We recently revisited Harvey Norman Holdings (ASX:HVN) after the Company reported sales performance for the period 1 July 2020 to 17 September 2020 (i.e. 1H21 to date). Sales performance was impressive, given strong demand across most regions. However, the key question is the extent to which the sales momentum can continue. Also, to what extent is HVN’s earnings leveraged to this sales momentum?

About Harvey Norman

Harvey Norman is a retailer that sells products in the following categories: electrical goods, furniture, computerised communications, bedding and manchester, kitchen appliances, small appliances, bathroom and tiles, carpets and flooring.

In Australia, the Company operates under a franchise system, under the Harvey Norman and Domayne brands. As at 30 June 2020, there were 194 franchised complexes in Australia and 96 Company-operated stores in international markets. These are namely New Zealand, Slovenia, Croatia, Ireland, Northern Ireland, Singapore and Malaysia.

In addition to franchised retail operations, HVN has a substantial property portfolio (valued at $2.6b). It consists of freehold investment properties in Australia, owner-occupied land and buildings in NZ, Singapore, Slovenia, Ireland and Australia and joint venture assets.

Key Fundamental Drivers

Sales Growth Reported in Most Regions

The broad-based nature of the +30% increase in sales for the 1H21 to date highlights that the consumer trend towards home improvement is a universal one in the face of movement and service consumption restrictions. Demand for consumer durables is strong across the group’s Australia & NZ and European operations. However, Asian demand remains soft as a result of COVID-19 concerns.

The Company’s international operations have been an area of strength. Performance was also better than expected in 2H20. Having said that, the pace of recovery post COVID-19 is likely to be variable.

Improvement in Competitiveness of Australian Franchise Operations

Having lagged competitor JB Hi-Fi in recent years, HVN’s Australian Franchise operations are currently performing broadly in line with both JB Hi-Fi and The Good Guys. In context, the Australian Franchise operations account for ~27% of overall sales but over 50% of group EBIT.

In an absolute sense, sales performance to date (+33.8% for 1H21 to date) has shown resilience. This is despite the adverse impact of 18 franchised complexes being closed due to Stage 4 restrictions in Melbourne. Up to 8% of HVN stores are located in Greater Melbourne. They also operated on a ‘delivery & click and collect only’ basis.

The key factor underpinning the strong sales performance in Australia is that domestic demand for consumer durables continues to exceed expectations and is likely to remain elevated throughout FY21. This is despite the impact from the tapering of fiscal stimulus measures from October 2020.

The Australian Franchise operations have benefited from a shift in consumer expenditure from travel and services into household goods. Robust sales of essential whitegoods, technology and home office furnishings, which were evident in 4Q20, have continued into 1H21. Recent data publications and industry feedback suggests that Australia retail, specifically household goods retailing, continued its strong momentum into October 2020.

This momentum is expected to remain throughout FY21, due to ongoing COVID-19 restrictions and an increasing focus on technology products (i.e. study/working from home), entertainment products and, more recently, furniture & bedding. There is also increased demand from renovation sales, with a strong pipeline for home-maker sales in the near term given that international travel restrictions are unlikely to ease anytime soon.

Operating Leverage Remains Very Strong

For its Australian Franchise operations, HVN has a high level of fixed costs given its franchisor structure. In turn, this has enabled an historically high level of operating leverage. The latter was a key driver of its 2H20 performance, with Profit Before Tax (PBT) margin growing by 378 basis points to a record 7.04%. This was 40 basis points higher than the previous peak in 1H10 and slightly ahead of JB Hi-Fi’s Australian business (6.8% in 2H20). It was also well ahead of The Good Guys (4.7% in 2H20).

In the most recent trading update, HVN disclosed that PBT for 1 July – 31 August was up by 186%. This compares to aggregate sales growth of ~30%, albeit over slightly different periods reported for PBT and sales in the recent trading update). This indicates a greater rate of operating leverage in 1H21 to date, in comparison to 2H20. So while HVN has significant leverage to sales growth, the degree of leveraging is stronger. In context, HVN’s operating leverage is estimated to be well ahead of that for its competitors (namely JB Hi-Fi, The Good Guys and Bunnings).

Potential for Capital Management Despite Balance Sheet Moving Back to a Net Debt Position

The balance sheet recently shifted to a net cash position, as cashflow was boosted by a temporary working capital reduction. However, the strong cashflow performance in FY20 is unlikely to be sustained. This is because working capital normalises post the COVID-19 driven sales peak. Accordingly, as the free cashflow position weakens, the balance sheet is expected to revert back to a net debt position in FY2. However, the extent of this is highly uncertain.

Notwithstanding this, there is still potential for capital management in the form of special dividends, given that there are substantial franking credits. This would augment the already attractive yield (~6% on a 1-year forward basis). However, it is worth noting that while the Company has, in the past, paid special dividends in order to return excess franking credits to shareholders. The timing and magnitude of further capital management initiatives depends on the extent to which further investment may be required on freehold property and development.

Fundamental View

Harvey Norman is expected to benefit from continued sales momentum in its key regions (in particular the Australian Franchise operations). This translates into a greater degree of profit growth given the recent strengthening in operating leverage.

Accordingly, with the shares currently trading on an undemanding multiple (2-year forward P/E multiple of ~12x which is in line with its 5-year average) and offering an attractive yield and potential for capital management; we consider HVN to be a stock worth considering.

Charting View

Our previous charting comment was in our weekly research (The Dynamic Investor) back on 4 August when HVN was trading at $3.63. We noticed that the chart was looking a bit more positive again and suggested a close above $3.80 should see it rally to higher levels. We have now seen HVN test the February peak and then ease back from it. At current levels we should be seeing some good support come in. If it cannot hold here then there is very strong support back near $4.20. Either way, we like the way HVN has been trading and these are the sorts of levels where you can look for a bounce higher to indicate the start of the next rally and the next buying opportunity.

 

Michael Gable is managing director of Fairmont Equities.

 

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