| 2014 | 2015 | ||||||
| Price: | 3.70 | EPS | NA | NA | |||
| Shares Out. (in M): | 1,063 | P/E | NA | NA | |||
| Market Cap (in $M): | 3,934 | P/FCF | NA | NA | |||
| Net Debt (in $M): | 563 | EBIT | 0 | 0 | |||
| TEV (in $M): | 4,792 | TEV/EBIT | NA | NA | |||
| Borrow Cost: | NA | ||||||
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"We will continue to support our franchisees with provision of “tactical support” to equip them with the means to manage the difficult trading environment. This unique feature of our franchised model promotes the essential strong alliance with franchisees to grow market share” – 2013 Annual Report
I. EXECUTIVE SUMMARY
Australia is an amazing country and home to several interesting things for the adventure-seeking person including the fantastic outdoor landscapes, beautiful beaches, the Aussie humor and friendly people. The Land Down Under is also home to Harvey Norman (ASX: HVN), a $3.9bn market cap retailer that at current 4 year stock highs, seems materially overvalued and a compelling short priced for perfection at 48x FCF and relative to asset value despite facing severe competition. From due-diligence and channel checks, we focus the summary on the key points, including tactical support, unique franchise structure, severe competitive landscape, some interesting (and deeply buried) footnotes, accounting disclosure, and finally valuation. While the write up has been submitted elsewhere previously and does not count towards annual submission, we summarize the key points here for VIC. All of the information in the write-up has been derived from public filings, news, industry research, and company, unless specifically noted. Please refer to the full disclaimer at the end.
Harvey Norman was an early pioneer in Australian retail and we respect the founders for their entrepreneurial success, primarily in the early years, from 1987 (IPO listing on ASX) to 2000. However, a lot has changed in the last decade with severe and relentless competition from domestic and online retail and HVN's core business has struggled, leading to our view on the stock at current highs. Indeed as a sign, over the last four years, the core Australian retail "franchise" business has received hundreds of millions of "tactical support" (receivables writeoff - refer to accounting entry in Appendix B). Franchisees put down almost $0 start up capital, receive a generous A$80-90K base salary from the parent, car lease, sign 30 day initial lease (not a typo) on owned property and receive potentially, working capital loan. Accounting/financial disclosure is limited, for analysts, for instance, i) limited disclosure on size of owned vs. leased properties, ii) gross rent revenue from franchisees “rising” every year despite declining trend in system-wide sales, tactical support, etc. iii) franchisee inventory is not recorded on the inventory line item in the consolidated balance sheet; instead, it appears as part of the receivables entry and there is iv) limited disclosure on tactical support. For legacy reasons, individual franchise performance is not fully consolidated, which results in limited visibility on unit franchisee cost structure. We do not make an assertion that the company is doing anything to violate accounting standards. But ultimately, we believe, that because HVN is a public company -- minority investors deserve transparent disclosure so that true earnings and cost structure is more transparent. Capital allocation has been poor – international expansion has been a drag with non-canceleable long-term leases in Ireland (A$243.3mm of lease liability in Ireland as of June 2014), acquisitions loss-making (Clive Peeters) and non-core investments – including “live stock” or mining accommodation questionable and a confirming sign from management itself that the core franchise business growth is sluggish. Indeed, over the last 10 and 15 years, HVN stock has significantly underperformed the ASX and sits on a huge pile of unpaid franking credits. Harvey Norman’s reliance on capital markets with upcoming debt-refi (A$370mm coming due on 22 Dec 2014) by offering security on some property instead of entirely funding through free cash flow is telling. Not to mention, off balance sheet debt of A$780.8mm of operating leases (incl. Ireland) and A$242.0mm in contingent liabilities (footnote 34 - i.e. guaranteeing performance of a number of controlled entities entering into operating leases and facilities with other parties) means that HVN's leverage should reflect off-balance sheet liabilities.
