In the past year the stock of Harvey Norman Holdings Ltd. has significantly outperformed the market, rallying over 50 per cent and outperforming the All Ordinaries which is up 15 per cent over the same period. Investor appetite has been driven by modest gains in consumer spending, the retailer's leverage to the housing completions cycle, a marginal recovery in sales and expectations of further gains. Trading 50 per cent above our valuation and 30 per cent above the consensus mean valuation for fiscal 2014, we argue a consumer recovery and exposure to the building cycle is more than priced in.
Figure: Harvey Norman Holdings Limited Price vs. Value Chart
Historical lows in the cash rate and home loan rates are stimulating the housing market, with August building approvals up 8 per cent on the previous year. Harvey Norman's exposure to homemaker categories positions it well compared with other discretionary retailers.
Two powerful drivers of consumer spending are property prices and perceptions of job security. While the latter is yet to improve, there is some anecdotal evidence strong capital city property prices are encouraging consumers to open their wallets after a long period of caution. This is known as the ‘wealth effect’, which is further boosted by a strong equity market.
Harvey Norman's late move into online retail is gaining traction, with online sales accounting for two per cent of group sales and annualised growth over 100 per cent, albeit off a low base. The established store network of 206 stores domestically is a competitive advantage, acting as fulfillment centres for the online channel.
Over the past couple of years, challenging trading conditions and a subdued housing market have weighed on Harvey Norman's earnings. Historically margins have ranged between four and five per cent but fell to 2.63 per cent in fiscal 2012 and to 2.40 per cent in fiscal 2013 respectively. Stronger franchise sales revenue in the second half of 2013 versus a year earlier suggest franchise margins have bottomed and tactical support will ease if sales continue to grow.
However, Harvey Norman will continue to face structural challenges. Its ‘omni-channel strategy’ is encouraging but the company faces increasing competition from domestic and offshore retailers, which will constrain margins and damp profit growth. Competitive threats include new entrants in whitegoods (JB Hi-fi Home) and home improvement (Woolworths owned Masters). If Masters and JB Hi Fi Home continue to invest in expansion, Harvey Norman is likely to lose market share.
Harvey Norman's offshore stores continue to weigh on earnings. In fiscal 2013, higher revenues in Asia and New Zealand were offset by lower revenues in Ireland and Eastern Europe. Hope of a recovery in its European operations was quashed with fourth quarter sales in Slovenia and Croatia disappointing with a third consecutive quarter of decline. Ireland posted a sales decline after six months in positive territory.
What differentiates Harvey Norman from other retailers and franchisors is its large property portfolio which is leased to franchises and other external tenants. Harvey Norman enjoys the profits of its retailing but also the stability of property returns and rising values. Harvey Norman holds $2.244 billion of property assets which equates to $2.11 of assets per share. However the net book value is lower due to the debt ascribed to the investment property.
We use a conservative adopted normalised return on equity (NROE) of 12 per cent and a required return (RR) of 13.3 per cent to derive our fiscal 14 valuation of $1.99. As a general rule, NROE below RR means a stock is sub-investment grade. In Harvey Norman's case the NROE is weighed down by its property portfolio.
Even in a bullish scenario using an adopted NROE of 14 per cent, we derive a valuation of $2.44 which is still 25 per cent below current prices, reinforcing our view the stock is overvalued.
To justify current prices Harvey Norman would need to achieve an NROE of 16.5 per cent, which is nearly four percentage points above the five-year average NROE of 12.6 per cent. Given the significant structural challenges in the sector and what is a subdued recovery at best, this outcome is unlikely.
Amelia Bott is an Equities Analyst at StocksInValue, a joint venture between Clime Investment Management, a value fund manager, and Eureka Report. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For an obligation free, FREE trial please visit www.stocksinvalue.com.au or call 1300 136 225.