesn’t matter whether there are 52 weeks in a year or 52.5 or 53.

Thirteen analysts cover the stock and this week, eight have upgraded (only one downgraded) their forecasts for 2012 (remember the downgrade could be an error on the part of teh analyst rather than the company disappointing) .  I still believe the business will mature but there could be some value in the turnaround and a stabilisation of strong cash flows, and returns on equity over the next few years around 35%.  This is the rate of return on equity the company generated on $21 million of equity in 2005 (its intrinsic value then was around $4.00).  Today the company is expected to return to 35% returns on equity but on 3 times the equity.  You should be able to estimate the intrinsic value from those metrics.

There have been terrific results amongst our fund holdings such as Credit Corp, Seek, Breville Group, ARB, Decmil and Maca.  Have you been encouraged by any of the results?  Start a discussion by clicking on the Comments button below.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 24 February 2012.

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After repotting a reduced annual net profit, what does the current economy hold for JB Hi-Fi’s future performance?  Roger Montgomery discusses his insights with the ABC’s David Taylor on The World Today program broadcast 13 February 2012.  Read/Listen here.

by Roger Montgomery Posted in Consumer discretionary, In the Press, Radio.

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You will have noticed that since November 16 every post here at the Blog has been a cautionary one.  You have not seen me post a ‘here’s possible good value’ story.  There is a little method in that, even though we might be unduly conservative.  But here goes again…

Many of you have heard me discuss JB Hi-Fi and its preferred status among retailers – I believe if JBH is doing it tough everyone else is doing it even tougher.  But we sold JBH from our holdings at $15.50 recently and I thought the story of why (ahead of a downgrade as it turns out) would be a good insight into the way we think.  Hopefully other investors can gain some insight into the process and fill in the 1) ‘bright prospects’ part of the equation that also requires 2) extraordinary businesses and 3) discounts to intrinsic value.

Starting way back in February 2010 we commented on the impending retirement of JBH’s Richard Uechtritz (now looking as well-timed as other prominent CEO departures, such as the Moss departure from Macquarie and I am sure you can list a few more – go right ahead) and the maturing outlook for the business itself.

“If JB Hi-Fi could re-employ all of its profits at the returns of about 45% it is generating now, its value would be over $38. That’s a pipe dream. The company is generating cash faster than it can ask its employees and contractors and landlords to employ the funds to open new stores. And because the profits also produce taxes and associated franking credits that have no value for the company, shareholders are being handed back the funds, which is a disappointment. However, as chairman Patrick Elliott implied when I spoke with him on radio this week, this is a function of growth and the limited size of the Australian population.

It happens eventually to all retailers and it will happen to JB Hi-Fi in the next five to seven years. The best you can hope for is that once the stores have saturated the market, directors stick to their knitting, and the company continues to generate high returns but pays out 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 (often at the behest of some institutional shareholder) and blow up the returns.

The result of not employing as much retained earnings at 45% is that the intrinsic value declines. It is still going up but not as much.”

In August here at the blog we wrote:

“The big story however is that Terry Smart will need to start looking beyond this organic growth to other strategies if JB Hi-Fi is to avoid developing the profile of another mature Australian retail business like Harvey Norman.”

and

“JB Hi-Fi needs to establish new and emerging business models to try and counter the shift away from physical music unit sales.”

and

“Having said that, the current sales environment is probably not representative of the future. Share market investors generally use the rear view mirror when assessing the future. I have previously discussed the “economics of enough”, which David Bussau from Opportunity International introduced me to many years ago. As it applies to consumers generally, they will get sick of trying to keep up with the latest technology, be happy with their TVs and replace everything less often – opting instead to ‘experience’ travel, food, adventure and other cultures. That of course doesn’t mean JB can’t grow its share-of-wallet. In the face of declining retail sales volume growth over the last five to ten years and deflation, JB is proving it is already the market leader.”

and

“JB Hi-Fi’s quality score dropped from A1 to A3 and interestingly, this was only partly due to the increase in debt. (We really need to know whether it was just timing issues and new stores that contributed to the jump in inventory).”

In addition to these comments I wrote more recently:

“The release of the iPhone 4S seemed to underwhelm technology reviewers when launched and a portion of the population do take their purchasing cues from such quarters.

The 4S is apparently an evolution in the iPhone series, rather than a revolution, and as such, fewer users of the most recent release – the iPhone 4 – will upgrade. Instead, it is likely that they will wait until the iPhone 5 is released next year (owners of the previous model the iPhone 3GS, however, should be coming off their two-year contracts about now and are expected to upgrade). We’ll come back to that shortly.

The iPhone doesn’t contribute anything like a majority profit to JB Hi-Fi’s bottom line. This is because margins on Apple products are slim. But the iPhone does generate foot traffic and phone upgraders also buy protective covers and other accessories on which JB Hi-Fi makes much more significant margins.

So why do we care so much about the iPhone?