Over the last 3-4 years, as rising tides lift all yachts, HVN stock sits at 3-4 year highs propped by a housing bubble in Australia (refer to links on the housing bubble in catalysts section) and non-core (and non-sustainable) significant FX “translation” gain in 2014 in the international business due to a declining A$. Management compensation is worth noting, multi-million dollar salaries for everyone on the executive committee and a Nov 2014 equity research note from Credit Suisse reading "HVN: Non-financial measures dominate "at-risk" remuneration. Mr. Munger says "Incentives matter" -- we pay particularly close attention in Asia to management alignment to minority shareholders. Related party transactions with Derni offer not great disclosure. In sum, at 48x FCF, HVN stock is more than priced for perfection, exacerbated by multiple factors, including debt refinancing with some property security, potential Australian housing bubble, sustainable quality of free cash flow, unsustainable “translation” FX gains, severe and relentless competition, high tactical support (a.k.a. receivables write-off) and recent capital allocation track record. It is also worth noting that large outside shareholder who we respect, Perpetual has sold off more than half of its shares in HVN at prices significantly below current despite previously hiring an independent third-party valuer to ascertain the value of the property. In a detailed 93-page report to Credit Suisse research (kudos to them) in Oct 2012, summarized "The rental rates sustaining HVN’s book value appear to be toward the upper end of the range expected for Bulky Goods. This outcome is surprising due to a relatively high proportion of HVN properties being in relatively low demographic areas and rural locations for which market rents and alternative use values would be likely to be lower". In sum, at current levels of over A$3.70, HVN seems overvalued with approx. 35-40% downside to current price (closer to our estimate of intrinsic value), realized over a 18-24 month time frame.
II. TACTICAL SUPPORT OF A$416.2MM IN LAST 4 YEARS (AMIDST A BULL MARKET) POINTS TO A SIGN OF LONG-TERM STRUCTURAL COMPETITIVE POSITION OF CORE FRANCHISE RETAIL BUSINESS
In the last 4 years, a sign of the core franchise business is buried in footnote 4 of the 2014 filings of Harvey Norman under “expenses and losses” called “tactical support” (accounting entries in Appendix B). So why is tactical support (a.k.a. receivables write-off) notable? First, over the last 3 years, tactical support has persistently stayed over A$100mm each year, which is not insignificant for a few reasons. Consider, that HVN has A$115.2mm in cash (after bank overdraft) (the company presents cash before bank overdraft on consolidated balance sheet...analysts should diligently flip to footnote 28(a)), A$707.9mm in interest bearing debt (A$370mm coming due on 22 Dec 2014), $780.8mm of operating leases, A$242.0mm in contingent liabilities and on average based on our estimate, A$75-100mm in "free" cash flow. Second, the size of tactical support sheds light on the franchise model. Appendix B illustrates tactical support, where Harvey Norman’s loan receivable with franchisee is reduced (matching the support) and in franchisee accounts (not consolidated), franchisee’s loan payable to Harvey Norman reduces. Given HVN has had an average of 686 franchisees in the last 4 years, this implies approx. A$150,000 of tactical support per year per franchisee. This is "conservative", as we divide tactical support between all franchisees (profitable and unprofitable) vs. just unprofitable franchisees. HVN simply does not provide disclosure to the number of unprofitable franchisees who receive tactical support (analysts valuing HVN including us would welcome such disclosure going back over time...). Importantly, HVN only started disclosing tactical support from the 2012 annual report... but the company has confirmed that this was offered even in prior years but the disclosure only started 2012 annual report. Why only start this disclosure from 2011-2012?
For readers, requiring an introduction to tactical support, an interesting article in the Australian media appeared on tactical support: http://www.brw.com.au/p/business/the_worrying_number_behind_harvey_UIFKWac83LJqreCf7flkoO
III. WHY ARE GROSS RENT REVENUE PAID BY FRANCHISEES RISING, DESPITE "30 DAY" INITIAL LEASE TERMS ON OWNED PROPERTIES, $100MM+ TACTICAL SUPPORT EACH YEAR IN LAST 3 YEARS AND DECLINING FRANCHISE SYSTEM-WIDE SALES TREND?
As of June 2014, in Australia, HVN has 198 complexes - it leases 118 and owns 80 properties (2013: 126 leased, 80 owned). Gross rent revenue from franchisees has marched higher despite declining franchisee fees and system-wide sales every year. No other revenue driver has marched consistently higher, every year. In addition, tactical support offered to franchisees remain stubbornly high (over A$100mm each year for the last 3 years). Investment properties over the last 3 years witnessed revaluation decrements of -A$24.9mm, -$59.12mm and -A$11.65mm. To add, franchisees in HVN owned properties, sign initial “30-day” (add to unique features for HVN) short-term leases, thereafter terminable at will. We spoke to industry analysts and 30-day initial leases is certainly unqiue in Australia...and globally. Therefore, you have a situation where rents are rising despite i) high tactical support, ii) declining trend in franchisee fees and system-wide sales, iii) revaluation decrements in the last 3 years and iv) 30-day initial lease. Finally, there is limited disclosure on the size of the owned vs. third party leased properties, which is odd, given the stated book value. Surely, minority investors deserve a little more transparency (HVN is a public company after all and not a private one).
