The question mark floating over Harvey's empire

Gerry Harvey's unique retailing model worked brilliantly in the period before the financial crisis when consumers were drawing on their home equity and future earnings capacity to spend up big. It's not working anywhere near as well in today's more conservative environment and the real question is whether the model is broken or just waiting for consumers to stop saving and start spending.

Harvey himself is an optimist and appears to be emboldened by a recent ‘'uptick'' in sales. Indeed, in January, after another difficult six months to December, Harvey Norman's Australian sales were 4.1 per cent higher than a year earlier and like-for-like sales were 5.8 per cent higher. Harvey himself believes that lower interest rates, stronger equities markets and a hoped-for improvement in housing will shift consumers into a ‘'buying cycle.''

The Harvey Norman model, with its mix of franchised and company-operated stores and the big property portfolio that supports it is leveraged to retail activity. There is a question mark, however, over whether that leverage will again work so well for it as it did pre-crisis.

A view of the impact of that leverage within an adverse environment was provided by the group's December-half results. Global sales were down 7.3 per cent in the half, Australian sales 8.6 per cent and earnings were down 36 per cent after a $45 million property devaluation.

If one goes back a little further, Harvey Norman's franchisee sales revenue was 11 per cent lower than it was two years ago, its company-operated store sales were 15.8 per cent lower, its earnings before interest and tax 44 per cent lower and its earnings after tax and property revaluations were 38 per cent lower.

It hasn't been an easy period for retailers generally and Harvey Norman, with its offering of home appliances, bedding, electronics, audio visual and IT products has been particularly hard hit.

Audio visual and IT has arguably experienced permanent structural change, as the category most impacted by the direct and indirect effects of the growth in online retailing. While Woolworths' down-sizing and sale of the Dick Smith chain, as well as the disappearance of other competitors, may stabilise the market it will almost certainly be re-based at much lower margins than were available pre-crisis.

Harvey was until relatively recently an e-commerce cynic but has now embraced a version of an 'omni channel' strategy. In Harvey Norman's case it is a ‘'click, pay and collect'' strategy which seeks to capitalise on the group's big store network.

Given that a lot of the product ranges in its stores are bulky goods, that makes sense, although it doesn't protect it from the increasing preparedness of consumers to browse in store and then compare pricing and buy online.

The December-half result shows the vulnerability of the Harvey Norman model to the kind of conditions it has been subjected to in recent years and which, unless both sales and margins improve, it may have to cope with in future.

Its franchising business experienced a 4.7 per cent fall in revenue and a 25.6 per cent fall in pre-tax earnings, from $95.5 million to $71 million. As the franchisees tried to protect their sales and market share their product margins were affected and Harvey Norman had to increase its ‘'tactical support'' for them from $45.3 million to $63.8 million.

Harvey sees the ‘'alliance'' between the group and the franchisees as a unique strength. It could also, in tough conditions, be seen as a vulnerability, particularly as the alliance is further buttressed by Harvey Norman's $2.1 billion property portfolio.

When the franchisees are doing well they require less central help and deliver rising franchisee fees and property income and values. When they aren't faring as well the operating leverage works against Harvey Norman. The Australian property portfolio's devaluation reduced the group's property segment's pre-tax earnings from $68.8 million to $14 million.

It is obvious that Harvey Norman and its franchisees would benefit from stronger retail conditions.

The growth of e-tailing is still in its infancy, however, at about six per cent of retail sales. As it continues to grow it will, at least, take some of the sales growth potential away from bricks and mortar retailers and/or some of the margin.

It will also, and indeed already is, have an impact on the retail property model, conferring more negotiating leverage on the tenants and under-mining the CPI-plus and revenue share models the big landlords have imposed. The era of consistently rising rents may be passing, which could have implications for the property-centric model Harvey has built.

Harvey is an exceptional retailer – the Harvey Norman model he created was extraordinarily clever and creative when it was launched and, until relatively recently, extremely successful.

Both the macro-economic environment and the emerging structural shifts in retailing are, however, presenting him (and his peers) with novel and ultimately existential challenges.

Whether or not the ‘'uptick'' in January's sales flows through into a stronger retail sales environment, any relief that might provide won't remove the need for Harvey and the other big retailers to continue to re-think and refine their models and expand their online presence and ambitions to try to adapt to an evolving retail industry landscape.