25743 Corporate Financial Analysis – Assignment 1

Recommendation Report:
JB Hi-FI (JBH.AX) – Consumer Discretionary

Name | Student ID | Lecturer Name | Lecture Time | Question | Nathan (Fortunato) Foti | 11049614 | Lorenzo Casavecchia | 6PM | 1 | Agnes Ho | 10427514 | Lorenzo Casavecchia | 6PM | 2 | Carrie (Shuhan) Chen | 11624261 | Lorenzo Casavecchia | 6PM | 3 | Nhan Doan Chi | 11814668 | Lorenzo Casavecchia | 12PM | 4 | Han Han | 11862618 | Lorenzo Casavecchia | 6PM | 5 |

Table of Contents

1. Executive Summary 3 2. Industry Analysis 4 2.1. Competitive Forces 4 2.2. Industry Life Cycle 5 2.3. Potential Investment Risks 5 3. Ratio Analysis 6 3.1. Profitability 6 3.2. Liquidity 6 4. Earnings Management 7 5. Relative Valuation Analysis 8 6. References 9 7. Appendix 10 7.1. Profitability Ratios 10

1. Executive Summary
This report aims to provide insight into JB Hi-Fi and covers an analysis of the Industry, Ratios, Earnings Management and Market Pricing.
JB Hi-Fi Pty Ltd (JB Hi-Fi) can be classified to operate in various industries including online video games, video game and recorded music retailing, domestic appliance retailing, computer software retailing, online camera and camcorders. Their main competitors are Harvey Norman, Good Guys, and EB Games. From the report, the key competitive forces are highlighted and the potential risks of investing in the company are listed.
The ratios covered in this report focuses primarily on the profitability and liquidity of the company. Through the relative valuation, it is identified that the company is over-valued in comparison to its peers.

