JB Hi-Fi Limited ( JBH )

Profit margins on the decline

Recommendation: Hold
Investment Rating
JBH operates over 157 branded electrical stores across Australia and New Zealand and is rapidly growing via an aggressive store roll-out program. The business has proven to be very resilient, trading strongly throughout the financial crisis as the younger target demographic continued to spend on entertainment. The industry constantly develops new gadgets and products, which drives organic growth. New stores will continue to drive earnings growth over the next few years, with many national locations still under represented. What growth opportunities lie beyond the 210 long-term store target remain unclear.
16 December 2011
Recommendation Trigger Guide

Note: Marker indicates price of $12.71 at publication date.

Snapshot Last Price Market Cap. 52 Week High 52 Week Low Shares on Issue Sector Moat Rating Intrinsic Valuation Risk Business Risk Pricing Risk Company Beta Sector Beta High High 1.25 1.34 $12.71 $1,256 million $20.50 $12.57 98.8 million GICS - Retailing None $12.76

Event

JBH expect 1H EBIT to be around 5% below pcp, subject to the Christmas trading performance being in line with recent months trends.

Impact

The 7.8% increase in sales is driven by the opening of 10 stores with a further six expected to open in the 2H. On a comparable basis sales decline 1.8% for the five month period to November which is an improvement from 3.5% decline for the first three months to September. Aggressive price discounting within the electrical market is reflected in the expected decline in 1H EBIT of 5% compared to pcp. We would have thought the 7.8% increase in top-line sales would have supported the profit margin as the business generates further operational benefits of scale. The EBIT decline is a concern leading us to downgrade our profit forecasts. It remains questionable if the current price discounting and margin erosion is a temporary liquidation event by competitors to clear stock or a reflection of the structural market changes posed by online competitors forcing retailers to accept a lower margin. We take a view that electrical retailing margins will remain under pressure as commoditisation and the ability to easily access products through online competitors is set to drive down traditional profit margins. JBH is actively evolving with its online offering reporting an 80% increase in internet sale, notably from a small base. Online retailers are at a distinct advantage because they avoid paying shop rents and the associated fittings and staffing costs. This competitive threat is likely to ensure tighter electrical profit margins become more of a norm rather than an exception.

Investment Fundamentals Year-end Jun NPAT ($m) EPS () EPS Growth (%) PE Ratio (x) DPS () Dividend Yield (%) Franking (%) FY10A FY11A FY12E FY13E 118.7 108.4 21.0 18.0 66.0 3.4 100 134.4 123.9 14.3 15.4 77.0 4.0 100 119.8 121.6 -1.8 12.3 75.0 5.0 100 126.3 128.2 5.4 11.7 79.0 5.3 100

Source: Morningstar analyst estimates. Price Chart

Business Description JB Hi-Fi Limited (JBH) is a specialty discount retailer of branded home entertainment products. The Group's products fall into consumer electronics, car sound systems, and music and DVDs and white goods. JBH does not operate a warehouse; instead all stock is delivered directly to each store and largely stored on the shop floor.

Recommendation Impact
We revise down our longer term margin assumptions to account for what we expect to become a lower returning industry as the internet effectively lowers the barriers to entry within the commoditised electrical retailing segment.

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JB Hi-Fi Limited (JBH)

Attractive low cost business model Thesis (Last Updated: 08/08/2011)
JBH is now Australias sixth largest retailer, having built a strong brand and healthy market share within the consumer electronics industry after the demise of smaller fragmented groups like Retravision and Beta Electrical. Australians have been quick to embrace the latest technology over the past decade thanks largely to low unemployment and low interest rates. Competitive advantage comes from JBHs low cost business model similar to listed US peers Best Buy and Circuit City. Price deflation and intense competition are longer term risks. Stores typically break even just under a year with mature stores on average contributing $20m in sales and $1.4m in profit. Around half of the existing store network has yet to mature. The business doesnt run warehouses and holds all stock at the store level, minimising storage and transport costs. The business model requires high turnover and foot traffic to compensate for low operating margins on consumer electronics, music and games. The product mix is updated with recent expansion into mobile phones and computers. Despite this, we still dont think the business carries any economic moat. Consumer electronic products have become commoditised while technology keeps converging. JBH needs to offer good incentives to attract mobile phone customers given the highly fragmented market. Consumer electronic margins will also be impacted by price deflation due to the higher A$ and intense competition. Management openly boasts its employees are incentivised and often have the ability to sell at cost to close a deal, sacrificing gross margin. Woolworths (WOW) plans to boost its Dick Smith consumer electronics division while the entry of Costco into the domestic market could further lower already low gross margins. Film and music distributors continue pushing content online diminishing the need for physical distribution.

