Harvey Norman Holdings Ltd ( HVN )

Harvey says no to buyback

Recommendation: Hold
Investment Rating
HVN gained a first mover advantage by the early adoption of the big box retail format. This enabled it to accumulate prime real-estate which attracts significant customer traffic. Property values have materially increased since HVN purchased. Australian stores operate under a franchisee business model. The franchisee system is a highly effective mechanism used to incentivise management. International operations are company-owned and may offer significant potential for earnings growth. The migration of retail dollars online is an emerging threat which adds an element of risk.
08 December 2011
Recommendation Trigger Guide

Note: Marker indicates price of $2.11 at publication date.

Snapshot Last Price Market Cap. 52 Week High 52 Week Low Shares on Issue Sector Moat Rating Intrinsic Valuation Risk Business Risk Pricing Risk Company Beta Sector Beta High High 1.31 1.34 $2.11 $2,241 million $3.24 $1.76 1,062.3 million GICS - Retailing None $2.22

Event

In August, the HVN board set up a sub-committee to review options for the possible return to shareholders of $645m in excess franking credits. Chairman Gerry Harvey is reported to have said he will not raise debt to buy back shares. HVN's balance sheet remains under-geared, with net debt to equity of only 22%. Harvey says: 'In the market we are in at the moment, I don't think that would be the smartest thing to do in terms of keeping the company in a strong position.'

Investment Fundamentals Year-end Jun FY10A FY11A FY12E FY13E 290.0 27.3 15.8 13.8 14.0 3.7 100 238.4 22.4 -17.8 13.9 12.0 3.8 100 231.7 21.8 -2.8 9.4 12.0 5.9 100 255.1 24.0 10.1 8.5 13.0 6.3 100

Impact

The reason why HVN has accumulated such a large reserve in franking credits is because of its history of only paying out 50% of earnings in dividends. This policy stems from Harvey's belief he expects to deliver a better return from re-investing funds into expanding the business domestically and offshore rather than paying it out. With offshore expansion in Ireland a disaster and domestic threats from online competitors, we feel it's time the board reassessed its dividend payment policy. There is significant untapped value within which is unlikely to be extracted, with directors controlling 48% of the shares on issue. Central to HVN's retail strategy is store ownership, which provides control to reposition, upgrade, manage rents and so protect the longer-term welfare of its retailers. With $2bn of property assets and HVN trading on a market capitalisation of $2.3bn, bankers must be drooling at the idea of a sell and lease back of these assets to free up capital. Harvey continues to go against what has become industry convention and retains a policy of ownership, which he views as instrumental in HVN's competitive advantage. We think the growing use of internet commerce is set to weaken the value of big-box retail outlets and perhaps its time to reassess the longer-term merits of property ownership versus leasing back its own assets.

NPAT ($m) EPS () EPS Growth (%) PE Ratio (x) DPS () Dividend Yield (%) Franking (%)

Source: Morningstar analyst estimates. Price Chart

Business Description Harvey Norman (HVN) is Australias leading electrical franchisor. HVN's principal activities consist of an integrated retail, franchise and property enterprise including Franchiser; Sale of furniture, bedding, computers, communications and consumer electrical products in New Zealand, Slovenia and Ireland; Property investment; Lessor of premises to Harvey Norman franchisees and other third parties; Media placement; Provision of consumer finance.

Recommendation Impact
No change to recommendation.

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Harvey Norman Holdings Ltd (HVN)

Event Analysis
Harvey says no to buyback

In August, the HVN board set up a sub-committee to review options for the possible return to shareholders of $645m in excess franking credits. Chairman Gerry Harvey is reported to have said he will not raise debt to buy back shares. HVN's balance sheet remains under-geared, with net debt to equity of only 22%. Harvey says: 'In the market we are in at the moment, I don't think that would be the smartest thing to do in terms of keeping the company in a strong position.' The reason why HVN has accumulated such a large reserve in franking credits is because of its history of only paying out 50% of earnings in dividends. This policy stems from Harvey's belief he expects to deliver a better return from re-investing funds into expanding the business domestically and offshore rather than paying it out. With offshore expansion in Ireland a disaster and domestic threats from online competitors, we feel it's time the board reassessed its dividend payment policy. There is significant untapped value within which is unlikely to be extracted, with directors controlling 48% of the shares on issue. Central to HVN's retail strategy is store ownership, which provides control to reposition, upgrade, manage rents and so protect the longer-term welfare of its retailers. With $2bn of property assets and HVN trading on a market capitalisation of $2.3bn, bankers must be drooling at the idea of a sell and lease back of these assets to free up capital. This proposal is commonly presented to Harvey on the back of share price weakness. Harvey continues to go against what has become industry convention and retains a policy of ownership, which he views as instrumental in HVN's competitive advantage. We think the growing use of internet commerce is set to weaken the value of big-box retail outlets and perhaps its time to reassess the longer-term merits of property ownership versus leasing back its own assets.

