Will Dick Smith Infect Electronics Retailing?

This story features JB HI-FI LIMITED, and other companies. For more info SHARE ANALYSIS: JBH

-Contagion likely to be limited
-Segment margins could be squeezed
-Long-term may benefit JBH, HVN
 

By Eva Brocklehurst

Dick Smith ((DSH)) has a problem, a serious problem. The company has such a substantial inventory overhang, to the tune of $60m, that it will weigh heavily on sales growth over Christmas.

The share price has been trounced and brokers have downgraded targets substantially. Deutsche Bank has reduced its target to 30c from $1.00 and Macquarie to 50c from $1.00.

While the majority of the company's inventory write-down is private label this is not altogether the case and Macquarie suspects further impairment may be required, dependent on how Christmas trading fares.

The company has backed away from prior earnings guidance, without providing any detail, and remains intent on reducing inventory and debt levels ahead of profits. The relative size of the current provision, versus the inventory held at the end of June, is a surprise and Macquarie considers this a poor reflection on underlying value and profitability.

The issue raises doubts about the outlook for the brand and the broker expects the stock to trade at a large discount until its cash position is stabilised, and it can again show stable sales growth and margins.

Credit Suisse notes the balance sheet is starting to look strained. The broker estimates the company has two key covenants. One is gross debt/earnings of 2.5 times which would require, using total debt of $70.5m in FY16, at least $28.2m earnings to avoid a breach.

Assuming the facility was fully drawn to $135m, this would require earnings of $54m. A free cash cover covenant of 1.3 times requires a minimum of $35m in earnings on Credit Suisse's FY16 estimates.

The broker believes there is more downside risk in the short term, amid a host of potential negatives including loss of supplier support, such as access to new product releases or adverse changes to creditor terms, and cannibalisation of higher margin sales with significantly discounted products.

There is also the risk of an aggressive competitor response over Christmas. Several brokers have looked at how the news reflects on competitors JB Hi-Fi ((JBH)) and Harvey Norman ((HVN)).

UBS considers JB Hi-Fi more exposed to the step-up in Dick Smith's promotional activity but suspects the impact will still be limited. While an irrational competitor does produce a sales risk – as was the case in 2011/12 – this issue is of Dick Smith's making and is occurring in a relatively robust retail environment, which reflects on the strength of JB Hi-Fi and Harvey Norman brands, in the broker's opinion.

UBS estimates there is a 66% overlap with JB Hi-Fi sales and 35% with Harvey Norman. JB Hi-FI has a much greater exposure than Harvey Norman via overlap of store locations. Hence, UBS believes, over time, there is a significant opportunity to take share from Dick Smith and upgrades JB Hi-Fi's rating to Buy from Neutral. The broker retains a Buy rating on Harvey Norman.

Citi is of a similar view, upgrading JB Hi-Fi to Neutral from Sell. There may be no new iPhone to boost sales this Christmas but JB Hi-Fi's recent share price fall is sufficiently pricing in any concerns, in the broker's view.

JB Hi-Fi is likely to suffer some collateral damage, Deutsche Bank maintains but, in the long term, the pressure on Dick Smith could be positive, in that it may prompt substantial store closures to the benefit of JB Hi-Fi's market share.

Deutsche Bank suspected for some time that Dick Smith had an inventory problem but the size is a surprise. The broker is also reminded of 2011-12 when the failure of Woolworths' ((WOW)) Sight & Sound and closure of 70 Dick Smith stores, by then-owner Woolworths, drove significant industry margin pressure.

Deutsche Bank reduces forecasts for Dick Smith earnings by 40% for FY16 and 60% for FY17. The broker refrains from downgrading to Sell, retaining a Hold rating, but acknowledges the future of the business is hard to predict. Moreover, while the private label accessories discounting may not have an impact on JB Hi-Fi, these will be difficult items to clear.

What the broker fears most is that Dick Smith will be forced to discount branded hardware too, in an effort to attract shoppers, and this could force JB Hi-Fi to follow suit. Deutsche Bank does not adjust sales estimates for JB Hi-Fi, but does reduce gross margin estimates.

In 2011/12 both JB Hi-Fi and Harvey Norman margins were affected as a result of their competitor's inventory clearance and the closure of stores. Still, Harvey Norman is not expected to be affected this time around as its growth is in homemaker categories and its stores are less reliant on electronics/IT retailing.

FNArena's database has two Hold (Macquarie, Deutsche Bank) and one Sell (Credit Suisse) for Dick Smith. The consensus target is 37c, signalling 7.2% upside to the last share price. The dividend yield on FY16 forecasts is 18.3% with 9.6% for FY17.

JB Hi-Fi has one Buy (UBS) and seven Hold. The consensus target is $19.86, signalling 11% upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 5.2% and 5.5% respectively. Harvey Norman has three Buy and three Sell ratings. The consensus target is $4.34, suggesting 11.5% upside to the last share price. The dividend yield on FY16 and FY17 is 5.8% and 5.7% respectively.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms