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Musings

Incentives

Creating the right incentives 

Last week JB Hi-Fi (JBH) announced that there were some discussions with The Good Guys (GG) on a possible acquisition and that these were preliminary and exploratory in nature.  The rationale for the acquisition is that it would turbo-charge JBH’s foray into the white goods space.

Based on media reports, revenue and EBITDA for the GG’s is circa $2 billion and $110 million respectively and that the owners are looking for a $1 billion exit.  Taking these numbers at face value would imply an acquisition EBITDA multiple of 9.1x.

As a long time shareholder of JBH, I have a few issues with this potential acquisition (at the above acquisition multiple):

  1. JBH’s management are really great operators. However, it’s track record of acquisitions aren’t as great. The Clive Anthony and Hill & Stewart acquisitions were both disasters but luckily both were relatively small acquisitions. GG on the other hand would be a material acquisition for JBH, which if successful would be significantly debt funded so the risks are much greater.
  2. The GG business model is a blend of company owned stores and franchisees. This doesn’t automatically fit with the current JBH model. Negotiating with that many franchisees will have it’s challenges.
  3. JBH’s EBITDA margin last year was 6.6% and its current trading at an EBITDA multiple of 8.8x. GG’s EBITDA margin on the other hand is 5.5% (based on media reports) and the owners are asking for 9.1x EBITDA acquisition price. At this price, shareholders will end up paying more for a business which is not only less efficient but once combined will be likely to be a drag margins and return of capital.
  4. This acquisition if it goes through will be a distraction. The real threat to JBH is not Harvey Norman or any of the brick and mortar stores but rather Amazon. This threat is real and I would much rather JBH allocate its resources (including capital) to strategies on how to counter the looming Amazon threat.

Given the significant risks, incompatibility of business models and high asking price, I wonder why management is still exploring an acquisition.

Are the synergies so compelling or is there such great strategic benefits to this acquisition?

Or does the earnings per share (EPS) growth target in the long term incentive plan (LTI) have anything to do with motivating management to grow earnings despite the risks?

EPS has long been the preferred performance hurdle for JBH’s LTI plans and based on the FY2015 annual report, the majority of the LTI plan still vests upon meeting EPS based performance targets.

“70% of these options vest upon achieving 5% growth compound annual EPS growth and the remaining 30% vest upon achieving 10% compound EPS growth. Where compound EPS growth is between 5% and 10%, up to 30% will vest on a linear basis” – JBH FY2015 annual report.

JBH is a wonderful business operator but its capital allocation decisions have been woeful. Examples include:

  • Acquisition of Clive Anthony is 2004. By 2012 all the Clive Anthony stores were shut down and rebranded to JB Hi Fi home stores. Any value paid for brand or goodwill would have come to naught.
  • In 2006, JBH acquired the Hill & Stewart stores in New Zealand. By 2010, all the stores were shut down.
  • JBH went on a share buyback spree in FY2011 and bought back $173 million of stock at an average price of $16.  As a result of this, debt went from $34 million in FY2010 to $233 million in FY2011 and the share price 1 year after the buyback was completed was trading at $9.24.  This buyback was terribly wealth destroying for shareholders.

The above 3 transactions destroyed shareholder value but in the short run provided a tailwind to EPS. The buyback is a positive for EPS growth since it directly reduces the denominator in the EPS calculation.

This begs the question – is the EPS target motivating management with the right incentives for shareholder value creation? I would argue not.