Property Value The Real Question For Harvey Norman

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– Harvey Norman posts a weak result
– franchisee support significantly increased
– sales not responding
– property valuation thus questioned

By Greg Peel

Shares in retailer Harvey Norman ((HVN)) have rallied some 14% since the end of the full-year period following downgrades to profit expectations in the order of 30%. While the market has generally been a little stronger, investors have clearly been looking for knock-down value. The real question, however, is as to whether HVN should not be valued much lower.

Management had already flagged the FY12 profit result at the last quarterly sales result announcement so there were no surprises on Friday on a net basis. On the breakdown, however, improved property earnings offset a weaker than expected retail result. Sales fell by 8% and profit was down 39%. The Australian franchisee business saw gross profit fall by 50%, including 70% in the second half.

The good news is that the last couple of months have seen more stability in gross margins according to management – an observation also made earlier by rival JB Hi-Fi ((JBH)). The consumer market nevertheless remains depressed, while management was quick to blame Woolworths ((WOW)) for Harvey's woes. The closure of Woolies' Sight & Sound, and especially Dick Smith stores, led to the sort of irrational pricing associated with clearance sales and sucked customers away from HVN. It is interesting though, notes BA-Merrill Lynch, that JB Hi Fi was nowhere near as impacted by the Dick Smith closures. Company-specific issues and structural factors are more importantly weighing on HVN, Merrills suggests. Citi believes weak sales and a “sticky” cost base are to blame.

Over the FY12 period, HVN increased its franchisee support by 106%. “Given support is only offered when a franchisee is not generating sufficient operating income to support their wage,” notes RBS Australia, “the number of loss-making stores has clearly increased”. As Citi points out, HVN reported a 5% drop in franchisee sales in FY12 but increased rents by 9%. The rent/sales ratio has risen by 100 basis points over five years, the analysts note. On that basis, Citi believes there is a 20% downside risk to rental income.

Which brings us to the question of property valuation on the books.

Deutsche Bank (Buy) was disappointed with the performance of HVN's retail operations, but notes the property book continued to deliver a “reliable” earnings stream. Property should limit the downside until trading conditions improve, Deutsche believes. The analysts are heartened by retail exposure to categories that aren't structurally threatened and suggests the troubled AV/IT category will become less important. HVN's format allows it to explore new categories and the “cost lever is yet to be pulled,” the analysts note.

UBS (Buy) also believes property should support HVN's current valuation.

JP Morgan (Neutral) acknowledges the more recent improvement in margins but remains cautious. The outlook for AV/IT is particularly weak, the analysts suggest, while agreeing with Deutsche that unlike other retailers, HVN does have the flexibility to realign its business towards more attractive areas. RBS Australia (Hold) believes it is reasonable to state that the valuation of HVN's property assets is tightly linked to the viability of its retail operations. This is a risk if margins don't improve in the second half of FY13.

Credit Suisse (Neutral) suggests a stabilisation in earnings may not come soon enough for franchises, for whom there is a risk irreparable damage has been inflicted on balance sheets. The risk to valuation would be some write-off of franchisee loan balances. There is thus a potential risk of property revaluation, CS believes. Like other areas of retail, the analysts note, HVN is charging franchises ahead of profitability.

Goldman Sachs (Sell) recognizes that HVN's valuation multiples are at historically low levels and that the company owns a sizeable property portfolio. However the analysts don't see the pressure on HVN's “system” profitability abating anytime soon given ongoing macro and industry headwinds.

Citi (Sell) believes franchisee margin recovery will likely be slow as going as the company focuses on market share instead. Operating costs are high compared to rivals and have proven difficult to cut. The analysts don't think a reliance on an eventually improving retail cycle will be enough. They would like to see store closures to reduce the cost base and contribute further to industry rationalisation.

Morgan Stanley (Underweight) believes HVN is overcharging franchisee rent to maintain property values then increasing “tactical support” to franchisees to offset this. Rental increases of the 9% magnitude in FY12 are unsustainable in the analysts' view. Indeed after crunching the numbers, the analysts believe a more realistic valuation for HVN's property portfolio would be $1.67bn compared to the stated $2.1bn. This would put the stock's ex-property forward FY13 multiple at 8.6x which is too expensive in Morgan Stanley's view. A reduction in property values will be the catalyst for the share price to fall in absolute terms, the analysts suggest.

Merrills notes the increase in franchisee support from $60m in FY11 to $124m in FY12, and notes this did little to improve franchisee sales, which were down. “In our view,” say the analysts, “this underpins the perception that the underlying position of Harvey Norman as a retail offer has materially deteriorated in FY12”.

If we leave property values aside for a moment, the other question is as to just what HVN plans to do to turnaround its deteriorating sales performance. 

Macquarie (Underperform) notes Harvey is a “destination brand” and that despite having the largest promotional marketing spend, and despite increasing tactical support to franchisees to counter aggressive market behaviour from competitors, the company could not prevent a loss of market share in FY12.

HVN has spent “significant time and energy” on its online platform, Macquarie notes, and online sales in FY12 were less than 1% of total sales. Customer searches for products on the site have grown by 25% but sales did not improve at all. The analysts wonder whether if this poor result is a further reflection on the HVN brand and whether consumers are simply using the website for information before shopping at preferred or more convenient retailers. Meanwhile, little has been done in-store to bring consumers back, Macquarie notes. One store, in Balgowlah, is being used as a trial of increased appliance floor space allocation but no accelerated roll-out has been identified.

“HVN appears to be pinning a major part of its turnaround plan,” says Merrills, “on improving its home segment based on the performance of one refitted store”. And so Merrills sums up a bearish view on HVN:

“We believe Harvey Norman's earnings performance will continue to deteriorate, with sustained poor market conditions likely to prevail and a lack (in our view) of a creditable strategy to improve the underlying performance of the business”.

Merrills forecasts a 17% earnings decline in FY13. No database broker changed its rating post the HVN result, which stands at two Buys, four Holds and two Sells (not including Sells from Goldman and Morgan Stanley) and the consensus price target is largely unchanged at $2.00, bearing in mind management provided updated guidance at the recent sales result. That is basically where HVN shares are currently trading. Targets nevertheless range from JP Morgan at $2.45 down to Merrills at $1.45.
 

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