Leading Retail Analyst, Craig Woolford from Investment Bank Citigroup, claims that during the last quarter Harvey Norman axed over one third of its electrical franchisees while also lifting franchise fees.
This has resulted in an “Impreessive lift” in sales for HVN. Citigroup also claims that because the distinction between audiovisual and computer products is beginning to disappear, HVN needs to merge its separate computer and electrical franchises to ensure it captures growth. Walford says that in early 2005, HVN began a trial of 10 stores where it merged the Electrical and Computer franchises. The company detailed the results from three of these stores, “No doubt best performing stores” said Woolford, where profit growth for the franchise was 54 percent on average from July to December 2005.
He also said that Harvey Norman has demonstrated a dramatic recovery in margins as it clawed back the financial support it had given franchisees over FY05. Woolford claims HVN income growth from property was also outstanding and that the company. He claims that the New Zealand business had reported a super-normal result with sales growth of 24 percent, four times the industry-average. Citigroup has upgraded HVN’s forecasts and target price by 16.2 percent, to 20.7 cents, and lifted its target price to $3.70 per share from $3.10 per share. Citigroup claim that the reason for the upgrade is the signal that a large part of HVN’s 2H05 drop in margins was a result of additional support to franchisees rather than HVN’s competitive position being compromised. Woolford claims that the outlook for HVN’s Franchise segment profit margins has improved. Given the 1H06 result, the company demonstrated that most of its 2H05 severe decline in margins was one-off support required to motivate its Franchisees in difficult times.
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For 1H06, the Franchise segment reported a 5.9 percent increase in EBIT on a 10.8 percent increase in ‘Other revenue’. The results also show a one-off ‘Sales revenue’ item of $24.8 million which actually related to inventory bought from Megamart and on-sold to Franchisees at zero profit. Citigroup claim that while the 1H06 result showed a 1.6 percentage point reduction in the segment’s EBIT margin, the result was a significant improvement on the 7.9 pp reduction in margins in 2H05. Harvey Norman has done three key things in its Franchise segment in 1H06: Lifted its franchise fee, Improved the performance of the electrical segment and sold higher-margin products with improved supplier terms.
The company’s Franchise fee as a percentage of system sales has increased from 15.9% in 1H05 to 16.3% . This equates to $6.3 million in additional income for HVN. The Electrical franchise segment rebounded from 3% sales growth in 2H06 to 10% growth in 1H06 through improved management. This segment had a change of management in the middle of 2005. The new Manager of Electrical, Mr David Ackery, has driven an impressive lift in sales for the franchisees by re-allocating many of the good franchisees to larger stores and demoting poor performing franchisees. “We estimate that over one-third of electrical franchisees had been moved in the past six months,” said Walford.
From various sources including Citigroup it is clear that Harvey Norman dominates the electronics and computer markets and generated stable gross margins in a very price competitive environment during the past year. This resulted in strong gross profit a result of better sales mix and the strong inventory turnover and customer traffic relative to competitors.
Harvey Norman’s move into two-channel audio and high-end CE products traditionally sold via the specialist reseller is paying off. In the audiovisual and components categories, HVN has captured more than the entire market’s growth. HVN has focused on the components market (including set-top boxes, receivers, hif-fi gear and other peripherals) in the past 12 months and generated a strong market share gain of 9.5 percent. This category is small, but generates higher gross profit margins than other categories.
In its latest financial report Harvey Norman gave an update on its move towards a re-structure of its computer and electrical franchise arrangements. Because the distinction between audiovisual and computer products is beginning to disappear, Citigroup claims that HVN needs to merge its separate computer and electrical franchises quickly to ensure it captures growth.
The company will continue to expand this strategy with a further 20 stores to undergo the transformation over the next year or two. This strategy of convergence should ensure HVN remains the market leader in electronics and computers, claims Citigroup. The potential lift in profits is significant, it says. The 54% rise in profitability is extreme, but if a 20% rise in profitability was applied to all 174 Australian stores, then the Franchise segment EBIT would rise 15%. Group EBIT would increase 7%.
Woolford said “We forcast lift in Franchise EBIT margins for 2H06. We forecast EBIT of $104.0 million and EBIT margin of 33.3%. Additionally, sales conditions continue to strengthen. HVN reported that its sales for the eight months to 28 February 2006 were growing at 12.1% with like-for-like sales growth of 6.5%. We estimate that like-for-like growth was close to 10% for January and February 2006.
On the question of risks associated with Harvey Norman, Citigroup claim that the company operates in a highly discretionary area of retailing. A slowdown in economic growth and in particular in the housing market would impact HVN’s sales and profitability. A severe correction in Australian house prices would hurt sales. In addition, given the high gearing of many Australian households, a sharp increase in interest rates would hurt HVN.
HVN is the largest retailer of computers, electrical and furniture products in Australia, but subject to increasing competition. New competitors are opening stores rapidly and attempting to take share from HVN. Competitor store openings could hurt both sales growth and profit margins at HVN. The senior management at HVN have worked at the company for a number of years. If those people were to leave the business it would expose significant strategic and operational risks for HVN. The company’s expansion offshore provides two sources of risk. In the positive, the offshore business may reach a large size and acceptable return on capital in a short amount of time. In the negative, offshore exposes the company to country, political and currency risks.
Woolford said “If HVN’s Franchise segment recovers better than we have forecast, then there’s a risk the stock price will rise further than our target price forecast. The Franchise segment has experienced a crunch in margins because of greater price competition. A full recovery of that deterioration would boost our valuation. Adverse developments in these risk factors may impede HVN’s share price reaching our valuation of $3.70 a share.”