WHAT HAVE SOME AUSTRALIAN SELL-SIDE ANALYSTS WRITTEN HISTORICALLY ON RENTS? Admittedly, while we generally do our own work and do not actively seek out consensus view, it is worth noting comments from sell-side analysts (CS, MS and CLSA) covering HVN on this topic. Credit Suisse research in Oct 2012, in a 93-page report, summarized on page 2 "The rental rates sustaining HVN’s book value appear to be toward the upper end of the range expected for Bulky Goods. This outcome is surprising due to a relatively high proportion of HVN properties being in relatively low demographic areas and rural locations for which market rents and alternative use values would be likely to be lower". Other CS reports discussed in section VII discuss the disclosure too. A CLSA equity research report in the report on Feb 2012 states and we simply quote "Paying franchisees tactical support to pay for rents they cannot afford is effectively robbing Peter to pay Paul". A Morgan Stanley report on Sept 1, 2012 said "We think HVN is over-charging franchisees rent to maintain property values and then increasing "tactical support" to offset this. Rental increases of this magnitude are unsustainable, in our view". Our view is not one to allege whether rents are fair or not. We simple note that gross rent revenue has marched higher despite declining franchisee fees, system-wide sales and tactical support. It is difficult to understand why in a franchisor-franchisee relationship that would be the case especially when initial lease terms are 30 days?
IV. WHY DOES HVN RELY ON CAPITAL MARKETS (UPCOMING RE-FI OF A$370MM FACILITY ON DEC 2014 AND A$240MM ON DEC 2016) ALSO PROVIDING SECURITY ON SOME INVESTMENT PROPERTY?
HVN’s reliance on the capital markets in the last 4 years, instead of entirely through free cash flow is telling. In Dec 2011, Harvey Norman extended the terms of the syndicated facility of A$610mm, otherwise payable in Dec 2012. Under the terms of the facility, A$370mm is repayable on 22 Dec 2014 and A$240mm repayable on 22 Dec 2016 (i.e. 24 months). The debt facilities are secured by some properties located in Australia and New Zealand. Why is this worth noting? Consider, that HVN has A$115.2mm in cash (after bank overdraft) (Note HVN shows on consolidated balance sheet shows cash before overdraft), A$707.9mm in interest bearing debt (A$370mm syndicated facility payable on 22 Dec 2014), A$780.8mm of operating leases and A$242.0mm in contingent liabilities. Therefore, based on the cash balance, HVN will likely refinance the Dec 2014 facility coming due as its not very likely to entirely repay back the facility. We do not believe refinancing is an issue currently given historically low rates globally, but it is worth noting for analysts and investors that HVN has reliance on capital markets, instead of free cash flow, which is fine in a bull market, but as value investors, we won't rely on bull markets to prop us. Franchisees have been paying increasing gross rent revenue to HVN on owned and leased properties (assume pass through given little disclosure). But, as discussed, tactical support of A$416mm over the last 4 years, has helped keep some franchisees in business, in addition to receiving other perks, etc. For the banks to provide working capital facility, HVN provides security on its investment property. To value the property, then doesn't HVN needs tenants (franchisees primarily) to keep paying rent? A Morgan Stanley report on Sept 2012 said " Rental increases are unsustainable, in our view". We don't have reason to disagree.
V. INTERNATIONAL BUSINESS IN IRELAND HAS LOST HUNDREDS OF MILLIONS (SEGMENT LOSSES 8 OUT OF 9 YEARS) WITH EXPENSIVE LONG-TERM LEASES
In Ireland and North Ireland, Harvey Norman has 14 stores, leased from third parties under expensive long-term leases. In Ireland alone, HVN has reported cumulative segment losses before taxes of an astounding approx. A$266.5mm over the last 9 years. As of June 2013, the company had nearly A$258.9mm in operating leases in Ireland and North Ireland. When will the losses in Ireland stop? Unlikely, anytime soon. Ireland has proven to be nothing short of a disaster. Mr. Harvey himself states ''I've never seen something get belted like Ireland'') lose hundreds of millions for HVN and shareholders, with unfortunately still no light at the end of the tunnel due to expensive long-term leases. Outside of Ireland, Slovenia and Croatia businesses barely make any money (5 year median of a mere A$3.0mm segment result before tax). In Singapore & Malaysia, Harvey Norman lost money in FY2014 with segment result before tax declining for 4 out of the last 5 years. In FY2014, A$ sales in international markets were boosted due to (non-core) FX translation of 12.88%, 9.95%, 17.33% and 15.77% in the NZ$, SG$, Euro and GBP vs. the A$. In FY2014, a closer look at the like for like (LFL) sales growth in local currency paints a clearer picture for analysts on business performance.
