Harvey Norman franchisees have been caught with too much stock just as sales momentum is heading backwards. The company is losing market share in both furniture and consumer electronics in Australia. But the large investment property portfolio provides downside protection.
HVN’s January trading update signalled a quickly slowing sales environment. November and December sales had already slowed so the January update embeds a trend of slowing comparable sales growth. Some of the impact is due to the unwinding of sales pulled forward by COVID-19 during the last year. Price inflation is also beginning to fade. Topping off the grim sales picture is the apparent loss of market share for HVN in both furniture and consumer electronics.
Specifically, the trading update showed comparable store sales for Australian franchisees had fallen -10.4% in January compared to last year. New Zealand sales fell -8.5%, Northern Ireland -27.2%, Slovenia & Croatia +10% and Malaysia -10.2%.
The situation In New Zealand where the company has 44 stores will be more protracted given the effects from cyclone Gabrielle may be quite extensive.
We expect comparable store sales growth to fall in FY23f and FY24f as consumers face up to higher interest rates and wind back spending on discretionary purchases as a consequence.
Compounding the sales problem for HVN is its bloated inventory position. At 31 December 2022, HVN had just over $1.1bn in receivables and $598m in inventories, it’s highest ever level of stock. The excess stock is often concentrated in a few categories that have not sold well through a period and we expect that seasonal products such as air-conditioners, bbqs and outdoor furniture are behind these figures.
The solution to carrying too much stock is to discount it and HVN has been spending more on marketing recently. Anecdotally, HVN’s TV ads often spruik an ‘interest free’ period which is currently at 60 months, indicating that promotional activity is rising.
The consequence of these factors will result in falling margins which we think will extend over a two year period rather than a rush.
Offsetting these negative factors is HVN’s strong balance sheet and its large property investment portfolio. The balance sheet has net debt of $553m placing gearing at 0.64x (net debt to EBITDA).
The property portfolio consists of $3.4bn of investment property or approximately $2.74 per share. This provides a genuine valuation buffer against the prospect of falling sales and tighter margins.
Investment View
The sales evidence points to lower earnings, but the counterfactual argument is the valuation support from the $3.4bn property portfolio. HVN has been and will persist with ‘support’ for its franchisees so that pretax profit margins will see a marked decline but from an elevated position through the pandemic (Figure 2). There is no near term catalyst to lift the share price performance, but we see limited downside due to the backstop of the property valuation. Despite the interim dividend cut, HVN is trading on an attractive net dividend yield of ~7% (gross yield ~10.8%).
Risks to Investment View
Higher interest rates might not impact the housing market as much as expected thus having less impact on furniture sales for HVN. If consumer confidence was less impacted by higher interest rates than anticipated, then HVN’s sales might be less impacted. Higher interest rates could also impact HVN’s property portfolio, and the capitalisation rate applied.
Recommendation
We have retained our Hold recommendation.
Figure 1: 1H23 RESULT
Figure 2: PRETAX FRANCHISEE MARGIN
Figure 3: PROFIT BEFORE TAX $M
