Will Harvey Norman’s Purple Patch Prevail?

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

As demand for home-based goods continues apace Harvey Norman is in a purple patch. How long will such buoyant times prevail?

-Economic slowdown could result in weaker demand
-Offshore business not yet in full recovery
-Dividend disappoints many
 

By Eva Brocklehurst

Harvey Norman ((HVN)) is experiencing exceptional circumstances, amid demand for home-based goods that reflects trends spurred on during the pandemic. Working from home, major renovations and a higher savings rate, particularly in regional Australia, have all contributed.

Can this continue? Citi believes the post-pandemic normalisation cycle will be elongated, given the strength of Australian housing construction, while Ord Minnett agrees momentum will be maintained for much of 2021 amid longer pandemic-related restrictions and an increased focus on the home.

The business was also cycling a spate of natural disasters in regional Australia in the first half. The main risk to Macquarie's outlook is economic contraction that could follow the removal of fiscal stimulus, which would in turn result in slower demand for home furnishings and appliances.

Trading was strong in Australia in the first half, with Credit Suisse noting there was a near tripling of earnings (EBIT) in the Australian franchise segment, which now comprises 60% of the business.

The broker highlights the successful offshore expansion strategy that makes Harvey Norman unique amongst Australian retailers. Singapore may be struggling but Credit Suisse regards this as temporary, and a reflection of the reliance that geography has on both business and tourism to drive shopper activity.

Macquarie notes like-for-like sales in the first seven weeks of the second half in Slovenia, Croatia and Northern Ireland were negative and the latter continues in lockdown until April 1 at the earliest.

Challenging trading, therefore, is likely to persist, particularly as Northern Ireland is leveraged to bedding which customers typically purchase in-store. Mobility restrictions have also been imposed in Malaysia until March 4. Macquarie assesses the offshore business now accounts for 21.5% of pre-tax profit and conditions ex Australasia are not yet in full recovery.

New Zealand was the main surprise for the broker as strong sales momentum continued. There was no disclosure about online sales, Macquarie points out, but it would appear the online store has performed well, particularly offshore.

One store was closed during the first half and there was some impact on franchisee profitability from reductions in rental income yet UBS remains confident about demand, noting the build up in household savings and the strength in the housing cycle.

Margin

The company's franchise structure drives very high operating leverage, well ahead of competitors such as JB Hi-Fi and The Good Guys ((JBH)). The highlight for Goldman Sachs was the expansion in the operating earnings (EBITDA) margin, to 10.9% of system sales, which compares to peaks of 8% historically.

The housing cycle should provide a buffer for the earnings outlook over FY22 and FY23, but the broker does not envisage the peak trading seen in the June quarter of 2020 to the March quarter of 2021 will be sustained.

Goldman Sachs, not one of the seven stockbrokers monitored daily on the FNArena database, suspects FY22 EBIT is likely to decline -30% on FY21. After outperforming the market and despite a reasonable valuation, the broker downgrades Harvey Norman to Neutral with a target of $5.10.

The main issue for Jarden is the level of Australian franchisee margins that can be sustained. History suggests normalisation occurs after strong periods of higher margins, as franchisee support normalises and promotional intensity returns.

Some normalisation to around 6.2% is forecast in FY22 and, expecting long-term margins to drop to 5.4%, Jarden, also not one of the seven, retains a preference for other stocks in the sector. The broker, with an Underweight rating and a target of $5.60, acknowledges Harvey Norman is a great beneficiary of the buoyant Australian housing market and reflects this in stronger second half forecasts.

Capital Management

Harvey Norman has decided not to return the JobKeeper subsidy received during the pandemic despite recent challenges by government officials. The interim dividend has stepped up to $0.20 per share but this disappointed Jarden, although a strong second half pay-out, around 100%, is considered likely.

Credit Suisse also complained about the low dividend payout-out, particularly for a business that finished the half-year net cash. There is no debt and no major capital commitments and the broker believes it only a matter of time before some form of capital management is undertaken.

Capital management should provide a catalyst on a 6-12 month view, UBS suggests, while Morgan Stanley also envisages scope for capital management. The broker understands investor reluctance to capitalise on the peak earnings but a strong housing market and high level of working from home are expected to provide support.

Harvey Norman, being in a net cash position for the first time, should be able to withstand significantly higher gearing levels, in Citi's view. As a result, the broker calculates up to around $600m of debt capacity and capital return potential in FY22.

With $477m of franking credits on the balance sheet, Citi assesses large capital returns are possible but unlikely, given board conservatism. What the broker does expect is a higher pay-out ratio and/or capital management in order to release some of the franking credits.

FNArena's database has four Buy ratings and two Hold. The consensus target is $5.79, suggesting 9.5% upside to the last share price. The dividend yield on FY21 and FY22 forecasts is 7.5% and 5.5%, respectively.

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