VI. CAPITAL ALLOCATION IN ACQUISITIONS (CLIVE PEETERS) AND NON-CORE BUSINESS (MINING ACCOMOATION) IS A SIGN OF SLOWING CORE RETAIL BUSINESS
HVN in 2010 stated that the acquisition of Clive Peeters would lead to a positive return within the first year. The following two years, HVN reported a loss of nearly A$100mm. In 2012, there were public articles in the Australian media that commented about Mr. Harvey’s plans to invest nearly A$100mm into mining accommodation, unrelated to the core franchising business (HVN will say this is core as its property…). Indeed an article titled “Mining all of his options” says “Harvey Norman has found an antidote to the malaise in Australian retailing. It has gone into the mining industry. Over the past 18 months Harvey Norman has invested millions in mining services - in particular accommodation in the Queensland town of Chinchilla. The article quotes Mr. Harvey saying the company “doesn't talk about it much (or at all according to analysts). He reckons it makes a better return than retailing right now”. Also, consider, that HVN also spends A$350mm consistently in marketing expenses (yet...system wide sales have declined every year) to protect its brand all the while it has limited pricing power and indeed the business suffers from deflationary headwinds (a fact the company admits in filings). A cursory google search on "Harvey Norman advertisements" will yield ample results that show Harvey Norman advertisements.The company also sits on nearly 17% of its market cap in unpaid franking credits, the highest as a % of market cap in the ASX 300. To pay them out, HVN needs to significantly lever itself. A simple search on Harvey Norman and franking credits tells the story as per below:
• “HVN faces pressure to dole out franking credits”: http://www.smh.com.au/business/harvey-norman-faces-pressure-to-dole-out-franking-credits-20131124-2y3xh.html
• “Investors deserve more franking credit”: http://www.theaustralian.com.au/business/opinion/investors-frankly-deserve-more-franking-credit/story-e6frg9if-1225824471198
• HVN tops list of franking credit hoarders: http://www.businessspectator.com.au/news/2013/11/22/retail/harvey-norman-tops-list-franking-credit-hoarders
VII. FINANCIAL DISCLOSURE SHOULD BE IMPROVED AS FOOTNOTES AND DISCLOSURE IS LIMITED. MINORITY INVESTORS WE THINK DESERVE SOME TRANSPARENCY FOR A LISTED COMPANY AS HVN IS NOT A PRIVATE COMPANY
Analyzing the earnings power of HVN is no easy feat as disclosure provided is limited. Franchisees are separate entities (full list on footnote 37 of the 2013 annual report) and not consolidated. It is important for analysts and investors to fully appreciate that sales made by franchisees in Australia do not form part of the financial results of the consolidated entity. The receivable line in HVN’s accounts is a reflection of the payable from franchisees. There is limited disclosure on revenue drivers, like i) franchisee fees, ii) rent from franchisees (i.e. disclosure on size of owned vs. leased and rent terms with franchisees on owned vs. rent on leased from third parties) and iii) interest (interest on excess inventory, etc.). Understanding the full reconciliation for tactical support left me confounded. HVN has several related party transactions. We bring to attention footnote 30 where loans of A$26.3mm and A$32.4mm were borrowed from related parties to a subsidiary of Harvey Norman called Derni. Based on filings, the figures were A$36.9mm, A$33.2mm, A$28.8mm, A$31.2mm and A$23.9mm respectively for 2011, 2010, 2009, 2008 and 2007 respectively. There is virtually limited disclosure on the "role" of Derni and why is it borrowing approx A$30mm every year from related parties. There must be a logical explanation, but it is certainly not clear. Don't minority investors deserve a little more transparency given HVN is a public company and NOT a private company? On the balance sheet of 2014 annual report, HVN shows cash balance before the bank overdraft (investors need to turn to footnote 28(a) and note 18 in 2014 Appendix 4E) to get the real cash balance. If analysts thought HVN was an Australian retailer selling electronics and furniture they might be excused for missing footnote (e) on the cash flow related to non-core business like mining accommodation or footnote 5(c) for consumer finance – i.e. leases for vehicles and live stock (another unique footnote!). Given the hard to understand disclosure, Credit Suisse in Sept 2012 authored a very interesting piece titled "Accounting for franchisees and other nuances in the Harvey Norman accounts".
WHAT HAVE SOME AUSTRALIAN SELL-SIDE ANALYSTS SAID HISTORICALLY OF DISCLOSURE?
