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Morningstar | Harvey Norman’s Property Portfolio to Contribute Less to Earnings Growth. FVE Lowered to AUD 3.20

We’ve lowered our earnings estimates for no-moat Harvey Norman’s portfolio segment, because we predict steady declines in footfall to impede on meaningful rent increases. We have cut our long-term rental growth forecast and now expect flat rental income over the next decade, from an already cautious 2.5% average growth rate previously. Our fair value estimate decreases by 6% to AUD 3.20 per share.

Many retailers are rationalising their store networks, such as Target, Big W, and Myer, and even Coles is aiming for a more measured store rollout following its recent investor day. Other retailers are seeking rent reductions, a topic that is top-of-mind for Premier Investments. We expect downward pressure on rents to mount as online’s share of the overall retailing market increases, resulting in less foot traffic in Australian stores. The online retailing market has grown at an average annual rate of 13% over the last five years and we project this trend to continue over the next five years, with e-commerce sales increasing by an average of 14% per year to fiscal 2023.

We expect the dominant players in their respective categories to take market share from smaller and weaker players, which are burdened with lower-traffic online channels, less competitive pricing or lower gross profit margins, or a higher cost of doing business. We expect Harvey Norman, together with JB Hi-Fi, to consolidate the brick-and-mortar channel in consumer electronics. A recent example is the acquisition of three 2nds World stores by Harvey Norman, after the retailer entered voluntary administration in April 2019. Yet, we don’t forecast Harvey Norman’s store count to increase. Rather, we expect the company to increase its online sales to maintain market share. We estimate e-commerce accounts for around 3% of Harvey Norman’s sales, offering opportunities to grow. This compares with the overall Australian retail market at 9%, and U.S. market-leader in consumer electronics Best Buy’s 17%.

Harvey Norman’s retail property segment is sizable and contributes about 30% of the company’s operating profits. It adds further exposure to the macroeconomic headwinds of cyclical soft consumer spending, weighing on Australian retail sales. We estimate the property portfolio will lose its importance, accounting for just over 20% of group EBIT in 10 years. Harvey Norman currently owns 94 of its 195 franchised complexes in Australia. According to A-REIT Aventus Group, this represents 15% of all Australian large-format retail centres larger than 10,000 square metres.

We expect lower tenant profitability to result in real rent reductions or vacancies. Bulls cite population growth and falling interest rates, but higher savings rates, rising unemployment, and a sluggish housing market are hard to ignore.

The Reserve Bank of Australia shares a similar view. In June 2019 it stated: “Given softer retail trading conditions, increased supply of retail space and the rise of online shopping, some landlords have been willing to offer lower rent increases or incentives.” As tenants are becoming more willing to reduce physical stores and expand their online presence, this is an effort to avoid vacancies and places downward pressure on rents.

Harvey Norman is not alone, with Stockland Corporation recently blaming rental growth of just 0.2% for lease renewals in the first half of fiscal 2019 on weak retail sales growth. On new leases, annualised rental growth was down 2.6% versus the previous leases, reflecting “tenant remixing and some downward rebasing of rents,” or in other words, rental demand has weakened in recent years.

As long as Harvey Norman’s properties are occupied by Harvey Norman franchisees selling consumer electronics, home appliances and furniture, strategies implemented by some landlords diversifying into other product categories are difficult to implement. In a bid to increase weekday foot traffic and improve customer-linger time, Aventus Group, a manager of large-format retail centres, is shifting away from furniture, bedding, and electronics, and “diversifying tenancy mix with more exposure to the everyday-needs category,” which include products and services such as food, health, and well-being. The everyday-needs category accounted for more than 50% of their new leasing deals in 2018.

Furniture is less amenable to e-commerce than other retail categories, and online penetration in Australia is currently negligible. However, there is potential for the category to be disrupted by online in Australia too.

For instance, U.S. listed William-Sonoma, specialising in appliances, kitchenware, and home furnishings, reported that in 2018 over 54% of their business was online. Meanwhile, IKEA is pushing their online presence domestically through virtual showrooms and opening its first Australian small-format store of 98 square metres in May 2019. These smaller studio stores are aimed to attract consumers that are increasingly short on time, and who prefer to shop at stores that are convenient to them rather than travel and spend time at destination-type stores.