EUR 850.00 For Business Accounts Only

Morningstar | Harvey Norman’s Franchisees Lose Market Share as Overseas Operations Benefit From Flagship Stores

No-moat rated Harvey Norman’s first-half sales and profit growth tracked below our prior full-year expectations, and we’ve slightly downgraded our near-term outlook. After a slow first half in the core Australian franchising operation, we expect the remainder of fiscal 2019 to be challenging as consumers grapple with relatively sluggish wage growth, a weakening housing market, and associated negative wealth effect as well as uncertainty around the upcoming Australian federal elections in May 2019. Overseas, the smaller company-owned operations fared much better, but sales growth was still below our too-optimistic prior expectations. Looking past the current year, we continue to see fierce competition from JB Hi-Fi, The Good Guys, and Amazon limiting market share gains in Australia. We also expect competition to stifle EBIT margin expansion, and franchising operating margins were down 20 basis point in the first half. Our long-term sales and underlying NPAT growth estimates are virtually unchanged, with both growing at a compound rate of 3% per year. Our fair value estimate is unchanged at AUD 3.40.

There is potential upside to our sales growth forecast, if the overseas success with its flagship store strategy, can be replicated in Australia. Yet, the new flagship store in Sydney must still prove itself, and any material sales uplift is likely to be met by price cutting by competitors seeking to protect their market share. Fading consumer sentiment is not the only headache for Australian retailers. A more long-lasting structural challenge is the migration of consumers to the online channel. This requires brick-and-mortar retailers to increase capital spending and operating costs to develop, maintain, and run an online channel, but it also opens the door to a raft of new competitors--the online pure players. Harvey Norman’s low online sales penetration remains a key concern of ours, which we estimate at only 3%--half that of JB Hi-Fi.

The company’s Australian franchising operations account for about half of the group’s operating profit. After signs of improving sales momentum into November 2018, Australian sales growth slowed again toward the end of the calendar year. Headline sales fell 1.7%, with like-for-like sales declining by 0.6%. We estimate Harvey Norman’s addressable market was flat in the first six months of fiscal 2019, and the decline in sales translates into a loss of market share. In contrast, Harvey Norman’s arch rival in consumer electronics, JB Hi-Fi, grew its Australian sales by 4% in the period. JB Hi-Fi’s strong online sales growth of over 20% accounted for about one third of its like-for-like sales growth, and we see Harvey Norman’s weaker online platform as a source of its relative underperformance. We’ve lowered our full-year headline sales growth estimate for fiscal 2019 to a decline of 2%, from flat sales previously.

The overseas segment generated about one quarter of the group’s pretax profits in the half and was the bright spot of the results but nevertheless tracked below our prior expectations. The company-operated stores grew headline sales by 12%, below our previous 17% forecast. We had expected more store openings in Malaysia, although management reiterated its target of 25 stores there by the end of fiscal 2020, up from the current 17 shops. The strong overseas sales growth was supported by flagship stores opened in all seven overseas countries over the past three years, increasing brand awareness and thus boosting sales at other existing stores in country. The sales increase resulted in EBIT margin expansion, and profits before tax increased by 25%. We had expected stronger headline sales and hence greater leverage, resulting in overseas profits rising by 34% for the full year. We have scaled back our full-year estimates in line with the half, with sales growth of 12% and profits increasing by 25% in fiscal 2019. Our longer-term forecasts are not materially higher, with annual overseas profits only 3% higher over the next decade.

The property segment composes roughly one quarter of group pretax profits--down from over 40% five years ago. The 13% increase in profits was mainly due to property revaluations totaling AUD 37 million, up AUD 14 million versus the pcp. The uplift in asset value bolsters gearing metrics but is non-cash in nature and doesn’t impact our DCF valuation.

The board declared a fully franked dividend of AUD 12 cents, in line with the pcp. We forecast dividends to total AUD 26 cents in fiscal 2019, offering an attractive yield of 8% at our fair value estimate.