• “Harvey Norman disclosure is worst in class and makes analysis artwork” – CLSA, Aug 2011
• “The working capital result was a little hard to interpret…” – Credit Suisse, Aug 2014
• “While the franchised structure makes it difficult to compare cost bases easily with JB Hi-Fi, we observe franchisee fees and rents paid to head office is ~19% of franchisee sales” – Morgan Stanley, May 2012
We quote Mr. Buffett on keeping things simple: “There seems to be human characteristic that likes to make things difficult” - Mr. Buffett
VIII. HARVEY NORMAN FACES INTENSE AND RELENTLESS COMPETITION AND HAS A HIGH FIXED COST STRUCTURE ADMITS COMPANY
Harvey Norman was an early pioneer in Australian retail and we admire the founders for their entrepreneurial success, primarily in the early years, from 1987 (IPO listing on ASX) to 2000. However, a lot has changed in the last decade with severe and relentless competition from domestic and online retail. For instance, Harvey Norman introduced its new “Omni Channel” strategy in its 2012 annual report, stating that “our omni-channel strategy, incorporating our integrated retail, franchise, property & digital operations, provides strategic advantages over our competitors”. The word “digital operations” and “omni-channel” were not present in the 2011 annual report, but appeared on page 1 of the 2012 & 2013 results presentations stating “Our Omni Channel strategy is the backbone of the business and we have made strong progress throughout the year”. The Sydney Morning Herald reported “Harvey Norman sick of internet spin” stating “Harvey Norman has joined the throng of downtrodden retailers this year to plaster its financial presentations with the term omni-channel… Amid the worst conditions the retail veteran has seen in more than 25 years, Mr. Harvey said the furniture, bedding and electronics business was booking only about $50,000 to $60,000 a day in online sales despite all the hype around internet shopping”. The Australian Financial Review in “Harvey finds faith in online shopping” stated “that would put him on a collision course with the large network of franchisees as franchisees receive none of the proceeds from Big Buys and in effect compete against it.” Mr. Harvey is quoted “Hopefully, I won’t have to compete for 5, 10, 20 years because I have to be careful I don’t upset my franchisees”. The Sydney Morning Herald wrote an article “A dinosaur fights back in the web age” . The article here titled “Harvey Norman looks to the heavens” quotes Mr. Harvey “expecting online sales in technology area to be 2 per cent of total sales this year, but in the other areas it'll be next to nothing''.
In addition to Harvey Norman’s slow move online, Australian retailers have been facing intense competition due to no GST imposed on purchases under A$1000 from overseas sites. A campaign backed by Australian retailers, including Myer, David Jones, Harvey Norman and a number of others placed full-page advertisements in some of the nation's newspapers. An article on the Sydney Morning Herald quoted said “Consumers are simply chasing the best deal and the best service and often these days that is found online…this is not about GST” . Mr. Harvey is quoted as rightly (we agree with Mr. Harvey) saying “Why can’t I have the same deal as overseas retailers?”. Finally, Harvey Norman announced the launch of a website to sell games on a GST-free website, based in Ireland. Outside of online commerce, the emergence of JB Hi-Fi as a market-share force within many of Harvey Norman’s categories has made inroads. Within the segments in which the two businesses compete (broadly AV, IT and communications), JB Hi-Fi offers consumers an efficient sales per store format and product offering. Consumers have preferred specialized retailers like JB Hi-Fi at the expense of more general retailers like HVN due in part also due to dated store format at HVN, which has contributed to share losses. Another issue that Harvey Norman faces is a high minimum wage cost structure in Australia.
An interview on ABC, Mr. Harvey is rightly quoted saying “I know people like myself where we've got resorts or we're in the hospitality business and we just can't make money because you're paying someone minimum $42 per hour or something on a Sunday”.
BUSINESS OVERVIEW
For US readers less familiar with Harvey Norman, the company is an Australian-based retailer of electrical, computer, furniture, entertainment and bedding goods listed in Oct 1987 on the Australian stock exchange (ASX: HVN). Harvey Norman traces its roots to Oct 1982 co-founded by retail giant, Gerry Harvey (owns approx 29.4% of company) and Ian Norman who opened their first store in Auburn, Sydney. Interested readers who wish to read the 1987 prospectus can go here (thanks to the public library: https://www.dropbox.com/s/wj6q7z43ndaz7rv/HVN-Prospectus-JC-140910.pdf?dl=0)
HARVEY NORMAN: THREE PARTS
1. AUSTRALIAN FRANCHISING OPERATIONS
As of June 2014, Harvey Norman has 677 Australian franchisees occupying approximately 198 franchised complexes in Australia, which means on average, approx. 3-4 franchisees per complex selling one or more key product categories. Out of the 198 complexes in Australia, HVN leases approx. 118 and owns 80 (In 2014, 8 leased sites were closed). The company’s website (www.harveynormanholdings.com.au), states “Harvey Norman, as a franchisor, grants franchises to independent business operators, as business owners who retail products for the home and office in categories: electrical, computers & communications, small appliances, furniture, bedding & manchester, home improvements, lighting, carpet and flooring.
