Upbeat Harvey Norman Rewards Shareholders

This story features HARVEY NORMAN HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: HVN

-Sales productivity best for some time
-But how long will momentum continue?
-What form will shareholder returns take?
 

By Eva Brocklehurst

Harvey Norman ((HVN)) has lifted expectations markedly on delivering a solid FY14 result. The company demonstrated its resilience, despite weak consumer confidence, and an improvement in sales and reduced costs from store closures drove the better profit and cash flow. While the move to reduce franchisee support was greeted positively by most brokers, they disagreed on the extent to which benefits will accrue over the longer term.

UBS upgrades the stock to Buy for three reasons: the trading outlook is improving, with macro indicators suggesting householder spending is picking up; there is further upside potential to earnings forecasts, given housing strength and better franchisee margins; and lastly, there is capital management. The lift in the second half dividend to 8c per share was a signal that the board is becoming more confident about returning cash to shareholders.

Citi took an opposing tack. The broker acknowledges the reduced tactical support for franchisees, which provided higher earnings and dividends, but wonders how long this can continue. Probably two more years, in the broker's opinion. After that, growth is likely to be slow. Citi considers that while higher payables are helpful, lower inventory or receivables would be better quality drivers for the stock. Add to this the closure of stores and competitive markets and the broker believes the long-term potential is limited. A Sell rating is retained.

The store is leveraged to new and established housing markets and Deutsche Bank believes this will continue to provide momentum. The broker also expects additional capital management in excess of the increased dividend. Deutsche Bank's operating earnings forecasts have increased modestly for FY15 and FY16. Typically, Harvey Norman provided little definitive guidance but the broker did observe that management was more upbeat than it had been in a long while. As Harvey Norman operates across all home maker categories, the CEO observed the group was well placed. Deutsche Bank noted the language regarding sales being "stable" was not insightful but took this to mean there was no dramatic change in conditions.

All geographies bar Asia reported an improvement in profitability. Asia was affected by declining consumer sentiment in Singapore and the redevelopment of the Suntec Mall, as well a difficulties arising form the implementation of new IT systems. The company has signalled it would be more inclined to increase the dividend pay-out than institute a buyback of shares. Going forward, Deutsche Bank assumes a 70% pay-out ratio, consistent with FY14. The broker also noted the property portfolio accounts for a smaller proportion of the enterprise value and has less of an impact on valuation than previously.

BA-Merrill Lynch found the key positive was the increase in cash realisation. The broker expects there is further room for earnings growth from franchising fee revenue, interest from franchisees and further reductions in tactical support. The broker retains a preference for Harvey Norman over the apparel-based retailers in line with a sector preference for exposure to household goods. Merrills considers the company is performing better than at any point in the past five years, but continued improvement in operations will be needed for this strong earnings growth to continue. Another key positive is that sales productivity has increased at a faster pace in Australia over the last ten years than in other developed markets. Combined with the low level of store saturation this means there is little evidence to suggest space rationalisation is needed.

Macquarie expects the leverage to residential markets will become more evident as strong housing demand translates into demand for household goods and appliances. In this case the stock offers an attractive exposure with the potential for capital management as well. Macquarie retains a Neutral rating as the stock is trading above the target of $3.29. On the subject of a buyback or special dividend the broker suspects a key motivation for a special dividend option may be the pending fall in the corporate tax rate to 28.5% from 30%. As such, Harvey Norman may want to return franking credits before the rate declines at which they are able to be distributed. Macquarie would not be surprised to see a special dividend paid in FY15.

Management has effectively dismissed a buyback or special dividend, in CIMB's view. The broker has lifted dividend forecasts, believing the absence of property development opportunities means the company can yield to desires for a higher-pay-out ratio. The broker considers sector consolidation also remains a medium-term opportunity across most segments. Harvey Norman's property assets underpin the valuation but the broker finds there is still some risk, given links to the viability of retail operations, although concedes this is becoming less of a concern.

Credit Suisse wants a few more details on the franchise performance and cash flow. The broker noted the positive outlook, which reflected cost and working capital benefits and a supportive household environment. The franchise segment may have improved but Credit Suisse believes this is largely related to the closure of loss-making franchisees. The benefits of the more efficient management of capital in the franchise and lower cost base should be realised from FY16 onwards. The loss in Ireland was less and this raises the prospect of that geography returning to profitability. Credit Suisse also observes Harvey Norman's exposure to consumer electronics and IT is low relative to JB Hi-Fi ((JBH)) and Dick Smith ((DSH)) and less affected by a slowing of product releases and tablet demand. Hence, this positively differentiates Harvey Norman as an investment opportunity.

On FNArena's database there are four Buy ratings, three Hold and one Sell. The consensus target is $3.58, suggesting 2.5% downside to the last share price. This compares with $3.27 ahead of the results. Targets range from $2.95 (Citi) to $4.20 (CIMB).
 

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