Margin Pressures Weigh on JB Hi-Fi

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– JB Hi-Fi lowers earnings guidance
– Update highlights ongoing margin pressures
– Issues regarded as cyclical rather than structural
– Broker ratings unchanged

By Chris Shaw

Last Friday JB Hi-Fi ((JBH)) released a trading update, management indicating while full year sales should meet expectations of around $3.1 billion net profit for the year is likely to fall short given ongoing margin compression.

Macquarie notes JB Hi-Fi is now expected to experience a 200 basis point fall in second half margins to around 20.9%. This suggests a full year net profit of $100-$105 million, which would be 12% lower than Macquarie had been forecasting.

In the view of Macquarie, JB Hi-Fi is caught in a difficult position as its market leadership requires a wide range and the lowest prices. At the same time, industry structure requires profitability and this is a challenge given a current face-off between consumer electronics retailers with the likes of Harvey Norman ((HVN)) needing its retail brands to perform and others such as the Woolworths ((WOW)) -owned Dick Smith appearing less committed to the sector.

This raises the question of whether or not the current tough market conditions are structural or cyclical. In UBS's view the market is experiencing a cyclical downturn stemming from irrational pricing as competitors chase increased market share.

With current trends expected to normalise in FY13 and with market consolidation to provide something of a boost to conditions, UBS sees an improvement in trading for JB Hi-Fi going forward as the market becomes more rational.

RBS Australia agrees, the broker seeing 2H12 as the low points for JB Hi-Fi's earnings this cycle. While issues at Dick Smith suggest some scope for protracted margin pressures, resolution of these issues are expected as a longer-term positive for market share for both JB Hi-Fi and Harvey Norman. 

To reflect this, RBS has factored in a partial recovery in margins in FY13. This means changes to estimates based on the update of earnings guidance are more severe in FY12 than in FY13, with RBS lowering its numbers by 13% and 8% respectively.

JP Morgan has been more severe and cut estimates by 13%, 24% and 25% respectively for FY12-FY14, while Macquarie's numbers have been cut 11%, 19% and 20%. Consensus earnings per share (EPS) estimates for JB Hi-Fi according to the FNArena database now stand at 108.4c for FY12 and 111.4c for FY13, which compares to the 123.9c achieved in FY11.

Price targets have been lowered in accordance with changes to earnings forecasts, BA Merrill Lynch lowering its target to $10.50 from $13.00, UBS to $9.55 from $13.10 and Citi to $10.80 from $12.50. The consensus price target for JB Hi-Fi according to the database is now $11.68, down from $13.00 prior to the update.

Despite the cuts to earnings and price targets ratings for JB Hi-Fi are unchanged, the database showing two Buy recommendations, four Holds and two Sell ratings. Arguing the Buy case is Macquarie, who notes while trading conditions are tough at present JB Hi-Hi is well capitalised, generates enough cash flow to cover dividends and industry consolidation appears to be at a tipping point.

Macquarie sees value in the stock at current levels, as does RBS. The key for RBS remains an improvement in gross profit margins, something the broker expects as disruptions such as store disclosures and inventory clearance pass through the market.

Among those on the Neutral side of the ledger is UBS, as while current issues are regarded as cyclical any significant improvement is likely to take some time as key drivers will be further industry consolidation and more rational pricing behaviour. This lack of earnings visibility suggests the stock is fairly priced in the broker's view.

While industry consolidation will likely be beneficial to JB Hi-Fi, JP Morgan doesn't see it as enough on its own to justify more than an Underweight rating on the stock. In the broker's view positive company specific measures won't be enough to outweigh the earnings pressures of poor consumer and industry positions, which limits the scope for share price outperformance. 

Shares in JB Hi-Fi today are weaker today despite a stronger overall market and as at 1.00pm the stock was 24c lower at $9.80. This compares to a trading range over the past year of $9.74 to $19.52, the current share price implying upside of around 20% relative to the consensus price target in the FNArena database.

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