Offshore May Be A Winner For Harvey Norman

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The company is included in ASX200, ASX300 and ALL-ORDS

Sales at Harvey Norman's Australian franchises have continued to weaken in the first months of FY19 so the focus is turning to offshore expansion to drive revenue and growth.

-Australian retailing likely to continue weakening as housing market cools
-Real estate component of valuation becoming more significant
-Long experience in offshore operations supports potential for success

By Eva Brocklehurst

A subdued scene for Australian bricks and mortar retailing has put the spotlight on the offshore expansion of Harvey Norman ((HVN)). Australian sales in the second half of FY18 were weaker than many expected and the company has stepped up its tactical support of franchisees to focus on its brand in a more competitive market.

Harvey Norman has indicated sales for the first two month of FY19 for Australian franchisees were down -2%, while expansion in offshore operations is accelerating. Offshore business reported profit of $116.3m in FY18, a record contribution.

While disappointed that the Australian business has deteriorated further, the plans for offshore could drive considerable growth, in Deutsche Bank's view, particularly if there are no further impairments in ancillary businesses.

At current levels the broker believes the valuation is attractive for investors that are mindful of the risk, particularly given a $2.60 per share valuation for property assets, which implies core retail assets are trading at around 4x operating earnings (EBITDA).

While current trends remain healthy, Macquarie adopts a more conservative view, believing offshore is a risky proposition. The broker's upside view for Harvey Norman is substantially based on the real estate component of the valuation, although the path towards crystallising this is unclear.

Despite the improving international performance, Morgan Stanley maintains an Underweight rating, believing Australian trading will continue to weaken as the housing market cools. The broker notes, despite a differing product mix, JB Hi-Fi ((JBH)) has "out-traded" Harvey Norman on all operating metrics. As the housing market fades the lowest cost operator is expected to win market share.

Citi agrees Harvey Norman is unlikely to experience an improvement in operating conditions over the next 12 months as competition remains high and housing is still coming off the boil. UBS, too, believes the Australian business is challenged, facing a stronger competitor in The Good Guys (JB Hi-Fi).

The Australian franchise segment reported a weaker outlook and result in FY18. Franchise fees fell -2%, consistent with a decline in profitability. Rent received increased 4%. Whilst Harvey Norman is not alone in real estate by collecting more rent on a declining retail performance, Credit Suisse warns the practice tends to weaken support for property valuation.

The opaque franchise structure causes a degree of scepticism regarding the accounts, although the broker notes cash conversion appeared solid at 98%. The company emphasised seasonal factors in its report but Credit Suisse considers a cyclical argument is more consistent with decelerating sales growth and softer housing sentiment.

Credit Suisse applies the traditional momentum versus property valuation argument when it comes to Harvey Norman. Typically, earnings and share price support weaken through a housing downturn. Meanwhile, investment property underwrites $2.17 a share in value, implying franchise and retail on 5.8x FY19 forecast operating earnings (EBIT).

Historically, the share price has tended to trade as a retailer rather than as an A-REIT, but the issue takes on more relevance in view of the potential downside risks resulting from the online expansion of retail in Australia. Credit Suisse believes there is an alternative driver of value, which would underwrite property independently of retail performance.

Capital Raising

Harvey Norman has announced an entitlement offer to raise $163.8m. The 1-for-17 pro rata offer at $2.50 a share is designed to reduce debt. Macquarie suggests this decision may well be correlated to an unexpected increase in the dividend, as a mechanism to support franking credits distribution while preserving the balance sheet.

The broker estimates for the capital raising will be around -4% dilutive to earnings per share, given the high spread between the yield and cost of debt.

CLSA believes the expansion in net debt, thanks to property purchases and dividends, and the entitlement offer send conflicting signals. Regardless, this is a dilutive capital raising and drives the broker, not one of the eight monitored daily on the FNArena database, to lower the target to $3.30 and downgrade to Sell from Underperform.

Morgan Stanley acknowledges it has long been critical of the lack of shareholder focus by Harvey Norman and the increased FY18 dividend suggests an improvement in that area. The capital raising to reduce debt from relatively modest levels increases the probability of future capital management in the form of either special dividends, off-market buybacks or capital returns, in the broker's opinion.

Offshore

The company is accelerating expansion of offshore operations, particularly Southeast Asia. Malaysia, the company asserts, could sustain a move to 50 stores by 2023 from the current 16. In the long-term, Morgan Stanley believes, while this may lift the risk profile, diversification benefits and future growth could win out.

The risks are easily recognisable and Credit Suisse points out that Harvey Norman has been expanding offshore for two decades and this should provide adequate information for any expansion that is being considered.

In FY18, operating earnings ex Australia and New Zealand represented 6% of the total. Particularly strong progress was being made in Singapore/Malaysia and to a lesser extent in Slovenia and Croatia. Harvey Norman intends to open 18 stores outside of Australia over the next two years. After considerable investment, Credit Suisse notes Ireland has also reached a sustainable break even.

Meanwhile, the carrying value of the the Coomboona dairy joint venture was impaired by -$20.7m in the first half, and a further -$28.8m was impaired in the second half based on the expected shortfall in the repayment of loans advanced.

There was -$95m outflow associated with loans to JV partners and unrelated parties in FY18. Credit Suisse makes the point that shareholders would be significantly better off if the company refrained from unrelated investments.

FNArena's database shows two Sell ratings, four Hold and one Buy (Deutsche Bank). The consensus target is $3.72, signalling 5.6% upside to the last share price. The dividend yield on FY19 and FY20 forecasts is 7.9% and 6.9% respectively.

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