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Harvey Norman Holdings Ltd (HVN)

HVN domestic entrepreneurial wizards Thesis (Last Updated: 02/09/2011)
Executive chairman Gerry Harvey is a retail master and entrepreneurial wizard. HVN has demonstrated a skilful ability to grow market share in cyclical downturns through increasing expenditure on marketing and supporting franchisees. HVN dominates the very competitive electrical retail industry. Heavyweights, such as Coles Megamart came and went. Smaller competitors, Betta Electric and NSW Retravision both fell into administration. Profit margins from older generation electrical equipment quickly deteriorate leaving retailers little to compensate for rising shop rents. HVN gained a first mover advantage by the early adoption of the big box retail format. This means it has accumulated prime real-estate which attracts significant customer traffic. Property values have materially increased since HVN purchased. The property portfolio is a unique distribution network. HVN has capitalised on its growth and re-invested into further cementing the value of this network. Electrical manufactures look favourably to HVN in promoting and launching new products. HVN uses this to offer its customers proprietary promotional deals. Online retail is an emerging threat to the high street retailer. Internet competitors with global buying power and low distribution costs means traditional domestic retail brands are under threat particularly those selling commoditised branded products. The decision by some manufacturers to sell direct to consumers represents a material threat to a high street retailer which is burdened with the extra distribution and marketing costs. Globalisation of retail through the internet means we have a no moat rating. HVNs domestic business is run on a franchisor business model. It owns the underlying building and franchisees run different segments such as furniture, white goods, electrical or computers. HVN charges the franchisee a clip of profits, marketing expenses, access to finance and store rental. HVN juggles its relationship with the franchisee through subsidising them in cyclical downturns or charging more in affluent times. Successful franchisees can makes millions and so attract industrys top sales talent. Non-performing franchisees get closed down and replaced. Competition and the hunger for profits means franchisees are exceptionally focused and vigilant to changes in customer demands and respond appropriately.

Valuation (Last Updated: 10/08/2011)

HVN delivers volatile returns depending on economic activity within Australia. We use conservative mid-cycle revenue forecasts of mid single digit growth. We assume profit margins to remain under pressure as competition from online entities makes pricing more transparent. We use a cost of equity of 10.3% to calculate our fair value of $2.22

Risk (Last Updated: 12/05/2011)

Retailers are inherently leveraged to consumer cycles, shop rent represents an off balance sheet debt which must be paid no matter how well the business is doing. This means when profits exceed fixed costs, returns on capital quickly expand, while losses quickly lead to the demise of non-performers. HVN will not run its franchisees out of business but rather subsidise rents during cyclical weakness, enabling market share gains. A risk to the electrical retail market is the commoditisation of products. HVN reacts to this by having a very competitive culture focused on finding the next big-ticket household item. Competitive culture has led to the merging of a number of the audio visual and computer franchisees to offer a new range of integrated digital services for customers. Succession planning is perceived as a risk. Mr Harvey is now distant from the day to day hands on role of running operations. There is strong experienced management team in place. This team has the skills to continue the strategic plan of international

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Harvey Norman Holdings Ltd (HVN)

expansion while maintaining a focus on domestic growth. the same margin. Commoditisation can result in consumers becoming less aware of brands and seek the lowest price.