It’s because when JB Hi-Fi announced its full-year results the company forecast more than $3 billion in sales and management cited growth from computing, telco, and accessories. They said:

“While we anticipate the market to remain challenging, our diversified product portfolio, particularly the categories of computers, telco and accessories, from which we expect strong growth, will assist JB Hi-Fi in delivering another year of solid sales and earnings in FY12. Assuming trading conditions are comparable with FY11, we expect sales in FY12 to be circa $3.2b, an 8% increase on prior year.”

It’s the lower “telco and accessories” sales that are expected to stem from the iPhone 4S underwhelming so-called early adopters and its most ardent fans that may put pressure on that sales forecast.”

Indeed the only thing that was going for JB Hi-Fi was its discount to intrinsic value.  Many investors believe that a stock I mention is below intrinsic value is a “darling’ of mine.  It isn’t.   A company must meet all of our criteria and it will only be held for as long as it does.  Those of you using Skaffold will however have seen JBH was trading only at a discount to one of the intrinsic value estimates – the intrinsic value based on analyst forecasts – but not the more conservative Skaffold Line valuation estimate of $13.16. See Figure 1.

Figure 1.

Both valuations are now likely to decline further in coming days -even the more conservative $13.16 valuation SKaffold has been displaying – and the downgrade may also be reflected in pressure on the company’s cash flow which Skaffold members would have already seen in the 2011 results and which prompted some of the above comments.  (See Figure 2. and note the negative funding gap line (international patents pending))

Figure 2. Showing declining operation cash flow and a growing Funding Gap (patents pending).

JB Hi-Fi was 5 per cent of our portfolio however we sold all of our position at $15.50 recently.  Our reasoning was simple;  Given present circumstances and expectations for retailing (having spoken to many retailers recently) many retailers JB Hi-Fi would have to revise their earlier outlook statements and this would produce lower future valuations.  At the same time analyst forecasts are typically optimistic in the first half of the financial year (this year being no exception to that rule) and we should therefore be demanding much larger discounts and JBH was not offering that margin of safety.  We also commented to our peers in conversations over the phone and in person that the delfation story – as explained by Gerry Harvey who noted selling plasma TVs for $399 this year means he has to sell three times the volume as last year to make the same money – would put pressure on profits because people already had enough plasma TVs.  Finally we also believed that ANZ’s profit growth being dominated by bad debt provisioning writedowns meant that credit growth was non-existant.  When you take away growth in credit card purchases – thats got to hurt discretionary retailers.

On November 7 we wrote to our Montgomery [Private] Fund investors thus:

A prominent media commentator and broker however wrote on December 6

“Our No.1 discretionary retail recommendation remains JB Hi-Fi (JBH). We all know 21% of JBH’s register is currently shorted, a massive short position usually reserved for financial impaired or structurally stuffed stocks. JBH is neither, and that is why we continue to be aggressively recommending buying the stock which generates 25% of its annual profit in December. JBH is trading on 11.2x bottom of the cycle earnings. Nowadays, the P/E’s of cyclical stocks compress with their earnings, meaning that both P/E and E bottom concurrently.”

So, JBH still has long term prospects that surpass many of its peers and I believe it still has a competitive advantage.  And if all those short sellers cover their position, the stock could rally.  That however would be speculating.  On the flip side, changes to accounting reporting standards will give it a lot more liabilities – contingent liabilities such as operating leases will need to come onto the balance sheet.  Also, the medium outlook, which includes deflation continuing, will put pressure on JB to sell more volume at precisely the time everyone may just have enough stuff.  Finally, the market may now finally catch up to the maturity story we described way back in 2010.  Of course consumers will return at some point and spending and credit growth will recover, but given the current weakness and fear among consumers the idea of requiring very, very large discounts to the more conservative estimates of intrinsic value dominates our thinking.

As always be sure to do your own research and seek and take personal professional advice.

Posted by Roger Montgomery, Value.able author and Fund Manager, 16 December 2011.

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On Wednesday November 2 Woolworths held a strategy briefing for professional investors. Woolworth’s effectively asked us to adopt a longer time frame before judging its performance and revealed four strategic priorities that I will describe in a moment.

Prior to the strategy day, the company updated the stock market with a growth outlook that was the lowest in a decade. The market responded negatively to the change and it entrenched previous sentiment by professional investors to switch from Woolworths to Coles.

But Woolworths remains a superior business from a business economics perspective, with high return on equity and it also remains cheaper than its competitor as measured by the larger discount to an estimate of its intrinsic value.

The wider sentiment towards Woolworths Supermarkets is that the period of strong growth is over, and the other businesses, such as Big W, the New Zealand supermarkets, the Masters hardware venture and a possible acquisition of The Warehouse group could be the focus of earnings growth for the company. Gambling pre-committments would not be.

Meanwhile, the Woolworths-owned Dick Smith electronics business appears to have failed to excite consumers and has certainly failed to excite investment professionals. Dick Smith is a relatively weak offering in a market that has been hit particularly hard by the empowerment of the consumer through high Australian dollar.

Moreover, in many ways these businesses are peripheral since the Australian Food & Liquor division accounts for 80% of earnings before interest and tax.