2. Industry Analysis 2.1. Competitive Forces
Threat of new entrants - Low

Due to dominating market share of existing companies in this industry, the likelihood of new entrants in the market is low. Establishing relationships and changing consumer behaviour would be quite difficult due to the current players brand loyalty and reputations as well as brand awareness amongst consumers. The current participants tend to possess large economies of scales therefore are able to lower their prices to a level where they can force new entrants out of the market. As the threat of new entrants is low this will increase the profit margins of the existing companies as they are still able to reap the benefits of economies of scales, market share and as their prices become more competitive this will allow them to increase profits.
Rivalry amongst existing competitors – High
The products being offered are undifferentiated and perishable. To gain the largest market share, the companies will enter into a price war as customers “shop around” to find the best possible price or product. This can be in the form of competitive prices, customer loyalty, and customer service. As such, it is essential to gain a competitive advantage and JB Hi-Fi does this through reduced prices.
Threat of Substitute Products and Services – Low
As technology and globalisation continues to increase this allows customers to find alternate sources of entertainment access to new products from international companies. For example, increase in gaming applications for smartphones provides an alternate source of entertainment which could affect the market for PC and console games. These competitive changes could put a constraint on industry profits as companies would need to focus on the physical selling of these products. There has also been an increase in accessing products online where customers are finding alternate sources which may have lower prices and as such, won’t feel the need to physically go to the stores and purchase the products.
Bargaining power of supplies – High
The prices of which the above companies sell their products is greatly affected by the prices set by the companies supplying these products. For example Microsoft, Kodak, Samsung, Sony and Apple operate in various industries across the world and due to their size they are able to set prices at their will. If this is the case customers will once again be able to search around for the best possible prices. This can affect industry profits as they then pass on these costs increases in their own prices.
Bargaining power of buyers – Low
The consumer discretionary industry is characterised by undifferentiated products and due to the premium pricing of some product ranges customers will become quite price sensitive therefore forces industry participants to face off with one another as they try and retain their market share. This may cut into their profits although will enable them to become competitive through the success marketing and advertisements and the service they provide to customers. Customers are unable to produce the goods themselves which don’t give them high bargaining power therefore they will continue to seek out the best possible price.
Business Strategy
JB HI FI’s business strategy is to provide an extensive product range, low prices, encourage new products and technology. They encourage innovation and diversification with new products, technology, merchandising formats, advertising and property locations in a responsible manner. As such, allows the company to increase revenue, profit margins and productivity. 2.2. Industry Life Cycle
JB Hi-Fi is in the mature phase of the industry life cycle. Over the years it has been generating relatively consistent profits despite operating in a competitive market and maintaining profits through its business model of low margins with high sales volume. It’s position in the market and its growth is in part driven by the expansion of new technologies (e.g. gaming consoles), acquisition of Clive Anthony’s and expansion into the electrical and home goods industry.
The industry has matured over the years with the exit of WOW Sight and Sound and Retravision from the consumer discretionary industry. The maturity in the industry highlights that growth of the company is achieved primarily through acquisitions and a focus on other income generating products and services amongst lowering costs and further increasing market share through new stores. It faces heavy competition with other retailers such as Harvey Norman and Dick Smith, which in turn leads to price erosion; impacting on the profit margins even further.
While there are high barriers to entry, its profits and growth could also be hindered by the state of the economy. The consumer discretionary industry is classified as a cyclical industry where consumers are likely to hold off purchasing discretionary items due to reduced disposable income. This may impact their ability to generate satisfactory profits as they have little to begin with. 2.3. Potential Investment Risks
Investing in JB Hi-Fi Pty Ltd has potential risks. These can be seen below: * A continued risk for the company remains its business model as it heavily relies on generating profit with a high volume of sales. Price matching, discounting and promotions would also reduce profit margins despite making more sales. If sales do not meet their forecast, they could run the risk of losing profits. * An increased accessibility to the internet and availability of entertainment, games, movies, TV shows and etc, via the internet creates a smaller market and weakened demand for traditional gaming consoles, media formats (DVDs, CDs) and software to be purchased in hard copy, thereby diminishing JB Hi Fi’s revenue from these sources. As technology continues to improve, the company’s ability to sell these products will also become increasingly difficult. * There is an increasing shift of focus for consumers to purchase goods online as there is often a lot more variety of products and sellers. To compete, JB Hi-Fi would need to ensure that their online prices are still competitive when compared to other sources. * Aggressive increase in stores could decrease the profit margins as it would require more investment and increased labour. While they have been converting some of their stores to include their electrical and whitegoods, it has yet to be seen whether they will be profitable in the long run.

