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Morningstar | Corporate Action: Entitlement Offer Bolsters Harvey Norman’s Coffers, While Focus Shifts Abroad

There was little to excite us in no-moat-rated Harvey Norman’s full-year results to June 2018, and even the core Australian franchisees segment saw its sales momentum further deteriorate in the first two months of fiscal 2019. Together with the results, management announced a renounceable entitlement offer to raise some AUD 164 million to keep its gearing in check. The offer price of AUD 2.50 per share is well below our fair value estimate and the current share price. A top-up facility provides eligible shareholders with the opportunity to apply for additional shares in excess of their entitlement at the same offer price. An information booklet will be mailed to eligible shareholders around Sept. 14. The positive impact of the time value of money on our fair value estimate is offset by the weaker-than-expected result, the more cautious earnings outlook, and the dilutionary effect of the equity raising. We maintain our fair value estimate of AUD 3.40, with shares screening as slightly overvalued at current prices.

The firm reported underlying net profit after tax of AUD 377 million, virtually flat on fiscal 2017. Adjusted earnings were 5% short of our estimate, mainly on lower-than-expected operating profits in both the Australian and international businesses. The total fiscal 2018 dividend was AUD 0.30, at a payout ratio of 89% of underlying EPS, higher than our AUD 0.25 estimate. We lifted our dividend payout expectations to 80% from 70% over our forecast period.

In Australia, intense competition in the consumer electronics and home appliances categories weighed on prices as franchisees protected market share. Franchisee sales slowed markedly in second-half fiscal 2018, with comparable sales declining by 0.8% in the third quarter and increasing by only 1.3% in fourth-quarter fiscal 2018. Headline franchisee sales of AUD 5.8 billion in fiscal 2018 were up only 2.6% year on year, falling 1.5% short of our sales estimate and our sales growth forecast of 4.1%.

Franchisees had a bleak start to fiscal 2019, with total sales and comparable sales both going backwards, down 2.0% and 1.1%, respectively. This compares with JB Hi-Fi’s slow but positive like-for-like sales growth in July, at 0.3% for JB Hi-Fi Australia and 1.4% for The Good Guys.

However, we expect sales growth to return, in part from the completion of the company’s Australian flagship store in the Western Sydney suburb of Auburn in September 2018--easily in time for the key Christmas trading period. Harvey Norman’s flagship stores overseas have outdone management expectations, and by strengthening the Harvey Norman brand, other stores have also experienced a sales uplift. We estimate comparable sales growth of 2.5% in fiscal 2018, and at around 3% over the long term as Harvey Norman successfully maintains its market share by ongoing consolidation of the brick-and-mortar channel.

Price-cutting and investments in customer service and online delivery options crimped franchisees’ operating margins and hence franchising fees to Harvey Norman. The company’s franchising operating margins were down 52 basis points to 4.9%, more severe than our expectation of a 15-basis-point decline. We expect competition to remain intense, but Harvey Norman to be a formidable contender and its Australian operating margin to average 4.8% in the long term.

The Australian segment remains the largest, contributing about half of the company’s operating profit. Yet the headwinds in Australia could have contributed to management’s decision to focus its store rollouts on overseas markets over the next two years, in particular Malaysia. Operating profits were also weaker here than we expected. The international company-operated stores account for about 20% of group profits. Total sales were up by 9.3% versus our estimate of 5.8% sales growth. We expect strong sales growth, especially in Malaysia, to result in total international retail sales growing at an average rate of 10% over the next two years, before moderating to around 3% in the longer term. However, operating margins in the retail segment increased by only 30 basis points to 5.4% but were short of our 5.9% estimate.

The property segment partially offset the franchising operations and retail segments. Underlying operating profits, excluding property revaluations, of AUD 137 million were 7% higher than our estimate of AUD 128 million, owing to slightly higher revenue and slightly lower costs.