Strategy (Last Updated: 12/05/2011)

HVN strategy is to leverage its scale to buy in bulk and derive higher margins. Scale also enables HVN to offer unique promotional activities for its customers. The stronger A$ and GST excemptions on imports has seen a rapid rise in internet commerce. HVN is developing a centralised online website to act as a referral type system and re-direct online sales to local stores to deliver product. International expansion remains the wild card which could deliver significant returns or absorb large amounts of management time and capital. Ireland continues to under perform while the UK mainland has been hinted at as a potential next move.

HVN has flourished in an environment of weak competition while the heavy weights, Coles and Woolworths have been embroiled in fighting larger battles in the supermarket and department store arena. The rapid emergence of JB HiFi shows a new electric retailer is able to enter the market and gain market share by offering competitive prices and customer service. Many Australian companies have lost millions of dollars trying to take their businesses offshore. HVN is conscious of this and is keeping its exposure small. International growth adds to the risk profile and could lead to more volatile returns.

Bull Points

Financial Overview
Growth

Insatiable appetite for new technology means manufacturers are designing new innovative products to attract customers back to the stores. The franchisees business model motivates and makes its business owners hungry and exceptionally focused to ensure they have the products in stock which customers want. HVNs investment in advertising means it now has one of the most recognized Australian brands. This differentiates HVN from competitors as the place to go for purchasing premium quality products and the best service. If HVN is successful in exporting its business model into Europe then this will open a new leg of potential earnings growth.

Growth will be under pressure for the next three years as consumers reign in expenditure after an extended period of spending.
Profitability

A key component to profitability is the franchisee margin. In times of economic weakness HVN subsidises its franchisees and spends more on advertising which means lower margin. In times of prosperity HVN can take away subsidises and charge more to lift returns.
Financial Health

Mr Harvey has always been in favour or raising equity rather than gearing up the balance sheet. This strategy means in an economic weakness HVN has the balance sheet reserves to take on debt to build market share. Gearing (net debt/equity) remains relatively low at 22%.

Bear Points

HVN does not have the scale of Coles or Woolworths to offer the lowest prices for a commoditised product. Flat Screen retail values have fallen from $15,000 to $400 in just a few years. This means HVN needs to sell more screens to get

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Harvey Norman Holdings Ltd (HVN)

Per Share
Year to 30 June Earnings Dividends Franking % 2009A 23.6 11.0 100.0 2010A 27.3 14.0 100.0 2011A 22.4 12.0 100.0 2012E 21.8 12.0 100.0 2013E 24.0 13.0 100.0

Cash Flow ($M)

Year to 30 June Receipts from Customers Net Operating Cashflow Capex Acquisitions & Investments Sale of Invest. & Subsid. Net Investing Cashflow Proceeds from Issues Dividends Paid Net Financing Cashflow Net Increase Cash Cash at Beginning Exchange Rate Adjust. Cash at End 2009A 2,459.1 442.5 -122.3 -123.3 --240.3 --127.5 -119.5 82.7 -21.3 -61.4 2010A 2,408.2 386.9 -84.1 -92.9 3.0 -163.0 --138.1 -184.3 39.5 61.4 -100.9 2011A 2,632.9 359.0 -170.8 -199.8 4.8 -366.7 --138.1 25.6 17.8 100.9 -118.7 2012E 2013E 2,656.0 2,677.8 243.3 249.1 -106.3 -108.8 -----106.3 -108.8 ---127.5 -138.1 -137.0 -140.3 --162.8 162.8 --162.8 162.8

Profit & Loss ($M)

Year to 30 June Sales Revenue EBITDA Depreciation & Amort. EBIT Net Interest Expense Profit Before Tax Tax Adjusted NPAT Reported NPAT 2009A 2,410.1 472.7 -91.0 381.7 5.0 386.7 -131.3 250.4 214.4 2010A 2,364.7 511.2 -82.9 428.3 10.4 438.7 -142.0 290.0 231.4 2011A 2,555.3 439.5 -89.4 350.0 -1.0 349.1 -107.5 234.2 252.3 2012E 2013E 2,640.9 2,702.2 384.6 418.0 --384.6 418.0 43.0 43.0 341.6 374.9 -102.5 -112.5 231.7 255.1 231.7 255.1

Growth
Year to 30 June Sales Revenue EBIT EPS DPS % % % % 2009A 2.6 -9.3 -29.9 -21.4 2010A -1.9 12.2 15.8 27.3 2011A 8.1 -18.3 -17.8 -14.3 2012E 3.3 9.9 -2.8 0.0 2013E 2.3 8.7 10.1 8.3

