Playing with bricks and mortar

The secular shift of retail dollars from bricks-and-mortar to online and the ensuing carnage has been really the only story in bricks-and-mortar retailing over the past two decades. It’s a well-worn narrative but difficult to dispute at this point in time.

However, what if I were to tell you that one could have invested money into a bricks-and-mortar retailer while this narrative was playing out and still made a 20%+ compounded annual return over 14 years?

An investment manager delivering anywher near these type of returns over such time horizon would be considered legendary. Yet this was exactly what JB Hifi (“JBH”) delivered for its IPO investors against the aforementioned headwinds.

Bricks-and-mortar on the offensive

Before the days of e-commerce, owning a successful specialty retail store meant you controlled the distribution of certain goods to a captive population. Because of market size constraints, it is typically irrational for competitors to enter the market against an established incumbent. Thus specialty retail tend to converge towards local monopolies or oligopolies and can often achieve high ROICs on initial invested capital. The catch though is that the very geographic constraints that protects the store from open competition also inhibit its scalability.

The magic happens when the retailer “strikes” a successful retail formula that is unique or novel enough to be replicated into new geographies against incumbents (or where there are no incumbents). The retailer now possesses the ability to redeploy profits from its existing store(s) into the creation of new stores at a similarly high ROIC. It is no longer a retail store but a powerful reinvestment machine with a pipeline of high ROIC investment opportunities.

And as the retailer grows its store footprint, it also gains various scale benefits such as lower average overhead costs, better supplier terms etc. This culminates in an extraordinarily powerful virtuous cycle.

While the machine is in full swing, the retailer can make many mistakes along the way and still grow its earnings at a tremendous pace due to the favourable reinvestment dynamics. Being on the offensive is where the real money is made in bricks-and-mortar retailing.

Game’s the same, just got more fierce

The advent of the internet has drastically altered the characteristics of moats in brick-and-mortar retail. Consumers can (and are) now simply stepping over these moats with often just a single click. Just as important, demand for products is increasingly generated elsewhere and no longer at the retail store front.

An obvious case study is Godfreys, a category specialist in vacuum cleaners that somehow “missed” consumer trends towards stick vacuums while refusing to stock Dyson’s category killing product range. It continued to operate under the belief that itself, as the middle man, was more important to the consumer than the products themselves. Thirty years ago this very MO may have driven Dyson out of the market. Today the same MO simply made Godfreys a cautionary tale.

As put forward in my Flight Centre note, a bricks-and-mortar retailer can be surprisingly competitive against its online competitors if its fixed customer acquisition costs (generally rent + employee costs) were sufficiently low relative to the variable customer acquisition costs of the hyper-competitive online world.

Under these lens, the key for a bricks-and-mortar retailer to remain competitive is to possess an edge that translates into the retailer getting more out of its fixed customer acquisition costs. For example, many vertically integrated bricks-and-mortar retailers (e.g. Apple Stores) have continued to thrive because they are able to generate organic product demand from elsewhere translating into higher levels of customer foot traffic given the same fixed customer acquisition costs.

On the other hand, bricks-and-mortar retailers that cannot get more out their fixed customer acquisition cost will continue their extended secular decline. Large format department stores are perhaps the best example of this – where they can neither generate organic product demand nor do they operate the type of store foot prints that can be readily optimised for more efficient foot traffic conversion.

Increasingly, these retailers take on the characteristics of a commoditised intermediary that simply stand between consumers and the goods they desire. And as product cycles and consumer trends continue to accelerate, the trade is increasingly volatile. Although one may do a good trade here and there under certain operating environments, success is often fleeting. As a commoditised intermediary, you are often one bad trade away from humility. Observe how long most “retail turnarounds” actually last. Myer’s new CEO has been touted to have “led the successful transformation at UK department store House of Fraser”. It is interesting then to see how its new owners have fared since.

The prevalence of the phrase “unseasonably cold / hot weather” in recent announcements from listed retailers may very well be sufficient to “turn” even the most ardent of climate change deniers!

Bricks-and-mortar on the defensive

In any trade where the operating environment is volatile, staying nimble and keeping your cost structure lean is key for longevity. This is however difficult in bricks-and-mortar retailing due to its predominantly fixed cost base.

