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Morningstar | JB Hi-Fi’s Rally Ignores the Competitive Threats. FVE Unchanged at AUD 24.50

No-moat JB Hi-Fi’s shares screen as overvalued at current prices after rising about 30% since the start of 2019. The market appears enamoured with the company’s market-leading position and competitive operating cost structure. However, investors aren’t getting a margin of safety to account for longer-term structural risks. We maintain our AUD 24.50 fair value estimate.

Like all traditional retailers, JB Hi-Fi continues to transform into an omnichannel, which brings into question the established retailing playbook of growing sales by rolling out stores, and also requires rethinking of the last-mile. The cyclical nature of the soft retailing environment is unlikely to have long-lasting negative effects on the intrinsic value of leading retailers such as JB Hi-Fi and shouldn’t worry fundamental investors too much.

A gradual decline in foot traffic in Australian stores is inevitable as e-commerce grows rapidly. We anticipate the dominant players in their respective categories to take market share from smaller and weaker players, which are burdened with lower-traffic online channels, less competitive pricing or lower gross profit margins, and the higher cost of doing business. We forecast JB Hi-Fi, together with Harvey Norman, will consolidate the brick-and-mortar channel in consumer electronics.

A recent example is the acquisition of three 2nds World stores by Harvey Norman, after the retailer entered voluntary administration in April 2019. Yet, we don’t forecast JB Hi-Fi’s store count to increase. Rather, we expect JB Hi-Fi to increase its online sales to maintain market share. The online retailing channel has grown at an average rate of 13% over the last five years, and we project this trend to continue over the next five years, with e-commerce sales increasing by an average of 14% per year to fiscal 2023.

E-commerce accounted for only 6% of JB Hi-Fi’s sales in the first half of fiscal 2019, offering opportunities to grow. JB Hi-Fi’s online penetration compares with the overall Australian retail market at 9%, and U.S. market-leader in consumer electronics Best Buy’s 17%.

Online brings unheard of pricing transparency to the consumer, together with a greater range of products and convenience. We expect price-based competition to remain highly competitive, especially now that Amazon has joined the market. JB Hi-Fi is well positioned to effectively compete with Amazon and other online competitors such as Kogan, but we expect operating margins will be stagnant at approximate current levels, despite average top-line growth averaging 3.7% over the next decade. We estimate the group’s EBIT margins to average 5.2% over the same period, just 10 basis points higher than in fiscal 2018.

Along with pricing, delivery fees and speed are also battlegrounds in online retailing. JB Hi-Fi’s extensive store network is an asset for fulfilling online orders. Customers can collect merchandise easily in stores, avoiding the need to pay for delivery, via a shipping or membership fee, or higher retail price. Conversely, a vast store network brings with it fixed costs in the form of inflation-linked rents and wages which need to be offset by top-line growth to remain profitable. We calculate JB Hi-Fi’s combined Australian like-for-like sales growth at The Good Guys and JB Hi-Fi were 2.6% in the first half of fiscal 2019. However, we estimate only 80% of this growth was attributable to in-store sales. As the group’s online penetration increases over time, the sales growth contribution from the brick-and-mortar channel is likely to deteriorate and weigh on the store network’s profitability.

The Australian economy has slowed in the second half of fiscal 2019 and retail sales have suffered from the negative wealth effect of declining house prices. However, offsetting this is the removal of the uncertainty associated with the federal election in May 2019 and the decision by the Australian central bank to cut interest rates. Nonetheless, a cyclical slowdown of the economy is immaterial to the fair value of retailers. Instead, a sell-off in retailing stocks because of cyclical earnings weakness could provide opportunities to long-term, fundamental investors. For more information, please see our report “The Morningstar Time Machine Revisits Australia's Last Recession” from May 20, 2019.

JB Hi-Fi’s sales growth weakened in the third quarter and Australian consumer electronics spending was down 0.4% in April 2019. Nevertheless, JB Hi-Fi has been winning market share in each of the first three quarters and management reaffirmed its revenue and earnings guidance Apr. 30. We maintain our 2019 sales growth and NPAT estimates of 3.4% and AUD 248 million, respectively, in line with JB Hi-Fi’s revenue guidance but beating its NPAT guidance range of AUD 237 million-AUD 245 million.