Balance Sheet ($M)

Year to 30 June Cash & Equivalent Receivables Inventories Other Current Assets Current Assets Prop. Plant & Equipment Intangibles Other Non-Current Assets Total Non-Current Assets Total Assets Interest Bearing Debt Other Liabilities Total Liabilities Net Assets Total Shareholders Equity 2009A 157.9 1,076.5 259.9 41.5 1,535.7 548.6 18.7 1,534.6 2,120.5 3,656.2 586.7 1,010.3 1,597.0 2,059.2 2,059.2 2010A 157.2 1,081.6 261.7 56.1 1,556.6 439.0 24.2 1,659.4 2,147.9 3,704.5 499.2 1,048.1 1,547.3 2,157.2 2,157.2 2011A 162.8 1,065.2 336.7 62.6 1,627.3 512.5 58.3 1,791.4 2,376.7 4,004.0 650.5 1,125.1 1,775.5 2,228.5 2,228.5 2012E 162.8 1,050.1 331.4 62.6 -2,220.4 58.3 204.3 -4,089.9 642.3 1,114.9 1,757.2 2,332.7 2,332.7 2013E 162.8 1,074.5 333.7 62.6 -2,329.2 58.3 204.3 -4,225.4 640.0 1,135.7 1,775.7 2,449.7 2,449.7

Ratios
Year to 30 June Price/Earnings EV/EBITDA Dividend Yield EBITDA Margin EBIT Margin Net Profit Margin ROE ROA ROIC Net Debt/Equity Interest Cover % % % % % % % % % % x 2009A 11.8 8.3 3.3 19.6 15.8 10.4 12.5 7.6 25.3 20.8 -2010A 13.8 7.5 4.2 21.6 18.1 12.3 13.8 8.6 32.8 15.9 -2011A 14.2 7.1 4.8 17.2 13.7 9.2 10.7 6.7 24.8 21.9 367.3 2012E 9.4 7.1 5.9 14.6 14.6 8.8 10.6 5.9 9.1 20.9 8.9 2013E 8.5 6.5 6.3 15.5 15.5 9.4 11.1 6.3 9.5 19.8 9.7

Top 5 Substantial Shareholders

Maple Brown Abbott Limited 6.1%

Principals & Directors

Principals

Company Secretary

Mr Chris Mentis

Previous Research
14/10/2011 02/09/2011 30/08/2011 10/08/2011 12/05/2011 08/03/2011 25/02/2011 30/11/2010 21/10/2010 07/09/2010 27/08/2010 28/07/2010 09/06/2010 21/04/2010 02/03/2010 26/02/2010 27/11/2009 Price trigger adjustment Trading conditions deteriorate further in July Price deflation squeezes profit margins Clive Peeters and Rick Hart get axed Online a material threat to high street retail Price deflation crimps profits Franchisees build market share in weak environment Not damaged, severely damaged Rapid technology deflation hits flat screen retail Clive Peeters to drive FY11 earnings growth Margin expansion on soft sales drives profit growth Deflation, stimulus effect hit 4Q revenues Retail on sale 3Q sales weak Franchisees deliver Strengthening domestic housing market drives demand for furniture Gerry Harvey confident of a strong Christmas

Directors

Mr Gerald Harvey(Executive Chairman) Ms Kay Leslie Page(Chief Executive Officer,Executive Director) Mr John Evyn Slack-Smith(Chief Operating Officer,Executive Director) Mr Michael John Harvey(Non-Executive Director) Mr Christopher Herbert Brown(Non-Executive Director) Mr Ian John Norman(Non-Executive Director) Mr Kenneth William Gunderson-Briggs(Non-Executive Director) Mr Graham Charles Paton(Non-Executive Director) Mr David Ackery(Executive Director) Mr Chris Mentis(Chief Financial Officer,Company Secretary)