3. Ratio Analysis 3.1. Profitability
In order to estimate JB HI-FI’s profitability ratio compared relatively to its industry peers, four comparable companies were chosen. Market capitalisation and companies’ business model were the main characteristics used to find the industry’s existing competitors. The four companies are Harvey Norman Limited (HVN), GUD Holdings Limited (GUD), Woolworth Limited (WOW) and Myer Holdings Limited (MYR).
Return on Sales (ROS) is calculated to measure how much the company is profiting from its sales. This ratio can vary with business cycle, thus, companies with similar business cycles were chosen. The following table illustrates the six year historical trend for each peer company: Company | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | Avg 6 yrs | JBH AT | 4.0579 | 4.3441 | 3.7068 | 3.3455 | 3.5178 | 3.6845 | 3.7761 | HVN AT | 10.5661 | 12.5228 | 9.4912 | 8.5764 | 9.1913 | 9.0690 | 9.9028 | GUD AT | 7.4307 | 9.7658 | 8.2592 | 7.2980 | 6.5588 | 5.2397 | 7.4254 | WOW AT | 3.7426 | 3.9254 | 4.0131 | 4.9477 | 4.0072 | 4.0333 | 4.1116 | MYR AT | 3.1853 | 5.5836 | 5.8556 | 5.1713 | 4.8248 | 3.5951 | 4.7026 |
Table [ 1 ]: ROS (%)
None of the companies has a high ROS, and that is due to the industry they are operating in. When the industry is particularly competitive, companies tend to decrease their ROS to maintain their market capitalisation. On average, HVN has a reasonably high ROS compared to its main competitors while JB Hi-FI has the lowest average at 3.77%.
In comparing the profitability ratio across these companies, JB Hi-Fi still retains the lowest ratios while Harvey Norman has the highest ratios. This highlights the difference in the strategies of these companies and how they choose to compete in the market. JB Hi-Fi’s profitability ratios typically highlight the drive for low prices with a high volume of sales to counteract the drop in profit margins. (See Appendix 7.1) 3.2. Liquidity Liquidity Ratios | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | Current Ratio | 1.3167 | 1.2516 | 1.4484 | 1.2152 | 1.2741 | 1.6416 | Quick Ratio | 0.3142 | 0.3298 | 0.2721 | 0.2407 | 0.3112 | 0.3394 |
The current ratio is used to test a company’s liquidity by deriving the proportion of current assets available to cover current liabilities. The higher the current ratio it indicates the company has more short terms assets and is readily available to pay off its short- term liabilities. Although the current ratio in 2014 is 1.64, which means it has current assets of $1.64 for every $1 of current liabilities. It indicates that JB HI-FI might have a liquidity issue after paying all its financial commitments.
The quick ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets that are to cover current liabilities. It is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. The Quick ratio in JB Hi-Fi is very low which indicates the company is relying too much on its inventories. The Quick Ratio indicates that the company is heavily relied on its inventories, it is very likely that JB HI-FI have a liquidity problem as inventories are difficult to turn into cash. 4. Earnings Management
In determining the level of accruals of the company, we firstly attempted the simple methods including accruals ratio based on Balance sheet approach, which is based on these formulas below: As a result, we have obtained accruals ratio from 2010 to 2014 as in Table 1 below: Accruals Ratio = Δ (NOA)/AVG(NOA) | 20109.55% | 201113.89% | 2012-19.34% | 20132.09% | 201435.55% |

Additionally, we also examined accruals amount by the Cash flow approach by using this formula: Accruals = Net Income - CFO - CFI
After that, we calculate the accruals ratio by dividing accruals amount by the average net operating assets. The result is show in table 2 below: Accruals/AVG(NOA) | 20107.52% | 201113.06% | 2012-20.1% | 2013-0.58% | 201434.24% |

As we can see in the Balance sheet and Cash flow chart, over the past years JB HIFI has experience fluctuated accruals with the peak at 2014. In 2012 and 2013, JB HIFI experiences negative Accruals ratio and nearly zero accruals ratio respectively. The decrease in long term borrowings and increase in amount of cash and short term marketable securities attributes to these accruals ratio figure. It started to rise again in 2013 partly due to the increase in long term borrowings influencing the amount of accruals.

While it is important to analyse Accruals ratio between periods, it is even more crucial to understand what can be improved from management point of view.
According to Jones (1991), Dechow, Sloan and Sweeney (1995), Rangan (198), Teoh et al. (1998a) and Teoh et al (1998b), the Jones model is able to decompose accruals into non-discretionary and discretionary parts. This ensures the discretionary accruals have more attention and can be managed accordingly while non-discretionary accruals should not be focused heavily due to market conditions.
However, standard Jones model is considered as less accurate in comparison to Modified Jones model, because of the error of discretionary accruals when discretion is applied over sale.
Therefore, while we examined both Accruals ratio by using Jones model and Modified Jones model, we decide to use the Modified Jones model as the best method to measure and interpret earning management quality since it is the most powerful test of earning management.
By using the alpha provided, we calculate the total assets divided by average total assets, this represents total accruals of JB HIFI. Secondly, to find the non-discretionary components, we multiple each alpha with its counterparts following this formula. Result is illustrated in the table 3 below: Modified Jones model’s discretionary | α1*Intercept | | -0.01624 | | | α2*(1/ATA)0.011228 | α3*(ΔREV- ΔAR)/ATA0.009279 | α4 * PPE/ATA-0.01678 | TA/ATA0.112513 | Discretionary12.50% | Jones model’s discretionary | α1*Intercept | -0.01684 | | α2*(1/ATA)0.010637 | α3*ΔREV/ATA0.013796 | α4 * PPE/ATA-0.01636 | TA/ATA0.112513 | Discretionary12.13% |