The impact of the company’s lower growth profile on intrinsic value, particularly intrinsic values over the next two years, has been negative and intrinsic value does not appear to be going anywhere in a great hurry (see Skaffold chart below).

This combination of circumstances, in my experience, set Woolworths shares up to be vulnerable to any negative shocks.

Estimating intrinsic value is not the same as predicting price direction, however the above circumstances are not unique historically in putting a lead on price appreciation.

On top of the above combination of factors, there is also the continuing debate in Parliament about the introduction of preset loss limits for poker machines, which, if introduced, would negatively impact Woolworths’ gaming business. Though it is most closely associated with supermarkets, Woolworths is actually the largest poker machine owner in the country, with more than 10,700 pokies.

And a few weeks ago, The Economic Times of India also reported that Woolworths appears to have been dumped by its Indian partner, Tata Group. Woolworths enjoyed a five-year partnership with Tata, introducing Dick Smith-style electronics stores to India under the Infiniti Retail brand. Even though foreign retailers are not permitted to have a direct presence in India, Woolworths partnership offered the hope of growth – albeit with a partner – if the rules were ever relaxed.

Nonetheless, despite these accumulative negative factors, Woolworths is regarded by conventional analysts and investors as a defensive’ company. Its strong cash flows and its status as a major retailer of food makes it an ideal investment in a recessionary or slow or low growth environment. The company also enjoys entrenched competitive advantages over smaller rivals that, until now, the ACCC has done little about. One example of this are the new EFTPOS charges.

From the first of this month, the new Eftpos Payments Australia Limited (EPAL) fees mean retailers incur a 5¢ fee for every transaction over $15 (75% of all EFTPOS transactions). Previously there was no fee and that will still be the case for transactions under $15, which means 25% of transactions.

The retailer’s bank will charge the retailers, some of whom are describing the charges as an “EFTPOS tax”, and they will have no choice but to pass on to the consumer.

Unsurprisingly, EPAL’s members include the major banks, Coles and Woolworths and, because they manage their own terminals, they can opt out of the new charges.

But despite these entrenched advantages, Woolworths has been hit – or so it says – by the state of the economy, noting in its annual report: “Consumer confidence remained historically low as customers reacted adversely to rising utility costs, interest rate hikes in the first half of the year and general global uncertainty, and opted to save rather than spend their money”.

From an investment perspective it is worth noting that retail investors now have a choice of supermarkets, with Coles improving its offering to consumers and taking market share from the incumbent Woolworths.

The investment community is not convinced that further changes to private-label offerings or more innovation around the supply chain will make a dramatic difference to the growth prospects for Woolworths, which set below forecast growth in household income, population and the economy.

One other source of earnings growth is cost-cutting, but the reality is that gains from such strategies are one-offs and again unlikely to excite investors.

Having presented the negatives – which have caused the share price to fall 12% since July, one positive was the strategy briefing’s opportunity to showcase new CEO Grant O’Brien, who replaces Michael Luscombe. The company announced that it planned to extend and defend its leadership in food and liquor, act on the “portfolio” to maximise shareholder value, maintain its track record of building new growth businesses (we’ll ignore Dick Smith) and finally, put in place the enablers for a new era of growth.

In the supermarkets business WOW hopes to grow fresh produce from 28% market share to 36% market share. If achieved this would be an additional $2.5b in sales. Woolies also wants to target a doubling of home brand sales and this aim flies in the face of the ACCC’s stated concerns.

The company will also open 35 new BIG W stores in next 5 years reaching 200 by 2016.

In a reflection of the massive structural shift online, BIG W’s 85,000 in-store SKUs will be expanded and all put online.

And the topic on the tip of everyone’s tongue; Masters. There are now five stores open, another two are due to open in December/January, there are 16 under construction another 100 in the pipeline and the company reported the venture is well ahead of budget.

I also note the advertised sale of $900 million of property ($380 million of which was sold last financial year); and, most recently, the oversubscribed $500 million hybrid note raising that substantially extend the balance sheet strength of the company.

Below we examine the intrinsic value track record and prospects for Woolworths based on current expectations for earnings growth and returns on equity using Skaffold.com

Woolworths (MQR: B2) is currently trading at the same price it was in December 2006 and February 2007, despite the fact profits have risen 11.1% pa, from $1.3 billion to a forecast $2.2 billion in 2012. This growth in profit however is offset by having 16 million more shares on issue; by increased borrowings – up $1.8 billion to $4.8 billion; and by retained earnings, which have risen by $2 billion. The increase in shares on issue and retained earnings have offset the positive impact on return on equity rising profit would normally have.

The latest estimate of its intrinsic value, of $23.23, is forecast to rise modestly over the next two years. For investors looking at opportunities to investigate only when a meaningful discount to intrinsic value is presented, a price of $19 or less for Woolworths would represent at least 20 per cent.

Posted by Roger Montgomery, Value.able author and Fund Manager, 17 November 2011.

by Roger Montgomery Posted in Companies, Consumer discretionary, Insightful Insights, Investing Education, Skaffold.

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