One industry I try to avoid when investing is the retail sector. It's quite hard to pinpoint any particular advantage that a retail store has over any other. There are a couple of exceptions, such as if the retail store sells an extremely popular brand or has a strong business model allowing it to offer the lowest prices.
Harvey Norman Holdings Limited (ASX: HVN) and JB Hi-Fi Limited (ASX: JBH) are two of Australia's biggest retailers listed on the ASX, other than Wesfarmers Ltd (ASX: WES) and Woolworths Limited (ASX: WOW). Harvey Norman has a market capitalisation of $5.5 billion and JB Hi-Fi's market capitalisation is approximately $3 billion. They are competitors in the home appliance and electronic goods market.
The recent JB Hi-Fi acquisition of The Good Guys looks like a smart move. It will make the combined business the biggest retailer of home appliances with 29% of the market, as well as the leading retailer of consumer electronic goods with 24% of the market. Harvey Norman only has 24% and 15% of each respective market.
The expected annual net synergies between The Good Guys and JB Hi-Fi should be between $15 million to $20 million. This is fairly significant considering JB Hi-Fi's net profit after tax in FY16 was $152.2 million. Does that make JB Hi-Fi a better investment than Harvey Norman?
Valuation
JB Hi-Fi is expected to deliver earnings per share (EPS) of 168.6 cents by FY17 (source: Commsec). This suggests it's trading at 15.8x FY17's estimated earnings.
Harvey Norman is trading at 14.8x FY17's estimated earnings, which is cheaper than JB Hi-Fi, but we need to consider future growth too.
Growth expected
Not only is The Good Guys acquisition expected to grow JB Hi-Fi's EPS by 11.7% in FY17, but the EPS is expected to grow by a further 13.5% in FY18. If it achieves this, the current price/earnings ratio may be decent value.
Harvey Norman on the other hand is only expected to grow earnings by 3.7% in FY17 and 5.7% in FY18. Sometimes it's worth paying a little more now for better growth over the longer term.
Dividend growth
JB Hi-Fi is currently trading with a grossed up dividend yield of 5.28% and is expected to grow its dividend by 27% by FY18. This would be a grossed up yield on cost of 6.71% by FY18.
Harvey Norman has a large grossed up dividend yield of 8.65% at 30 cents per share. However it's forecast to decrease the dividend to 29.8 cents per share by FY18, which would be a grossed up yield on cost of 8.6%.
I'd rather own a business that is growing its dividend rather than reducing it. JB Hi-Fi would be my pick of the two for its strong predicted dividend and profit growth over the next couple of years.
However, there is one huge danger looming to both companies.
Amazon
There is a lot of talk about Amazon coming to Australia in 2017. When Amazon does eventually set up here, it could cause huge disruption to the incumbent retailers. You only have to look at North America and Europe to see how successful retailers have been at fighting Amazon – they haven't been successful at all.
The only way for JB Hi-Fi and Harvey Norman to win is to offer services that a website simply can't. Better customer service, loyalty programs and clever add-on sales in store, whilst also being able to show the customer many other products in one visit.
If they try to compete on price alone, they will lose. Amazon has shown it's willing to operate on razor-thin margins or even a loss to beat competitors. JB Hi-Fi and Harvey Norman could become showrooms where consumers go to try out a product and then buy it cheaper online.
Foolish takeaway
Our retail giants have got a problem ahead of them if they don't plan on how to combat Amazon's arrival. Of course, it will be difficult even if they are making plans.
Due to this likely challenge, I think there are few retailers which can keep growing profits over the long term, and JB Hi-Fi and Harvey Norman have two of the biggest targets on their backs. I think Foolish investors would be wise to steer clear of this sector.
