Housing Strength Buoys Harvey Norman

This story features HARVEY NORMAN HOLDINGS LIMITED. For more info SHARE ANALYSIS: HVN

-Higher quality franchise growth
-Store numbers contract
-Property JV income lower
-Audio visual more competitive
 

By Eva Brocklehurst

Harvey Norman ((HVN)) enjoyed improvements in franchising margins and sales in the first half. All businesses grew, with the highlight being Australian franchises, while international businesses were boosted by FX benefits.

Margin expansion signals lower tactical support payments for franchisees, which in turn reflects higher quality growth, in Macquarie's view. With three stores closing and no new ones opening over the half, store count is lower than it was four years ago, the broker observes. This will remain a headwind to sales growth, although Macquarie found it interesting that the company claims it is winning market share in a number of large categories, despite the contraction in the store network. All up, Macquarie considers the positives are now captured in the share price and downgrades to Underperform from Neutral.

JP Morgan acknowledges store closures will weigh on sales but considers the like-for-like growth and focus on home categories will compensate, by leveraging the improvement in housing in Australia, particularly in NSW.

Australian franchising stood out while New Zealand was also strong. Ireland appears on track to break even in FY16. This has led to increased confidence on the part of UBS that management can deliver cost savings. The stock is expected to continue to outperform over the next 12 months, with scope for further capital management as well. UBS expects Harvey Norman to return to the historical average 4.6% for franchisee margins in FY16.

Debt metrics are comfortable, but Credit Suisse envisages little room for active capital management. The pay-out ratio increased to 68% in the first half and there remains scope for a moderate increase in the ratio because of low capital investment requirements. The company has a $600m franking account surplus. Nevertheless, Credit Suisse considers it unlikely the franking credits will be released by raising capital to fund a dividend.

Cash flow was lower than brokers expected but this was explained by the early purchase of inventory ahead of FX-related price increases. This should help second half margins, although sacrificing working capital efficiency in the short term, Deutsche Bank maintains. It also provides the company's franchisees with a competitive advantage. The second half has started well and Deutsche Bank also expects momentum to continue on the back of new housing starts, upgrading forecasts on the back of the Australian franchise operations, somewhat offset by reductions to the Asia and property segments.

Property was affected by a weak performance in mining accommodation, which reduced the share of profits from joint ventures. Management plans to tender for infrastructure projects to offset the weaker demand from mining. Deutsche Bank notes there was little in the way of definitive commentary but pointed to the upbeat outlook on consumer sentiment. Management is confident that Australian sentiment will remain stable, citing strong equity markets and housing strength. Petrol prices were also singled out as a boost to sentiment, although this has subsided a little since the start of the year.

Morgans notes NSW remains the strongest region and the commitment from Australia's central bank to support the housing industry underpins confidence that the tailwind from housing will continue into the medium term. Harvey Norman is a late-cycle beneficiary of housing starts and demand should be strong for some time to come. Downside risks come in the form of an inability to pass through FX inflation or poor execution of internal cost reduction programs, as well as further market share loss in the audio visual/technology segment, which the broker observes has become more competitive.

Asia remains the weakest geography. Singapore led the weakness as the retail environment remains challenging. A strengthening of Malaysia's economy was insufficient to offset cautious consumer sentiment in that country. In New Zealand, growth came despite commentary from competitors about soft consumer sentiment. Management indicated it made gains in market share, helped by the exit of The Good Guys from the NZ market.

Ratings on FNArena's database run the gamut, with four Buy, one Hold and three Sell.The consensus price target is $4.18, suggesting 5.5% downside to the last share price. This compares with $3.67 ahead of the results. The dividend yield on FY15 and FY16 forecasts is 6.6% and 4.6% respectively.
 

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