Valuation (Last Updated: 16/12/2011)

After a period of rapid earnings and revenue growth driven by a store role out program we now expect earnings growth to moderate to an average of around 6%pa for the next five years. Structural risks associated with the emerging threats of online competitors means we use a relatively high discount rate of 12% and little to no margin growth from current levels, to determine our valuation of $12.76.

Risk (Last Updated: 08/08/2011)

The consumer electronics industry usually cycles over a ten years period where high profits encourage new competitors driving down profitability. International giants Costco as well as Woolworths have boasted plans to compete aggressively in consumer electronics, possibly flooding the market with cheap imports as the A$ continues rising and Asian suppliers look for higher volumes. Online competitors are also ramping up while film, music and other content distributors continue seeking vertical integration by pushing content online diminishing the need for physical distribution. This will force a rapid change in JBHs product mix over the next five to ten years.

Strategy (Last Updated: 08/08/2011)

Growth is driven by a store rollout program which adds around 13-15 sites per year with a long term goal of 214 national stores. The product mix is constantly revised to ensure competitiveness. JBHs reluctance to take on the new devices illustrates strict product selection. Margin gains derive from scale benefits which reduce the cost of doing business. Diversification into New Zealand is still in its early stage and is not likely to contribute in a meaningful way in the near term.

Bull Points

JBHs younger, budget conscious demographic is less likely to have a

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JB Hi-Fi Limited (JBH)

mortgage and more likely to rent or live with their parents.

The business has an established national network, strong brand and customer loyalty. It has cemented itself as the category killer, similar to Bunnings in Hardware.

Bear Points

Comparable sales growth will grind to a halt as consumers wallets tighten. JBH has no moat commoditised products. and sells

Physical content will be phased out within the next ten years, so will need to find other products to fill floorspace.

Financial Overview
Growth

Guidance is for FY12 sales revenue of around $3.2bn. Another 16 stores will open in FY12.
Profitability

FY11 revenue increased 8.3% to $2.96bn, gross margins up 28bps to 22%, the cost of doing business remains low at 14.5% with EBIT up 11.9% to $196m.
Financial Health

The share buy back will increase debt and reduce interest coverage from 33x to 15x utilising our forecasts for FY12.This level still remains relatively low with sufficient financial capacity to continue the store role out program.

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JB Hi-Fi Limited (JBH)

Per Share
Year to 30 June Earnings Dividends Franking % 2009A 89.6 44.0 100.0 2010A 108.4 66.0 100.0 2011A 123.9 77.0 100.0 2012E 121.6 75.0 100.0 2013E 128.2 79.0 100.0

Cash Flow ($M)

Year to 30 June Receipts from Customers Net Operating Cashflow Capex Acquisitions & Investments Sale of Invest. & Subsid. Net Investing Cashflow Proceeds from Issues Dividends Paid Net Financing Cashflow Net Increase Cash Cash at Beginning Exchange Rate Adjust. Cash at End 2009A 2,511.9 145.6 -44.4 ---43.9 4.2 -33.2 -64.3 37.4 -1.5 -.1 35.8 2010A 2,965.8 152.1 -56.8 ---55.8 6.8 -67.1 -80.2 16.1 35.8 -.1 51.7 2011A 3,267.5 109.9 -45.1 ---43.9 9.3 -88.4 -90.9 -24.8 51.7 .3 27.2 2012E 2013E 3,114.2 3,354.8 170.6 153.1 -36.9 -55.5 -----36.9 -55.5 ---73.9 -77.8 -73.9 -77.8 59.8 19.8 27.2 87.1 --87.1 106.9

Profit & Loss ($M)