2011 Morningstar, Inc. All rights reserved. The data and content contained herein are not guaranteed to be accurate, complete or timely. Neither Morningstar, nor its affiliates nor their content providers will have any liability for use or distribution of any of this information. To the extent that any of the content above constitutes advice, it is general advice that has been prepared by Morningstar Australasia Pty Ltd ABN: 95 090 665 544, AFSL: 240892 (a subsidiary of Morningstar, Inc.), without reference to your objectives, financial situation or needs. Before acting on any advice, you should consider the appropriateness of the advice and we recommend you obtain financial, legal and taxation advice before making any financial investment decision. If applicable investors should obtain the relevant product disclosure statement and consider it before making any decision to invest. Some material is copyright and published under licence from ASX Operations Pty Limited ACN 004 523 782 ("ASXO"). DISCLOSURE: Employees may have an interest in the securities discussed in this report. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf.

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Harvey Norman Holdings Ltd (HVN)

Research Methodology
We seek undervalued stocks with a medium to long-term investment time horizon. Companies that make the best investments tend to be those able to grow earnings per share year after year and which are able grow at rates above the average of the market. Earnings growth supports a solid and growing dividend stream which is the essence of shareholder return. In searching for the best businesses in the market, we want to see an ability to turn revenue into profits and a record of strong returns to equity. The ability to generate strong free cash flow is critical as this is where the funds come from to pay dividends or to invest in new growth areas. The greatest free cash flow generators will have strong margins, good controls over working capital and limited requirement for capital expenditure. The best businesses will also have robust balance sheets including a not onerous level of debt. We believe in strong, experienced and disciplined management. We ascribe a moat rating to each stock researched: Wide, Narrow or None. The moat is the competitive advantage that one company has over other companies in the same industry. Wide moat firms have unique skills or assets, allowing them to stay ahead of the competition and earn above-average profits for many years. Returns on their invested capital will exceed the cost of that capital. Without a moat, highly profitable firms can have their profits competed away. Other companies will see how attractive the market is and try to move in to reap some of the rewards themselves. Sources of economic moats include innovation skills or first mover advantages, a superior cost position, the ability to provide a range of products to suit the needs of a variety of markets, high switching costs or locking out of competitors. The moat rating is just one of the ingredients used in determining whether a company is undervalued, though it is obviously an important one. We are not saying that no-moat companies should be avoided. Simply, the very best long term investments are in wide moat firms bought when they are undervalued.

Business Risk
Business risk encompasses all operational risk and financial risk. Companies with low business risk have the most reliable earnings streams. A change in business conditions may reduce earnings predictability and therefore increase risk. Examples are market entry of a new competitor, unfavourable shifts in the economy, changes in key management personnel, major investment in an uncertain new venture or acquisition, and increased interest burden caused by higher debt levels or raised interest rates.

Pricing Risk
Pricing risk reflects the premium or discount implied in the current price of the shares. Many growth stocks trade on high earnings multiples giving them high pricing risk though they may have low business risk. Investors should consider their risk tolerance before investing in the share market. Many investors will decide to have only low risk stocks in their portfolio though others will accept higher risk levels in order to pursue higher returns.

Recommendations
Our qualitative recommendations simple and easy to understand: are

Buy: Suitable for purchase now Accumulate: Undervalued but there is time to purchase Hold: Appropriately priced, neither buy nor sell Reduce: Sell part holding Sell: Sell all holdings now Avoid: Not investment grade

Intrinsic Value
Intrinsic Value (otherwise known as Fair or Underlying Value) is the analyst's interpretation of what the stock is worth today. The stock is considered to be undervalued when the quoted price is below this point or overvalued where the price is above it. Whether to invest in a stock will depend on consideration of the prospective return and the risk undertaken. Prospective return includes both share price moves and dividend yield. Our analysts incorporate the stock's risk in their intrinsic value. Other things being equal, lower risk stocks will have greater intrinsic value than higher risk ones. A stock becomes a buy when the quoted share price is at a discount to intrinsic value that provides a sufficient prospective return.

Economic Moats
The pursuit of high quality businesses is central to our investment philosophy. These offer the greatest gains to the long term investor, so long as they are bought at a reasonable price. The concept of economic moats is valuable in assessing the quality of a business, with the phrase popularised by Warren Buffett and Charlie Munger. Just as wide moats protected castles from invaders in medieval times, businesses with wide economic moats have strong defences against their profits being competed away.

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