From the table, we can conclude that the positive discretionary ratio indicating income-increasing earnings management such as “understanding of bad debts and understanding of write-offs”. Especially, the cash and marketable securities of financial year 2014 have seen a dramatic decrease of 1.5 times in comparison to 2013 level. Depreciation amortisation seems to consistently increase while total assets rise insignificantly.
In comparison to industry average, JB HIFI has a discretionary component that is much more formidable than the industrial average. Furthermore, its discretionary rate of 12.50% also exceeds the consumer discretionary 95th percentile of 7%. Additionally, JB HIFI discretionary accruals approximately equals S&P/ASX200 95th average. These comparisons indicate JB HIFI certainly has some earning managements practice in place. The gradual increase in revenues may partly be explained as JB HIFI has exercised income smoothing practices.
Another reason that can clarify the wide gap between company’s discretionary ratio and industry average is that JB HIFI position itself as market leader. Besides, it is a unique business that does not have any similar competitors within the country making it far more difficult to find a fittest category to compare.

In summary, due to positive earning managements and above average accruals ratio comparing with ASX200, JB HIFI has raised doubt in its revenue’s growth. Thus, while JB HIFI’s revenue growth seems to be gradual and stable, investors should consider the level of discretionary accruals as it may contribute to unsustainable growth in the future.

5. Relative Valuation Analysis
In evaluating the relative valuation, three multiples were analysed to price JB Hi-Fi. This included EV/EBITDA, P/E and P/BV. These three multiples are very popular to pricing and it has been used to calculate the average price in order to obtain a better idea about the expected market value of JB Hi-Fi.
In this analysis, we looked at similar and comparable global peer companies which have similar growth rates and return on capital to JB Hi-Fi.
The dividend payout ratio was used to calculate growth rate since 2009 to 2014:

Based on JB Hi-Fi’s average 5 years growth rate 6.32%, three similar global companies were identified and these include HARVEY NORMAN HOLDINGS LTD (5.83%), LOTTE HIMART CO LTD (6.27%) and K'S HOLDINGS CORP (7.36%).
The Return on capital was also calculated and based on 2009 to 2014:

Based on JB Hi-Fi’s average ROC, K'S HOLDINGS CORP (ROC: 6.87%) was chosen as the target comparable company. JB Hi-Fi’s expected price was then calculated using the three relative multiples and the most recent 2014 data.

Comparably speaking, $10.44 is JB Hi-Fi’s expected share price. This is relatively lower than the market price which can be seen today at roughly $18.40. This indicates that the stock is significantly over-valued and is not worth as much from a relative value. However, if we look at comparable firms, it can be deduced that based on the Price to Earnings ratio, JB Hi-Fi is only slightly over valued in comparison to its peers. We can use this price as a guide to make an investment decision. However, there are other financial variables that could affect relative ratio.

