upgraded to buy $21.95 target, page-3

Deutsche Bank:

Solid result, fairly valued
JB Hi-Fi underlined its resilient business model with a robust result in a difficult trading environment. Full year profit guidance was broadly in line with our expectations and consensus. We remain confident in the group's ability to deliver medium-term growth through new stores, category growth and cost leverage despite the deflationary pressures. However, trading on 15.5x FY11, we think that
the share price appropriately captures that growth potential. Hold

Weaker top-line, better margin and cost control
JBH reported 1H11 results in line with expectations with NPAT of $87.9m compared our expectation of $86.2m. While sales were marginally below our expectations, the group compensated for this with stronger margin and cost control than we were anticipating. The top-end of the full year guidance of $134m-$139m was largely in line with our expectations and consensus. Sales were significantly impacted by price deflation in flat panel TV?s and the weak performance of game consoles relative to the prior year.

More conservative view on 2H sales but improving trends expected

We have marginally reduced our forecasts by taking a more conservative view on 2H sales given the uncertain consumer environment and continued price deflation.

While our 2H sales growth (+14%) is an increase in the run rate on 1H (+8%), the comp base is significantly easier, there will be a benefit from the 13 new stores opened in 1H (and 5 to be opened in 2H) and selling prices on flat panel TV?s should begin to stabilize as we cycle the price reductions from last year.

Valuation/risk

We derive our JBH price target by growing our $19.00/share DCF at the cost of equity and subtracting forecast dividends. Our DCF incorporates a WACC of 10.7%, a RFR of 6.25%, an ERP of 6% and a perpetuity growth rate of 2%.

Risks

to our price target include a faster/ slower recovery in consumer spending, continued deflation in the audio-visual category and higher than expected cost increases.

Result summary
JBH delivered a robust result in a difficult environment. While the result may be overshadowed by Myer downgrading FY11 guidance on the same day, we believe it highlighted the resilience of the group?s business model despite some of the toughest industry conditions in a number of years and intense price competition in a number of
categories.

Sales were slightly below our expectations driven by negative comp stores sales in the half (-1.5%). However, this was offset by another half of strong gross profit improvement and flat cost of doing business as a percentage of sales. Combined this led to 38bps increase in the
EBIT margin and a respectable 14% growth in EBIT. The quality of the result was also strong given an increase in D&A of 18.6% given the continued store rollout programme and a strong increase in free cash flow.

While the dividend was higher than we anticipated, it reflected the reweighting of the dividend to an equal payout ratio in both halves (60%) rather than the traditional weighting to the second half. Management confirmed that this will result in a lower dividend in 2H11 than 1H11 although the payout will remain unchanged.

Outlook
The group noted that it is cycling a weak 2H10 sales result but still expected the second half to be challenging given the volatile consumer spending environment. The group also noted that it expected lower operating leverage given the strong GP performance in 2H10 and strong wage productivity.
Current trading in the first five weeks of 2H had been challenging but in line with 1H with comp store sales in Australia flat (1H11: -1.6%). We consider this performance to be relatively strong as JBH?s sales in early 2H10 were strong with the group cycling a base of 7.2% in January (before falling off rapidly over the remainder of the half). This feedback is consistent with a number of other retailers which have noted an improving trend over the last
few months and not consistent with Myer which noted a sharp deterioration in trading in January.

The group has guided to sales of c.$3bn in FY11 and NPAT of $134-$139m (a 13-17% increase on the prior year). Given the numbers reported today, that implies the following growth rates in the second half.

While 2H sales growth of 14% may still look high in the current environment, there are a number of factors that should support this level of growth. The comparison base is much easier (9.9% reported in 1H10 and -2% in 2H10), we start to cycle the worst of the deflation in flat panels which should lead to some price stability and there will be a benefit from the 13 stores opened in 1H11 (5 more stores in 2H).

While the dividend payout was maintained, the group highlighted that it is has commenced a capital management review which will be announced by the end of May. Given that the group has a net cash position, we think it is sensible to return more cash to shareholders ?
particularly as management has effectively ruled out acquisitions. However, we think that it is unlikely to take the form of a large one-off payout but rather more likely to be an increase in the payout ratio. For now, we have retained the payout ratio at 60% in our forecasts which
results in an accumulation of cash on the balance sheet in the outer years.

For the first time we can remember, the group has referred to the industry in its outlook. It expects all categories to remain competitive but that industry growth should remain strong. It has noted the digital TV switchover, the growth of internet TV, tablet computers, smart phones and new gaming titles as sources of growth in coming years. This is in line with our view of the market.

Other key points
Sales weakness disguises some strong performances
With sales below our expectations, it would be easy to consider the sales result disappointing. But while we were surprised by the weakness in some areas, other areas
performed very strongly. For example, consumer electronics (c.60% of sales) achieved growth of 4.4% despite flat panel TV?s being a significant part of this category where comp
stores were negative due to lower selling prices. By implication, areas like computers and telcos held up very well to make up for the decline in TV?s.

The software category (music, movies and games) declined by 10%. However, within this, games which includes console sales declined by 18% due to lower sales of the Nintendo Wii and DS and Sony PSP as they cycled the strong base from the prior year. The company does not provide a breakdown of the size of the subcategories, but the numbers suggest that the performance of music and movies was relatively robust.

Gross profit

Similar to 2H10, the group again delivered a strong gross profit performance. While a competitive market is normally associated with a declining gross margin in retail, the group was able to offset the lower selling prices through increased levels of supplier support, mix, merchandising and inventory management. While declining console sales may have impacted sales, given that the items were sold at almost no margin in 2H10 (due to the competition in the market), the lower sales has benefitted the group?s margin. JBH has also been working on improving the availability and display of lower priced, high margin items within stores which is having a positive impact.

Management was again asked on the call whether the gross margin improvement was sustainable. And while it did caution that the improvement in gross margin in 2H11 will be lower than 1H11 (as 2H10 already benefitted from many of the same factors), there were no material one-off items identified that will drop out in future periods.

Cost of doing business

If we were being critical, we would note that the CODB (as a percentage sales) was only in line with the prior year at 13.2%. However, given that the sales growth rate was as a low as it has been over that the period and the group continues to open stores, it does demonstrate good cost discipline in our opinion. The group has note that it expects lower operational leverage in 2H11. This is consistent with our forecasts. The operating leverage in 1H came primarily from a fairly low increase in sales and marketing.

The group noted some labour productivity increases despite a 4.28% retail wage increase in July 2010. However, we suspect that marketing may have been another area that declined as a percentage of sales both through economies of scale and less dollar spend required to maintain share of voice.

Valuation and price target unchanged
We value JBH at $19.00 using a DCF. We assume a beta of 1.0, risk free rate of 6.25%, market risk premium of 6.0% (WACC 10.7%) and a terminal growth rate of 2.0%. When assessing our terminal growth we consider the rate at which a company is reinvesting cashflows and the rate of return those cash flows are generating. We value JBH using a DCF because it best captures the potential for sales growth and EBIT margin expansion beyond the next 12 months.

We obtain our $20.55/share price target by growing our DCF at the cost of equity and subtracting forecast dividends for the next 12 months.

Relative performance

JBH is trading at 14.1x 12 months forward, a 1% premium to market (ASX 200 All Industrials ex financials). On our valuation JBH is trading at a 12 month forward PE of 13.9x. We believe this is appropriate given the three year EPS CAGR of 15% and high quality balance sheet.