Year to 30 June Sales Revenue EBITDA Depreciation & Amort. EBIT Net Interest Expense Profit Before Tax Tax Adjusted NPAT Reported NPAT 2009A 2,327.3 160.7 -18.7 142.0 -6.5 135.5 -41.1 94.4 94.4 2010A 2,731.3 198.4 -23.3 175.1 -5.5 169.6 -50.9 118.7 118.7 2011A 2,959.3 223.3 -27.3 196.0 -4.0 191.9 -57.5 134.4 109.7 2012E 2013E 3,142.0 3,360.8 211.9 222.9 28.3 30.2 183.6 192.6 12.4 12.2 171.2 180.4 -51.4 -54.1 119.8 126.3 119.8 126.3

Growth
Year to 30 June Sales Revenue EBIT EPS DPS % % % % 2009A 27.3 38.8 45.1 69.2 2010A 17.4 23.3 21.0 50.0 2011A 8.3 11.9 14.3 16.7 2012E 6.2 -6.3 -1.8 -2.6 2013E 7.0 4.9 5.4 5.3

Balance Sheet ($M)

Year to 30 June Cash & Equivalent Receivables Inventories Other Current Assets Current Assets Prop. Plant & Equipment Intangibles Other Non-Current Assets Total Non-Current Assets Total Assets Interest Bearing Debt Other Liabilities Total Liabilities Net Assets Total Shareholders Equity 2009A 35.8 60.3 324.5 5.7 426.2 136.1 81.4 18.0 235.4 661.7 89.4 343.0 432.4 229.3 229.3 2010A 51.7 63.5 334.8 4.5 454.5 164.0 83.9 12.0 259.8 714.3 69.6 351.4 421.0 293.3 293.3 2011A 27.2 58.3 406.9 8.6 501.1 169.6 78.7 17.8 266.1 767.1 232.6 382.2 614.8 152.3 152.3 2012E 87.1 86.1 387.8 8.6 -178.2 78.7 17.8 -844.3 232.6 413.4 646.0 198.3 198.3 2013E 106.9 92.1 415.2 8.6 -203.4 78.7 17.8 -922.7 232.6 443.5 676.0 246.7 246.7

Ratios
Year to 30 June Price/Earnings EV/EBITDA Dividend Yield EBITDA Margin EBIT Margin Net Profit Margin ROE ROA ROIC Net Debt/Equity Interest Cover % % % % % % % % % % x 2009A 12.9 10.6 2.9 6.9 6.1 4.1 41.2 15.1 35.0 23.4 21.9 2010A 18.1 10.5 3.5 7.3 6.4 4.3 40.5 17.3 39.4 6.1 31.8 2011A 15.4 8.5 4.5 7.5 6.6 4.5 88.2 18.1 38.4 134.8 48.6 2012E 12.3 7.5 5.0 6.7 5.8 3.8 68.4 14.9 33.4 73.4 14.8 2013E 11.7 7.1 5.3 6.6 5.7 3.8 56.8 14.3 33.3 50.9 15.8

Top 5 Substantial Shareholders

National Australia Bank Limited Integrity Investment Management UBS AG and its related bodies corporate Hyperion Asset Management Limited Westpac Banking Corp/BT Investment Management Ltd 12.0% 8.2% 6.8% 6.5% 6.3%

Principals & Directors

Principals

Chairman Company Secretary

Directors

Mr Patrick F Elliott Mr Richard Murray

Mr Patrick F Elliott(Chairman)

Previous Research
19/10/2011 14/10/2011 09/08/2011 30/06/2011 22/06/2011 30/03/2011 07/02/2011 08/12/2010 14/10/2010 09/08/2010 12/05/2010 08/02/2010 16/12/2009 22/10/2009 11/08/2009 09/06/2009 27/05/2009 Retail weakness continues in September quarter Price trigger adjustment Performing in a tough retail environment Tough trading conditions Under Review Buy-back to return franking credits More to the headline Blurry picture Stuck on pause Good but not great Should score goals Becoming attractive Christmas shoppers aficionado Store expansion upgraded Tune in for FY10 Earnings growth continues, store guidance updated The $100m question

Mr Gary Levin(Non-Executive Director) Mr Richard Anders Uechtritz(Non-Executive Director) Mr Terry Smart(Executive Director) Mr James (Jim) King(Non-Executive Director) Mr Gregory Richards(Non-Executive Director) Ms Beth Laughton(Non-Executive Director)