6. References 1. Ma, W. 2014, ‘Amazon, Twitter, JB Hifi and Groupon may be worth billions but their profit margins are tiny’, News, viewed 27 March 2015, <http://www.news.com.au/finance/business/amazon-twitter-jb-hifi-and-groupon-may-be-worth-billions-but-their-profit-margins-are-tiny/story-fnda1bsz-1226988308293> 2. JB Hi-Fi Pty Ltd 2015, ‘2014 Full Yea Results’, viewed 27 March 2015, <https://www.jbhifi.com.au/Documents/Announcements/Company%20Announcement%20-%202014%20Full%20Year%20Results.pdf> 3. IBISWorld 2015, ‘IBISWorld Industry Report G4221a: Domestic Applicant Retailing in Australia’, viewed 27 March 2015, < http://clients1.ibisworld.com.au.ezproxy.lib.uts.edu.au/reports/au/industry/default.aspx?entid=1838> 4. IBISWorld 2015, ‘IBISWorld Industry Report OD4189: Online Video Game Sales in Australia’, viewed 27 March 2015, < http://clients1.ibisworld.com.au.ezproxy.lib.uts.edu.au/reports/au/industry/default.aspx?entid=4189> 5. IBISWorld 2015, ‘IBISWorld Industry Report G4242: Video Game and Recorded Music Retailing in Australia’, viewed 27 March 2015, < http://clients1.ibisworld.com.au.ezproxy.lib.uts.edu.au/reports/au/industry/default.aspx?entid=415> 6. IBISWorld 2015, ‘IBISWorld Industry Report OD4171: Online Computer Software Sales in Australia’, viewed 27 March 2015, < http://clients1.ibisworld.com.au.ezproxy.lib.uts.edu.au/reports/au/industry/default.aspx?entid=4171> 7. IBISWorld 2015, ‘IBISWorld Industry Report G4222: Computer and Software Retailing in Australia’, viewed 27 March 2015, < http://clients1.ibisworld.com.au.ezproxy.lib.uts.edu.au/reports/au/industry/default.aspx?entid=1836> 8. Islam, Md. Aminul, Ruhani Ali, and Zamri Ahmad. 2011, 'Is Modified Jones Model Effective In Detecting Earnings Management? Evidence From A Developing Economy', International Journal of Economics and Finance, Issue 3.2 (2011)

7. Appendix 7.1. Profitability Ratios Gross Profit Margin | | | | | | Company | 2010 | 2011 | 2012 | 2013 | 2014 | JBH AT | 0.22 | 0.22 | 0.21 | 0.22 | 0.22 | HVN AT | 0.59 | 0.56 | 0.56 | 0.58 | 0.56 | GUD AT | 0.43 | 0.40 | 0.40 | 0.38 | 0.37 | WOW AT | 0.26 | 0.26 | 0.26 | 0.27 | 0.27 | MYR AT | 0.43 | 0.44 | 0.46 | 0.47 | 0.47 | | | | | | | | Operating Profit Margin | | | | | | | Company | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | JBH AT | 6.1 | 6.41 | 6.62 | 5.16 | 5.37 | 5.49 | HVN AT | 17.19 | 19.7 | 15.1 | 12.45 | 12.65 | 13.98 | GUD AT | 12.98 | 15.08 | 13 | 13.88 | 9.46 | 8.29 | WOW AT | 5.73 | 5.97 | 6.13 | 7.07 | 6.36 | 6.21 | MYR AT | 7.35 | 9.23 | 9.27 | 8.44 | 7.93 | 5.85 | | | | | | | | EBIT Margin | | | | | | | Company | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | JBH AT | 6.1 | 6.41 | 6.62 | 5.16 | 5.37 | 5.49 | HVN AT | 17.19 | 19.7 | 15.1 | 12.45 | 12.65 | 13.98 | GUD AT | 12.98 | 15.08 | 13 | 13.88 | 9.46 | 8.29 | WOW AT | 5.73 | 5.97 | 6.13 | 7.07 | 6.36 | 6.21 | MYR AT | 7.35 | 9.23 | 9.27 | 8.44 | 7.93 | 5.85 | | | | | | | | EBITDA Margin | | | | | | | Company | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | JBH AT | 6.91 | 7.26 | 7.54 | 6.15 | 6.38 | 6.51 | HVN AT | 20.95 | 23.2 | 18.61 | 16.19 | 16.65 | 17.17 | GUD AT | 15.23 | 17.37 | 15.34 | 16.13 | 11.83 | 10.72 | WOW AT | 7.2 | 7.5 | 7.72 | 8.66 | 8.01 | 7.84 | MYR AT | 9.34 | 11.46 | 12.12 | 11.44 | 11.21 | 9.07 |