Harvey Norman’s franchise structure in Australia was established originally to navigate restrictions on trading hours for larger retail businesses. In Australia, Harvey Norman franchisees invest practically insignificant upfront capital of their own on day 1, receive an annual salary on average, approx. A$85-90,000 and a leased vehicle. Indeed, a closer look at footnote 5(c) on page 85 of the 2013 annual report shows leases in respect of vehicles and livestock (not a typo although it left me confounded). The inventory with franchisees in not on the inventory line item of the consolidated balance sheet but part of the $1bn+ receivables balance on consolidated balance sheet. Given the insignificant start up capital that is invested from franchisees (relative to well known franchisees globally - see http://www.entrepreneur.com/franchises/rankings/franchise500-115608/2014,-1.html), and that franchisees in HVN’s owned stores sign initial 30-day lease terms, are franchisees genuine business owners when considering global precedents of franchise businesses?
2. INTERNATIONAL OPERATIONS
Harvey Norman’s retail operations in overseas markets differs in structure to the Australian franchised system. This primarily includes the 82 Harvey Norman branded company-operated stores in New Zealand, Ireland, North Ireland, Singapore, Malaysia, Slovenia and Croatia out of which 70% are leased from third parties.
The international business in Ireland has been nothing short of a disaster. There are several public articles that we refer to that highlight HVN’s challenges in Ireland. The Irish Independent in an article “Harvey Regrets His Norman Invasion” writes “Mr. Harvey described the performance of Irish stores as "catastrophic" and said he regretted expanding into the market. He added that the investment was too big to pull out now. The Irish Echo in “Ireland an unsolvable problem for us” says “costly long-term leases at Harvey Norman’s Irish stores are the Australian retail giant’s woes … with lease terms of up to 20 years”. The article further states that “a drastic improvement in macroeconomic conditions in Ireland was needed before it could make a profit. However, there was no mention of pulling the plug”. The Sydney Morning Herald in an article titled “Ireland crushes Norman conquest” writes “Mr. Harvey has never shirked the size of his problem in Ireland. Among his colorful descriptions of the venture in recent years are lines like: ''catastrophic'', a return of the ''potato famine'', Northern Ireland was a ''bad mistake'', ''Ireland is a real worry'' and ''I've never seen something get belted like Ireland''. Despite this, management continues to sink money into Ireland with the state-of-the-art showroom renovation in Dublin in 2014.
3. INVESTMENT PROPERTY AS OF JUNE 30, 2014
LEASED: Australia: 118; New Zealand: 18; Slovenia/Croatia: 1; Ireland: 14; Asia: 27; Total Leased: 178
OWNED: Australia: 80; New Zealand: 17; Slovenia/Croatia: 5; Ireland: 0; Asia: 0; Total Owned: 102
IX. VALUATION AT 48x FCF MEANS STOCK CURRENTLY PRICED FOR PERFECTION ALSO GIVEN SEVERE COMPETITION AND SLOW GROWTH IN CORE BUSINESS
As rising tides lift all yachts, Harvey Norman (ASX: HVN) sits at a 4 year high, up more than 100% from December 2012. At these levels, HVN stock is demonstrably overvalued relative to its sustainable free cash flow and asset value. Importantly, while analysts would expect franchise businesses to be capital light and enjoy high ROIC, the same we dont believe applies to HVN. Why? Simply, because franchisees invest insignificant capital, receive a annual salary and use of a car vehicle lease. So here you have it, a stock price that has appreciated significantly, while the core business has not followed exactly followed in sync. Competition is intense and relentless, and price discounting (not pricing power) is the name of the game.
HOW DO VALUE INVESTORS ATTEMPT TO VALUE HVN ON BACK OF THE ENVELOPE?