2011 Morningstar, Inc. All rights reserved. The data and content contained herein are not guaranteed to be accurate, complete or timely. Neither Morningstar, nor its affiliates nor their content providers will have any liability for use or distribution of any of this information. To the extent that any of the content above constitutes advice, it is general advice that has been prepared by Morningstar Australasia Pty Ltd ABN: 95 090 665 544, AFSL: 240892 (a subsidiary of Morningstar, Inc.), without reference to your objectives, financial situation or needs. Before acting on any advice, you should consider the appropriateness of the advice and we recommend you obtain financial, legal and taxation advice before making any financial investment decision. If applicable investors should obtain the relevant product disclosure statement and consider it before making any decision to invest. Some material is copyright and published under licence from ASX Operations Pty Limited ACN 004 523 782 ("ASXO"). DISCLOSURE: Employees may have an interest in the securities discussed in this report. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf.

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JB Hi-Fi Limited (JBH)

Research Methodology
We seek undervalued stocks with a medium to long-term investment time horizon. Companies that make the best investments tend to be those able to grow earnings per share year after year and which are able grow at rates above the average of the market. Earnings growth supports a solid and growing dividend stream which is the essence of shareholder return. In searching for the best businesses in the market, we want to see an ability to turn revenue into profits and a record of strong returns to equity. The ability to generate strong free cash flow is critical as this is where the funds come from to pay dividends or to invest in new growth areas. The greatest free cash flow generators will have strong margins, good controls over working capital and limited requirement for capital expenditure. The best businesses will also have robust balance sheets including a not onerous level of debt. We believe in strong, experienced and disciplined management. We ascribe a moat rating to each stock researched: Wide, Narrow or None. The moat is the competitive advantage that one company has over other companies in the same industry. Wide moat firms have unique skills or assets, allowing them to stay ahead of the competition and earn above-average profits for many years. Returns on their invested capital will exceed the cost of that capital. Without a moat, highly profitable firms can have their profits competed away. Other companies will see how attractive the market is and try to move in to reap some of the rewards themselves. Sources of economic moats include innovation skills or first mover advantages, a superior cost position, the ability to provide a range of products to suit the needs of a variety of markets, high switching costs or locking out of competitors. The moat rating is just one of the ingredients used in determining whether a company is undervalued, though it is obviously an important one. We are not saying that no-moat companies should be avoided. Simply, the very best long term investments are in wide moat firms bought when they are undervalued.

Business Risk
Business risk encompasses all operational risk and financial risk. Companies with low business risk have the most reliable earnings streams. A change in business conditions may reduce earnings predictability and therefore increase risk. Examples are market entry of a new competitor, unfavourable shifts in the economy, changes in key management personnel, major investment in an uncertain new venture or acquisition, and increased interest burden caused by higher debt levels or raised interest rates.

Pricing Risk
Pricing risk reflects the premium or discount implied in the current price of the shares. Many growth stocks trade on high earnings multiples giving them high pricing risk though they may have low business risk. Investors should consider their risk tolerance before investing in the share market. Many investors will decide to have only low risk stocks in their portfolio though others will accept higher risk levels in order to pursue higher returns.

Recommendations
Our qualitative recommendations simple and easy to understand: are

Buy: Suitable for purchase now Accumulate: Undervalued but there is time to purchase Hold: Appropriately priced, neither buy nor sell Reduce: Sell part holding Sell: Sell all holdings now Avoid: Not investment grade

Intrinsic Value
Intrinsic Value (otherwise known as Fair or Underlying Value) is the analyst's interpretation of what the stock is worth today. The stock is considered to be undervalued when the quoted price is below this point or overvalued where the price is above it. Whether to invest in a stock will depend on consideration of the prospective return and the risk undertaken. Prospective return includes both share price moves and dividend yield. Our analysts incorporate the stock's risk in their intrinsic value. Other things being equal, lower risk stocks will have greater intrinsic value than higher risk ones. A stock becomes a buy when the quoted share price is at a discount to intrinsic value that provides a sufficient prospective return.

Economic Moats
The pursuit of high quality businesses is central to our investment philosophy. These offer the greatest gains to the long term investor, so long as they are bought at a reasonable price. The concept of economic moats is valuable in assessing the quality of a business, with the phrase popularised by Warren Buffett and Charlie Munger. Just as wide moats protected castles from invaders in medieval times, businesses with wide economic moats have strong defences against their profits being competed away.

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