structural decline or ready to rebound?

Hi guys

I remember this one when it listed a while back as Fone Zone. I hadn't looked at it for years but i saw it mentioned the other day so thought i'd revisit. It has a few things going for it on the qualitative side (high management ownership, reasonably honest and competent management, seemingly good relationships with its suppliers Telstra and Apple, shareholder-friendly behaviour i.e. not issuing shares), so let's look at the quantitative aspects.

The first thing that jumps out at me is their declining EBITDA & EBIT margins over time. From 2007, their EBITDA and EBIT margins have tracked as follows:
- EBIT: 5.7%, 4.0%, 2.8%, 4.0%, 2.9%, and 1.7%.
- EBITDA: 8.6%, 6.1%, 4.8%, 6.0%, 4.8%, and 4.1%.

When i see margin decline like that over time, i get worried. At its core, a business's ability to generate value for shareholders is via its ability to either expand EBIT margins over time, or generate more sales per dollar of assets (i.e. lift asset turnover). If one side of the value creation equation (margins, in this case) is being compromised, i get concerned immediately. I know this business has gone through a heavily regenerative phase over the last few years as they've rebranded and refreshed a lot of their stores, but to own this business, you have to believe that this is going to pay off in a big way (i.e. margins are going to rebound). At the moment, the benefits of their store regeneration and repositioning aren't showing up in the numbers at all - there is no like-for-like sales growth at all and in some cases there is like-for-like sales shrinkage, and as certain expenses (leases, marketing & employee expenses) tend to grow with inflation, this is worrying. If they can't grow like-for-like sales at inflation or more (which is what their cost base is essentially growing at), then margins almost certainly can't meaningfully improve - you can't sack the sales staff, renege on lease payments or meaningfully reduce back office staff in this business.

So, what's going on with their margins? Well, the decline is mostly in their gross margin - that is, the spread between what they buy and sell their products at. Since 2008, it has declined from 35.4% to 32.6%. That's a worrying trend as it suggests their ability to apply a wholesale mark-up is declining - the same thing is happening at JB Hi Fi, and in a business that's all about margin, a 50-100bps decline in gross margins is a concern. They're managing their operating costs pretty well aside from that - total operating costs (i.e. sales, marketing, employee, occupancy and depreciation) has declined from 34% to 32.9% of sales since 2008. The margin decline is mostly in their computing business, and this is what they're trying to revitalise via the Apple reseller store roll-out.

So, that brings me to the crux of the isssue: is this decline in margins a structural one which won't be reversed (i.e. is their business being eaten by the internet, has sales power reverted to the wholesalers/suppliers etc.), or will their margins spring back in a year or two on the back of their store refreshment, the Apple stores trading to expectation, and having closed their unprofitable stores? If you believe the former, then this business is not cheap at all and is probably expensive, because regardless of their ability to grow sales, they'd be doing so at ever reducing margins and will be locked in a cycle of having to constantly spend to refresh their stores just to maintain sales. If you believe the latter (i.e. they can get their EBIT margin up to perhaps 3-4% and their long-term capex is roughly 2% of sales), then it's probably not a bad bet.

So, i'll throw it out there: where do people think the margins on this business are likely to be in a year or two's time? The Apple store is an interesting concept - they are entirely tied to the performance of Apple products which are beyond their control, so if Apple release a few dud products or good products continue coming from competitors like Samsung, Google, Microsoft and Nokia, sales in this division will struggle. The good part of this arrangement is that Apple fund part of the capex VTG put into the stores, so Apple are incentivised to not cannibalise the VTG store's sales by opening up their own store next door. In a way, it's a shame they didn't think of this Apple concept 5-6 years ago, as it would've done phenomenally well, but whether it will do as well in the next 5 years is harder to say - there's no doubt Apple are facing increased competition in their core products segments (i.e. tablets, phones, computers).

Cheers