In our humble view, valuing Harvey Norman on reported accounting profits, P/E, EBITDA is inaccurate as franchisee financial performance and position are not consolidated and earnings need to be adjusted to core earnings. As franchisees receive a salary, car, sign “30-day” initial lease, they are less like genuine business owners, but more like employees who share in a cut of profits, or if loss-making, receive tactical support (not a bad deal for franchisees). As a result, there is limited visibility on the cost structure and earnings power of each of the 676 franchisees in Australia. Therefore, to value HVN, it is important to understand, the sustainable free cash flow for HVN over various economic cycles. At A$3.7, HVN has an approx. market cap of A$3.9bn and Enterprise Value of A$4.8bn, not factoring into leases of A$780mm. We estimate over a rolling 5 year period to smooth out effects of lumpy capex or timing differences that HVN makes an average of A$75-100mm in free cash flow per our estimates. This translates to a generous 48x normalized FCF multiple. Consider, that HVN has had A$100mm+ in tactical support every year the last 3 years. Without tactical support, franchisees cannot (not for too long), keep paying high gross rents. Consider, also that HVN spends A$350mm in “marketing” alone. Without marketing, sales decline and the already slow growth, declines further. HVN is not a growth stock with no moat, and does not earn high ROIC. So at 48x FCF, the way, we see it, is you have a Heads I Lose, Tails I Don’t Win situation...at current prices.
Scenario I (Our Bull Case): If we simply took the total assets of A$4,225.3mm (which includes A$1,903.5mm of investment properties at face value) and total liabilities of A$1734.2mm, we get net assets is A$2,491.1mm. Given 1,063.3mm shares, this gets us to net asset per share of A$2.3, i.e. 36.7% below current share price.
Scenario II (Adjust for Leases Off-Balance Sheet, Intangibles and Contingent Liability): We have to factor in the off-balance sheet liabilities, approx. A$780mm in operating leases and A$242mm of contingent liability (i.e. HVN has guaranteed for a number of controlled entities operating lease obligations and facilities with other parties). If we assume, HVN can cancel some leases and to not be onerous, just take 50% of the operating lease liability and the rest of the contingent liability, we get net assets of A$1,788mm. There is another A$100mm of intangible assets (goodwill, software licences, etc)., which we deduct to get to net assets of A$1,688mm. This then gets us to A$1.58 net assets per share, i.e. 57% below current share price. This case 2 assumes the face value of investment properties, as reported on the consolidated balance sheet.
Scenario III (Real Estate): Given the poor disclosure on HVN properties, how do analysts estimate a rough back of the envelope math valuation of the real estate, without hiring a independent valuer? As mentioned previously, according to this article , Perpetual had hired one and as per published announcements on Harvey Norman’s website, has sold nearly half of their position at prices below recent levels. As of June 2014, HVN has 198 franchised complexes in Australia, i.e. 80 owned and 118 leased from third parties. Consequently, the A$227.4mm gross revenue from franchisees on footnote (2) is gross rent from the owned properties and gross rent from leased properties, which we assume, some of this is pass-through. Gross rent to franchisees and third party tenants of A$171.02mm is buried in the footnote 13. To get to net operating income, we deduct operating expense of A$41.56mm from A$171.02mm to get to A$129.5mm. In our model, we have to adjust this for tactical support offered to the franchisees who receive tactical support within the 80 or so owned properties. If we assume an average tactical support of A$150,000 per franchisee was provided to 1 out of 3 franchisees within the 80 franchised complexes, we get tactical support of A$12mm, i.e. 80 franchisees multipled by A$150,000 in tactical support per franchisee. Deducting this we get A$117.5mm. Remember, the leases on the properties to franchisees are initial 30-day leases. Despite that, we apply a generous 7.5% capitalization rate, which gets us to A$1.6bn on the investment properties in Australia vs. the A$1.9bn figure on 2014 Appendix 4E. On page 13 of the Appendix 4E, we see a A$350.6mm value for owned land and buildings internationally, i.e. New Zealand, Singapore Slovenia and A$27.5mm in joint venture properties. We take those at book, and this gets us to A$1.95bn in investment property value instead of the A$2.29bn. Credit Suisse research in Oct 2012, in a 93-page report, summarized on page 2 "The rental rates sustaining HVN’s book value appear to be toward the upper end of the range expected for Bulky Goods. This outcome is surprising due to a relatively high proportion of HVN properties being in relatively low demographic areas and rural locations for which market rents and alternative use values would be likely to be lower". Analysts should do their own work.
BOTTOMLINE: For value investors, HVN seems priced for perfection at 48x free cash flow and based on asset value, in addition to multiple factors, including, tactical support, bubble in Australian housing, debt refinancing with property security, unsustainable increasing rents, large outside shareholder selling and non-core FX translation gains.
WHAT ARE THE RISKS?
