Description

Overview:

Harvey Norman (“HVN”) is a high-quality franchisor and retailer with upside optionality embedded in international expansion and its freehold property portfolio. I believe that now is an appropriate time to enter for the medium to long term, as the market is pricing in the reversion from goods to services upon reopening. Whilst this is correct and revenue/earnings will decline, it is important to recognize the value embedded in the underlying business.

Key Points:

·         Leading retail franchise business in Australia

·         Growth opportunities through offshore expansion

·         Upside to freehold property valuation

End Market:

Harvey Norman has an estimated end-market of $63.7B based on FY20 figures for consumer electronics, household appliances, and furniture, floor coverings, and household goods expenditure from the Australian Bureau of Statistics. Harvey Norman’s product mix is unknown but was last disclosed in 2004, where 22% of sales were furniture-related and the remainder were consumer electronics, appliances and adjacent verticals. Based on Harvey Norman’s sales figures, as well as the market data outlined above, HVN only has 10-15% penetration as of FY20. The domestic end-market is relatively immaterial, however, because the crux of my thesis is mainly growth opportunities through offshore expansion, which competitors like JBH (which are also extremely high quality and worth looking at) do not have.

Business Model:

Harvey Norman is an integrated retail, franchise and property business. It is multi-branded across Harvey Norman, Domayne, and Joyce Mayne (which is mostly a legacy concept with very few stores).

Australian Network:

·         The Australian store network operates under a franchise system.

·         Harvey Norman provides the store’s capital base and franchisees handle operating expenses.

·         There is a c.70%/30% profit-share arrangement in Harvey Norman’s favour.

Offshore Network:

·         The offshore network is company-operated, just like any other retail business.

Network Sales:

Organic Growth:

·         Harvey Norman’s domestic network sales have grown at 7.8% p.a. over 2016-2020. This has been driven by population grown of 1-2% and the remainder by per. capita expenditure growth (driven by income growth with income elasticity near one). I by no means expect this growth going forward. Rather, my model is pricing in LSD c.1% population growth and c.1-2% per. capita expenditure growth (proxy for SSS growth), after an initial decline that brings revenue growth in line with trend c.4% growth from FY19.

Growth Opportunities:

·         As mentioned, HVN has been expanding internationally, throughout New Zealand, Singapore, Malaysia, Slovenia, Ireland, and Croatia. It is quite difficult to price an open-ended growth story, but we can at least look at what rates of growth can be supported by current cash flow generation and returns on capital. HVN expanded its company-operated store base by c.7% in FY20 and c.12% in FY21. I am pricing in a ten-year expansion rate of c.3-3.5%.

In summary, my network sales are being driven by c.1% population growth, c.1-2% per. capita expenditure growth, and c.3-3.5% growth in the offshore store base.

Return on Capital:

I have shown a summary calculation below. Note that I am imperfectly revising the ROUA for a ten-year lease term, mainly because I use this to normalize when comparing across companies. The franchisee-operated retail segment generates a far lower return on capital than the company-operated segment. Given that HVN’s expansion overseas is via company-operated stores, this implies upside for aggregate return on capital metrics (which lots of investors use to price stocks these days) based on changing store mix alone.

Margin:

Strong sales performance has allowed for operating leverage in stores, with EBITDA margins increasing from c.10.5% in FY20 to c.12.5% in FY21 for company-operated stores and increasing from c.8% to c.11% for franchised stores. I am pricing in a reversion to c.6-8% EBITDA margins for the long-term, ignoring any medium-term scaling benefits to be conservative.

Valuation:

The following assumptions are made:

1)       SSS growth of c.2-3% p.a.

a.        The market has historically grown at c.4-5% p.a.

2)       Network expansion of c.3-4% p.a.

a.        The company has expanded at MSD to HSD over the last 2-3 years.

3)       EBITDA % of revenue at c.7-7.5% for company-operated stores.

a.        The last 2-3 years have benefitted retailers via strong operating leverage. This is merely a reversion to “normal.”

4)       EBITDA % of revenue at c.6.5-7.0% for franchise-operated stores.

a.        Similar to above, except that franchise stores have tended to outperform on a profit-share-adjusted basis so this must be considered, as well as the 70/30 split.

5)       New stores are leased rather than bought outright

a.        This is in line with historical figures. Most freehold property is held in Australia and New Zealand.

6)       The property segment increases rent at a CPI escalation rate (already negotiated) of c.2% p.a.

a.        The base level of EBITDA is also adjusted to strip out fair value gains and losses that distort historical margins.

7)       Working Capital ratios revert to FY19 levels to highlight a “return to normal” and deleveraging of operations and the retailing cycle.

Valuation of HVN’s Offshore Growth:

Based on my DCF, HVN’s offshore growth opportunities are worth approximately $0.5-1/sh based on a sensitized expansion rate of 0-4% and same-store-sales growth of 2.3% p.a. This is approximately 10-20% of the current share price of $5.16. The remaining business is being priced at 4.5-5x EBIT whereas comparable retailers are priced at 7-10x EBIT.

HVN’s historical discount can be explained by lower capital efficiency in terms of buying rather than leasing property. This does not hold going forward for the expansion overseas via mostly leased stores.

Valuation of HVN’s Property Segment:

On a superficial basis, the property segment leads to a lower return on capital. However, the capitalization rate on property earnings should also reflect the lower risk relative to the other retail business. Comparable property portfolios like HomeCo and BWP Trust use capitalization rate of c.5.6-5.7% whereas Harvey Norman uses a rate of c.7% for its freehold property portfolio. Using this capitalization rate on Harvey Norman’s adjusted (for gains and losses) property earnings yields c.$2.43/sh or 47% of the current share price. The remaining retail business is worth c.$5.62/sh in my DCF’s base case, resulting in a SOTP valuation of c.$8.05/sh (+ 56%)

Some discussion on this point is required. The main reason for the different capitalization rate is the shorter lease terms granted by Harvey Norman vs. HomeCo and BWP Trust. This implies higher risk of vacancy. I believe that the risk of vacancy is vastly overestimated on this basis; the strength of HVN’s franchise means that they are unlikely to have a shortage of prospective franchisees. This considered, I believe that the discount imposed on HVN’s property portfolio is unwarranted and presents additional valuation upside.

Summary of Valuation:

I have summarized my DCF and SOTP valuation results below, which all use fairly conservative assumptions:

Key Risk:

• Failure to expand overseas (though this has been occurring for several years).
• Potential to be outcompeted domestically by JBH in the consumer electronics segment. They don't disclose mix so it is hard to tell exactly. Overall SSS performance for HVN vs. JBH domestic has been similar (7% vs. 8% growth over 2016-2020) so unlikely unless big mix change from HVN.

Catalyst

• Getting over the hump of reversion to services from goods.
• Long-term expansion plan and value creation, supported by strong dividend payout in the meantime (7% yield).
• Property portfolio's underlying value can be unlocked when new management come in (likely within the next five years).