JB Hi-Fi's rally conceals a complex reality

I DON'T look at things in the same way as the rest of the market and as a result I often reach vastly different conclusions.

I DON'T look at things in the same way as the rest of the market and as a result I often reach vastly different conclusions.

Being different doesn't bother me, especially when the rest of the market is looking at negative returns.

The reaction to JB Hi-Fi's full-year results earlier this week was another example and the subsequent rally in the share price reflected a conclusion that was the opposite to mine.

The market often takes a macro-economic, or top-down, view and it is our belief that retail stocks will eventually benefit from a cyclical turnaround.

This turnaround, combined with lower debt and cheap interest rates, will also encourage mergers and acquisitions.

But for long-term value investors it is essential to look at the business itself.

JB Hi-Fi reported an uptick in sales but that was not enough to earn volume-based discounts from suppliers, so the profit margin shrank. The company also reported market share gains - although you would expect that when your competitors are going broke - but the competition that remained was still selling products at cheaper prices and pressuring margins.

The company was relatively upbeat about its competitive position but the founder and former chief executive has sold most, if not all, of his shares in the past few years.

More revealing to us was that the cashflow appeared to have been boosted by a substantial $100 million increase in payables. In other words, JB Hi-Fi held off paying its suppliers just a little longer.

Then there was the matter of earnings per share declining by a significant 13.7 per cent to a normalised $1.07 a share, lower than last year's or 2010's profits, despite a rather large share buyback last year.

Most important to us is the fact now, despite an attractive discount to our estimate of intrinsic value, the company's prospects are clouded by the maturing business and structural challenges.

Our valuation program, Skaffold.com, reveals flat to declining intrinsic value in the future as well as falling returns on equity.

The quantitative factors that would lead us to invest are not in place, but neither are the qualitative factors. My team has spent some time internet shopping this week to work out how JB Hi-Fi's low pricing promise is being maintained relative to the online competition.

Our key observations were that JB Hi-Fi's website does not impress relative to the alternatives.

Aside from the fact the brand personality seems a bit nasty and the range limited (especially relative to US peers), the prices are not the lowest.

Compared with Australian retailers JB Hi-Fi has very competitive pricing on Apple iPods.

Indeed, it are reasonably competitive with US retailers.

But on other products it is 10-20 per cent higher in price, with the exception being headphones, a category in which the competition appears fairly thin in Australia, so JB Hi-Fi is taking advantage of that.

Compared with US retailers, JB Hi-Fi appears to be 20-50 per cent more expensive, and especially expensive on headphones and televisions, which are too expensive for consumers to have shipped from overseas.

So where it can, JB Hi-Fi charges more, but these categories are open to increasing competition, disloyal customers and continued price deflation.

JB Hi-Fi's claims of being able to match it with Amazon on cost of doing business don't appear to be reflected in our findings.

Its cost of doing business appears to benefit from higher prices that may not be sustainable and, given the Australian-US pricing differentials, it appears there is scope for further price deflation in Australia.

Roger Montgomery is the founder of Montgomery Investment Management and the author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com.