Right upfront we will say, that we look for great long ideas and not short ideas as the market can stay irrational for long. In the current market, there are simply not that many great risk-reward longs. The first key risk is that the australian housing market keeps marching higher. Based on our research and speaking to property analysts, it is likely that the Australian housing bubble is near its end, than the beginning or midway. This is a risk and something that is difficult to predict and certainly very few people can predict when the boom turns to bust. Nevertheless, Harvey Norman does not actually breakout the furniture, bedding, and home appliances category and what sort of revenue and EBIT contribution come directly from franchisees involved in this category. While, I expect that this category is doing better than computers and electrical, it is difficult to imagine gangbusters growth, and consumers shopping for new furniture and beds consistently in a country with a small population. The next risk is M&A/Spin-off. While M&A risk can’t entirely be ruled out, the franchisee business model structure would put suitors off. Mr. Harvey is unlikely to want to sell his property as he has said many occassions in several public articles, that it is an asset you want to hold on to (we agree), so we would put this in the unlikely camp.
KEY SOURCES: Company historical filings, website, CapitalIQ, public news articles, industry reports, sell-side research, company, others.
APPENDIX A: USEFUL LINKS TO COMPANY REPORTS
APPENDIX B: TACTICAL SUPPORT ACCOUNTING JOURNAL ENTRY
Franchisor’s Books (Harvey Norman)
• Dr Tactical Support Expense (P&L)
• Cr Loan Receivable from the Franchisee (Balance Sheet)
Franchisee’s Books (do not form part of accounts as they are separate entries)
• Dr Loan Payable to Franchisor (Balance Sheet)
• Cr Tactical Support received (P&L)
Source: Company
APPENDIX C: MISCELLANEOUS NEWS ARTICLES
Source: Public news articles
LARGE OUTSIDE AUSTRALIAN SHAREHOLDER, PERPETUAL HAS BEEN SELLING HVN WITH SHARE PRICE INCREASE: It is worth noting that well-respected Australian fund manager, Perpetual, and amongst the largest outside shareholders of HVN has been selling into strength, and sold down almost half of its shareholding in HVN, and at prices much lower than current as per the links below. We understand from the Australian Financial Review article that Perpetual had hired an independent property agent to value the property due to the poor disclosure (which we discussed at length in an earlier section). So why has been Perpetual been selling at current prices and prices well below current (refer to PDFs below)? We reference below on HVN’s website:
AUSTRALIAN HOUSING BULL MARKET FOR HOW LONG?: For readers interested to learn the state of Australian housing, a cursory search on “Australian housing boom” will take you to multiple articles on the boom ready to burst? Readers should read the articles below (and many others publicly available). We are fundamenta investors and not "experts"on predicting house prices or macro-economics.
RELIANCE ON CAPITAL MARKETS WITH DEBT RE-FI INSTEAD OF INTERNAL FREE CASH FLOW: Harvey Norman’s reliance on the capital markets in the last 4 years, instead of entirely through free cash flow seems a sign of the long-term competitive advantages of the business. This seems not entirely surprising given tactical support and free cash flow of core business. For instance, in Dec 2011, Harvey Norman extended the terms of the syndication facility of A$610mm , which was otherwise payable in December 2012. Under the terms of the syndicated facility, A$370mm is repayable on 22 December 2014 (i.e. this year) and A$240mm repayable on 22 December 2016 (just over 24 months) as per the table below. In February 2012, Harvey Norman, took a facility agreement for a loan facility of A$85mm , which was secured by properties located in Australia and New Zealand. While the company’s net debt to equity looks reasonable given property accounts for 50% of stated book value, analysts should also factor in the leverage that Harvey Norman has A$707.9mm in interest bearing debt, A$780mm of operating lease obligations and A$242mm in contingent liabilities. While leases and contingent liabilities have declined in the last year, they are still high and analysts should factor them into leverage calculations.
DISCLAIMER
The write up is not investment advice or a recommendation or solicitation for any fund or to buy or sell any securities now or at any time. The author and related persons may hold a position and make no representation that it will continue to hold long or short positions in the securities and disclaims any obligation to notify the market of any changes. The author and related persons may change its views about or its investment positions at any time, for any reason or no reason. This includes buying, selling, covering or otherwise changing the form or substance of its investment. The author disclaims any obligation to notify the market of any change. The information and analysis presented is based on publicly available information through filings, sell-side research, industry analysts and/or company or otherwise sourced. The author recognizes that there may be non-public information in the possession of the company or others that could lead the company or others to disagree with the author's analyses, conclusions and opinions. Any forecasts or estimates should not be relied upon (not the least due to the disclosure) and could turn out to be incorrect. While the author has tried to present the facts it believes are accurate, the author makes no representation or warranty, express or implied, as to the accuracy or completeness of the write up, and expressly disclaims any liability relating to the write up or such communications (or any inaccuracies or omissions therein). Thus one should conduct their own independent analysis before independently considering a position in securities. Except where otherwise indicated, the write up speaks as of the date, and the author undertakes no obligation to correct, update or revise the write up or to otherwise provide any additional materials.
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