Investor Snapshot: Harvey Norman

My investment thesis on Harvey Norman is that its shares offer very lucrative short term returns though in the long term the stock price is likely to fall as the accumulative consumer shift towards low cost online retailers indicates an overvaluation of Harvey Norman’s shares.

Bull Analysis:

On 10 Feb, Harvey Norman shares hit a three month high at $4.14. Harvey Norman’s significant outperformance of the market last month, where it reached its two month high of $3.78 while the ASX200 dropped 1%, indicates the positive effects from retail spending. Harvey Norman’s sales were strong in July to December, but surged after Christmas. The relatively weak consumer sentiment at the start of December last year could be due to a consumer expectation of post Christmas sales. This may impact on profit margins as retailers are then incentivised to provide larger discounts earlier, as seen through JB Hi Fi’s discounting competition with Dick Smith. However, competitors’ price deflations will see market share reductions and Harvey Norman could use this to their advantage to dominate once cyclical trends make a comeback. I believe this momentum will continue- the RBA’s recent decision to lower interest rates to 2.25% has positive internal and external corporate impacts. It will boost retail expenditure by fuelling consumer confidence, and also lower Harvey Norman’s cost of debt. This forecast extends globally. Depreciation of the Australian dollars means domestic retail suppliers increase market share as they are now more competitive than those overseas.

Whilst earnings revisions favor a downside, this is predominantly attributed to the resource sector due to the weak commodity prices. For Harvey Norman, falling commodity prices increases savings in the supply chain, thereby boosting corporate earnings.  Moreover, Harvey Norman’s standing as a furniture and entertainment store in the retail sector increases their leverage to outperform due to its strong connection with the housing market. Potential for continued high sales growth reminiscent of pre GFC housing boom growth where consumption of discretionary items soared (in particular flat screen TVs) remains likely.

Harvey Norman’s retail property ownership will continue to sustain a strong and consistent cash flow in case there are any cyclical downturns. It also ensures control over rental hikes during upturns. As the 2.3bn property assets supports the company’s value, it enables protection for shareholders against risky business ventures, thereby allowing Harvey Norman to adapt at a slower pace. The company’s debt to capital is 25.2%, making it undergeared and increasing the potential to return its $600m franking credits to shareholders. In general, there is good control over the company’s strategic approach due to share ownership for executives, which matches their interests with shareholders in terms of focusing on returns on capital. They are issued options at 3.02, which, given the currently strong share price movements, are valuable as incentives.

Bear Analysis:

However, Harvey Norman’s downside risks have more longer term, negative repercussions on stock price. Whilst its healthy $2.2bn balance sheet is indicative of long term growth, Harvey Norman’s brick and mortar retail model is under threat from the rapid adoption of online distribution channels. Scale advantages in retail are sourced from a powerful market standing to conduct negotiations with suppliers for larger volumes and lower costs. However, the rapid e-commerce growth means the consumer market expands to an international base, diminishing Harvey Norman’s scale advantage from its dominant domestic presence. Competitors including Kogan and AppliancesOnline operate on lower costs and therefore deliver products at a lower price by leveraging greater sales or lack of site costs which enables a 24 hour shopfront. This competitive advantage magnifies for such retail products due to their elastic demand being linked with the fluctuations of the business cycle. Moreover, as 97% of consumers use the internet as a research and sale mechanism, price transparency increases which reduces the significance of salespeople. The sector most affected by the availability and accessibility of consumer reviews and price comparison is electronics, which consists of 40% of Harvey Norman’s sales.

Whilst Harvey Norman is investing capital to focus on transitioning into integrated omni-channel retailing, whereby an online platform is included with their traditional store network, I predict its online sales to remain relatively subdued due to consumer perception of its brand as a high end retailer. To ensure this strategy is a success, the retailer must focus on what they are selling rather than how. Currently, selling mainly commoditised electronics, consumers will continue to display minimal distributor loyalty due to the accessibility of lower priced products. Amazon’s innovation in their distribution is likely to mean such a global giant will take the biggest cut of international sales.

Their high operating costs in supporting an extensive nation-wide franchise portfolio also makes restructuring inefficient when evolving the business model, as when Harvey Norman decides on closing stores in the long term, they would need to find another business to sell their stores to. I do not see management implementing any radical changes to the existing business model especially as it is likely they view any weaknesses in the market as a cyclical, macroeconomic downturn. Such structural threats means returns may slide below cost of capital.

Moreover, with the subdued Northern Hemisphere economy, their Irish capital investment needs to be addressed as it is consistently delivering losses since their housing market stall, with a 4% operating loss in 2014. However, management has stated a long term commitment to this expansion, though I believe it risks an opportunity cost of revitalising domestic profit margins as management wastes time and shareholder capital in offshore investments.  

In conclusion, I believe the current macroeconomic trends including housing, interest rates, currency and retail conditions will boost Harvey Norman’s stock price performance, though unless the business model innovates to adapt to the shift of retail dollars to online platforms, Harvey Norman will face stock price deflation in the long term.

Sources: The Australian, Sydney Morning Herald