Harvey Norman ain't no bargain

Why would anyone sell Harvey Norman? The company's 'everything under one roof' business model, combined with direct property ownership and franchising has been extremely successful. Over the past 20 years, the company's revenue has increased from $74m to $1.4bn. Fortunes have been made.

Of its 283 retail outlets, the company owns 81 outright. The investment property portfolio is worth $2.3bn alone, accounting for more than half of Harvey Norman's market capitalisation. The remainder is tied up in an incredibly strong brand with leading positions in consumer electronics, appliances, furniture and bedding.

Yet something is wrong. Over the past five years Harvey Norman hasn't managed to expand beyond around 300 stores and same-store sales have been consistently weak. There's one clear reason: competition is increasing and the company is losing market share.

The internet has unleashed a tsunami on the retail industry and it won't work to bunker down and wait for it to pass. The online retail model has lower operating costs. Renting a warehouse near a freeway and selling through a website is far less expensive than renting space in hundreds of shopping centres, fitting them out, filling them with stock and staffing them with friendly salespeople. While online sales will take market share from traditional retailers slowly, in certain categories it will be much faster.

The most vulnerable category is electronics and computers, which account for about 40% of Harvey Norman's total sales, particularly since manufacturers such as Dell and Apple have paved the way for online distribution. Audio-visual equipment is also under threat.

Even categories less exposed – such as furniture, bedding and white goods (which comprise 50% of Harvey's sales) – are being threatened by global operators such as IKEA and new chains such as Woolworths' Masters. Furthermore, JB Hi-Fi has recently expanded into white goods and home appliances. Only furniture and bedding should remain impervious to online competition.

Price deflation to continue

Harvey Norman's buying clout and the absence of well-known online electrical retailing brands will initially contain the market share loss. But it will exert downward pressure on prices. The established trend of price deflation in electrical products will inevitably continue, meaning sales growth would have to come from higher volumes – and that's a tall order.

These structural threats say nothing of cyclical ones such as housing starts and unemployment. Australia has enjoyed a huge, once in a generation, resources boom. This has boosted employment and incomes across the land, helping us to buy new houses and fill them with shiny TVs and plush couches.

But the boom is busting and we don't see the next decade being anywhere near as favourable for retailers as the last. We expect these three threats to cause Harvey Norman's margins to come under increasing pressure – indeed, the company's operating margin has already fallen from around 24% five years ago to 18% today.

What's Harvey worth?

Harvey Norman's valuation needs to be considered against this gloomy backdrop. The company can be thought of as two interrelated businesses – its retailing/franchise business and its large property portfolio. Let's start by estimating the value of the property.

The portfolio of company-owned stores has a balance sheet value of $2.3bn, based on market valuations. Based on our broader views about property valuations in this country we'd consider this to be on the generous side. We'd estimate fair value for the portfolio to be closer to $2bn, and a cheap valuation of $1.5bn.

So what about the remaining retailing business?

Although Harvey Norman reports separate earnings for owned and franchised stores, they are muddied by the rent saved by owning many of the properties.

We estimate that rent-adjusted earnings before interest and tax (EBIT) could swing between $100m and $300m over the next few years depending on the economic environment. All things being equal, we'd be willing to pay a higher multiple when EBIT is closer to $100m and a lower one when it's closer to $300m. We'd suggest a value of between $1bn and $1.5bn for the retailing business.

Adding on the property value of between $1.5bn and $2bn, and deducting net debt of $595m we arrive at an equity value of $1.9bn–$2.9bn, or $1.80–$2.70 per share. That's well below the current market price of $3.20, which assumes a lot of growth in retailing profits.

The right price would compensate for many of these problems, but at the current share price there's no margin of safety. We recommend you take advantage of the market's enthusiasm. SELL.