The high ROICs achievable in bricks-and-mortar retail is partly because the key asset required to operate a retail store, the property, is typically not owned by the retailer. Therefore, the value of the most important asset utilised is not included in the denominator (yes, there is a corresponding reduction in your numerator due to rental expenses paid – but the nuance here is that property investors typically demand a much lower ROIC). This of course is perfectly logical when your intent is to operate the store until the end of the lease commitment (if not in perpetuity).

As an aside, with the introduction of IFRS 16 in 2019, lease commitments will need to be brought onto Balance Sheet with a matching right of use asset. This will likely bring to light the real asset intensity of retail businesses.

Where it becomes interesting is when a retailer needs to recalibrate its cost structure in response to a changing operating environment. It is very difficult to shrink or optimise a retail store footprint as off-balance sheet lease commitments immediately turn into on-balance sheet liabilities should one attempt to exit leases prior to their expiry.

In other words, a store rollout in reversal is extraordinarily painful. Being on the defensive in bricks-and-mortar retailing is not where you want to be.

JB Hifi on the offensive

Although JB Hifi was founded way back in 1974, it really “grew up” in the 2000s during the age of the e-commerce. It has always recognised its role as a middle man between consumers and the goods that they desire and has masterfully navigated its product range from one high growth category to the next high growth category. What it sells today is almost unrecognisable from what it sold just 14 years ago at IPO:

JBH is the example used by the Private Equity industry to prove that there was once a time when IPO investors didn’t get done buying shares from a Private Equity vendor. The key here was that the vendors left behind a substantial store rollout path for IPO investors (JBH listed with only 26 stores). So not only did investors acquire a profitable retail chain, they also acquire a long pipeline of proprietary high ROIC reinvestments opportunities (which has proven over time to be vastly more valuable). This is critical in understanding JBH’s phenomenal investment returns.

The fact that JBH generated $152m in NPAT in FY2016 utilising total original contributed equity of a mere $49m should be all you need to know about its compounded returns on capital.

However, JBH’s store growth trajectory appears to have reached a plateau (the magic number appears to be 214). JBH’s forays offshore and into home appliances have not proven successful with respect to yielding a new store rollout pathway. On the surface, JBH may look the same – i.e. an Australasian retail chain selling electronic products – but the underlying “machine” is now without a high ROIC reinvestment pipeline.

Nevertheless, as a market darling of growth investors, there are many structural forces acting upon you where you simply have no choice but to find a way to continue grow your revenue and earnings.

Offensive or defensive acquisition?

To nobody’s surprise, JBH was front of the queue when the opportunity for a company transforming acquisition in The Good Guys (“TGG”) came up. The market and analysts overwhelmingly approved of this acquisition. Headline transaction metrics looked good as each JBH share immediately gained 11.6% more earnings (i.e. it was EPS accretive). There were $20m of synergies to be extracted.

Make no mistake, JBH has proven itself to be a phenomenal world class retail operator with an industry leading low cost operating model. However, acquiring a mature retail store footprint (at a ROIC of c.8.5%) simply does not change the fact that JBH is currently without a high ROIC reinvestment pipeline which was crucial to its previous financial success. In fact as an economic entity it now carries a weaker balance sheet, significantly higher balance of non-cancellable operating lease commitments and contain many more moving pieces that could go wrong – all in exchange for a once-off earnings sugar hit.

Contrast this with a bricks-and-mortar retail acquisition that has proven to be truly “transformational” over time (although they may not have realised it at the time) – Just Group’s acquisition of Smiggle’s 18 store footprint in 2007 for $29m. Today Smiggle operates 332 stores and most importantly has continued to find store rollout pathways in new geographies. Smiggle now underwrites a very significant chunk of Premier Investments’ $2.5bn market valuation.

Figuring out whether JBH will deliver $15m or $20m of synergies from the TGG acquisition may make your financial modelling look more rigorous but it won’t make you real money over the long-run. Instead, focus on understanding the intricacies of what really drives the economics of a business – how the underlying “machine” really works – and you’ll not only make more money over the long run but also sleep much better at night.

Note: The above article constitutes the author’s personal opinion (“foreign shorter opinion”) and is for entertainment purposes only. Unlike professional broker research notes, this article is inherently biased. It should therefore not to be construed as financial advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. The author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this article. Disclosure – I hold a short position in JBH at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION. Any positions held by the author may, for example, be part of a pair trade or a hedging position so it is not informative in isolation).