How long can JBH and SUL defy the retail gloom?

How long can JBH and SUL defy the retail gloom?

JB Hi-Fi (ASX:JBH) and Super Retail Group (ASX:SUL) recently released their HY19 results. They were surprisingly strong, beating market expectations that have been progressively downgraded amid slumping national retail sales and foot traffic numbers. The question for investors is: how long can they defy the retail gloom?

JB Hi-Fi, the discount electronics and appliance retailer, achieved net operating profit after tax (NPAT) growth of 5.5 per cent to $160 million, which beat expectations of $153 million.  Despite plunging new house sales to 2001 levels, slumping apartment sales, and accelerating house price declines, JBH’s result was driven by the fridge and appliance retailer The Good Guys, which the company bought for $870 million in September 2016.

The Good Guys EBIT came in at $44m versus expectations of $38m, now suggesting JBH paid a little more than 10 times EBIT.  As an aside, for the year ending June 30, 2016, The Good Guys generated earnings before tax (EBIT) of $74.2 million of the back of $2.09 billion in revenue.

Perhaps more importantly, JBH’s share price was $30 at the time of The Good Guys acquisition. A little more than 2 years later the shares remain 22 per cent lower.

Despite the solid result for the half year ending December 31, 2018, and perhaps unsurprisingly, considering the deteriorating national retail conditions, JBH’s challenges are increasing. JBH Australia’s January comparable sales growth of 1.5 per cent is well below the prior corresponding period’s (Jan 18’s) 4.8 per cent. The Good Guys are weak at 0.3 per cent.

If we are at ‘peak JBH retail sales’, a reasonable concern would be that operating leverage begins to work in reverse and there’s also a real risk that The Good Guys could deteriorate further if macro and housing trends continue on their present trend.

Keep in mind the RBA recently downgraded Australia’s 2019 growth from 3.25 per cent to 2.75 per cent, Australian monthly new house sales have slumped to 2001 levels, and foreign and domestic property investors have deserted the property market suggesting there won’t be a recovery any time soon.

Australian December home loans fell 6.1 per cent month on month to $17.4 billion, much sharper than the two per cent decline expected and the weakest figure in more than 5 years. Loans were down 19.8 per year, year on year, the biggest decline since 2008. Meanwhile, remembering 30 per cent of our exports go to China, that country’s commerce ministry said on February 12 that consumption growth in China is “very likely” to slow further this year as the economy cools.

It shouldn’t be surprising that retailers, especially those specialising in selling appliances and home furnishings, are going to soon be doing it much tougher.

JBH downgraded its FY2019 sales guidance slightly for JB Hi-Fi Australia, which is now $4.73 billion versus $4.75 billion previously. The Good Guys sales guidance was maintained at $2.15 billion. Total Group forecast sales are A$50 million softer at $7.1 billion versus $7.15 billion previously. FY2019 NPAT is guided to grow by between 1.6 per cent and 5.1 per cent, which is a little better than market expectations but implies a slowing in the second half.

The difficulty with investing at this juncture, despite what appears to be a reasonable price, is the outlook. High levels of household debt, little wage growth and perhaps peak employment, along with an expected ALP victory making things worse for house prices and the wealth of families, suggests demand for JBH and The Good Guys products could continue to face pressure.  On the surface it appears JBH is trading at a small discount to our estimated intrinsic value range.  A deterioration in the outlook and the rate of that deterioration is something however that cannot be quantified and therefore is unlikely to be factored into comments by management.  We simply don’t know how deep the housing slow-down is going to plunge and an ALP victory could render conditions materially worse.

Super Retail Group

Like JB Hi-Fi, Super Retail Group (ASX:SUL) – owner of Super Cheap Auto, Rebel Sport, BCF and Macpac, pre-released stronger than expected results. In particular the company revealed EBIT ahead of market expectations and strengthening like-for-like numbers in every brand except Macpac.

For the first half of 2019, SUL announced sales up 6 per cent to A$1.4 billion and EBIT up 10 per cent to $124.5 million.

One worrying development was a roughly 20 per cent, or A$58 million, year-on-year fall in operating cash flow despite EBITDA (often used as a proxy for cash flow) rising by more than 10 per cent.  According to the company, and a broker, a third of this can be explained by pre-paid rent and the remainder can be explained by trade creditor funding boosting cash flow in the 2018 corresponding period. Because this wasn’t repeated in the first half of 2019, it looked like a deterioration against the prior corresponding number.

The company did announce it had taken a one-off A$32 million pre-tax charge relating to staff underpayments plus A$11 million of interest, while the first six weeks of the second half of the financial year has kicked off strongly with BCF and Sports like-for-likes up 8 per cent, Auto four per cent stronger and only Macpac down two per cent.

For retailers, we think these results are a positive sign only for the short term. It may be simply that the better managed companies have yet to see the softening environment catch up with them. Of course, this pessimism may already be factored into share prices with JBH down 23 per cent from its all-time highs in 2016, and SUL down 44 per cent from its 2013 highs. Moreover, it is reasonable to expect investors to turn their attention to the currently nascent digital threat.

The Digital Threat Remains

Longer term the issue remains the online threat and the migration of sales from brick & mortar to online. Retailers who haven’t sufficiently invested could see a permanent destruction in value.

While the trepidation surrounding Amazon’s arrival has faded somewhat, and according to Deloitte research 90 per cent of retailers said Amazon hasn’t affected their business since its local launch in 2017, the reality is that Amazon remains very much in ‘start-up’ mode. David White, national leader of Deloitte’s Retail, Wholesale & Distribution Group, said we are “yet to see the full force of Amazon locally”, adding “Amazon Australia continues to invest heavily in its infrastructure and people, but it’s not realistic to expect the creation of a multi-billion-dollar business overnight. So, it’s a word of warning – under-estimate Amazon at your peril.”

Investors in Australian retailers need to ask management what digital strategies their company is investing in. While Deloitte’s lead retail analyst encourages retailers not to take their foot off the accelerator when investing in technology, it will be essential that the spending is directed towards technology that can pinpoint customer preferences and target shopping patterns at a minimum.

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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.