Harvey Norman Holdings Ltd

Investment Rating

HVN gained a first mover advantage by the early adoption of the big box retailformat. This enabled it to accumulate prime real-estate which attracts significantcustomer traffic. Property values have materially increased since HVNpurchased. Australian stores operate under a franchisee business model. Thefranchisee system is a highly effective mechanism used to incentivisemanagement. International operations are company-owned and may offersignificant potential for earnings growth. The migration of retail dollars online isan emerging threat which adds an element of risk.

Event

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

Impact

• The reason why HVN has accumulated such a large reserve in frankingcredits is because of its history of only paying out 50% of earnings individends. This policy stems from Harvey's belief he expects to deliver abetter return from re-investing funds into expanding the businessdomestically and offshore rather than paying it out. With offshore expansionin Ireland a disaster and domestic threats from online competitors, we feelit'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 retailstrategy 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 ofthese assets to free up capital. Harvey continues to go against what hasbecome industry convention and retains a policy of ownership, which heviews as instrumental in HVN's competitive advantage. We think the growinguse of internet commerce is set to weaken the value of big-box retail outletsand perhaps it’s time to reassess the longer-term merits of propertyownership versus leasing back its own assets.

Recommendation Impact

No change to recommendation.

Harvey Norman Holdings Ltd ( HVN )Harvey says no to buyback

Recommendation: Hold 08 December 2011

Recommendation Trigger Guide

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

Snapshot

Last PriceMarket Cap.52 Week High52 Week LowShares on IssueSectorMoat RatingIntrinsic Valuation

$2.11$2,241 million$3.24$1.761,062.3 millionGICS - RetailingNone$2.22

Risk

Business RiskPricing RiskCompany BetaSector Beta

HighHigh1.311.34

Investment Fundamentals

Year-end Jun FY10A FY11A FY12E FY13E

NPAT ($m) 290.0 238.4 231.7 255.1EPS (¢) 27.3 22.4 21.8 24.0EPS Growth (%) 15.8 -17.8 -2.8 10.1PE Ratio (x) 13.8 13.9 9.4 8.5DPS (¢) 14.0 12.0 12.0 13.0Dividend Yield (%) 3.7 3.8 5.9 6.3Franking (%) 100 100 100 100

Source: Morningstar analyst estimates.

Price Chart

Business Description

Harvey Norman (HVN) is Australia´s leading electricalfranchisor. HVN's principal activities consist of anintegrated retail, franchise and property enterpriseincluding Franchiser; Sale of furniture, bedding,computers, communications and consumer electricalproducts in New Zealand, Slovenia and Ireland;Property investment; Lessor of premises to HarveyNorman franchisees and other third parties; Mediaplacement; Provision of consumer finance.

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Event AnalysisHarvey says no to buyback

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

The reason why HVN has accumulated such a large reserve in franking credits is becauseof its history of only paying out 50% of earnings in dividends. This policy stems fromHarvey's belief he expects to deliver a better return from re-investing funds into expandingthe business domestically and offshore rather than paying it out. With offshore expansion inIreland a disaster and domestic threats from online competitors, we feel it's time the boardreassessed its dividend payment policy.

There is significant untapped value within which is unlikely to be extracted, with directorscontrolling 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-termwelfare of its retailers. With $2bn of property assets and HVN trading on a marketcapitalisation of $2.3bn, bankers must be drooling at the idea of a sell and lease back ofthese assets to free up capital. This proposal is commonly presented to Harvey on the backof share price weakness. Harvey continues to go against what has become industryconvention and retains a policy of ownership, which he views as instrumental in HVN'scompetitive advantage. We think the growing use of internet commerce is set to weaken thevalue of big-box retail outlets and perhaps it’s time to reassess the longer-term merits ofproperty ownership versus leasing back its own assets.

Harvey Norman Holdings Ltd (HVN)



HVN domestic entrepreneurial wizards

Thesis (Last Updated: 02/09/2011)

Executive chairman Gerry Harvey is a retailmaster and entrepreneurial wizard. HVNhas demonstrated a skilful ability to growmarket share in cyclical downturns throughincreasing expenditure on marketing andsupporting franchisees.

HVN dominates the very competitiveelectrical retail industry. Heavyweights,such as Coles Megamart came and went.Smaller competitors, Betta Electric andNSW Retravision both fell intoadministration. Profit margins from oldergeneration electrical equipment quicklydeteriorate leaving retailers little tocompensate for rising shop rents.

HVN gained a first mover advantage by theearly adoption of the big box retail format.This means it has accumulated primereal-estate which attracts significantcustomer traffic. Property values havematerially increased since HVN purchased.The property portfolio is a uniquedistribution network. HVN has capitalisedon its growth and re-invested into furthercementing the value of this network.Electrical manufactures look favourably toHVN in promoting and launching newproducts. HVN uses this to offer itscustomers proprietary promotional deals.

Online retail is an emerging threat to thehigh street retailer. Internet competitorswith global buying power and lowdistribution costs means traditionaldomestic retail brands are under threatparticularly those selling commoditisedbranded products. The decision by somemanufacturers to sell direct to consumersrepresents a material threat to a high streetretailer which is burdened with the extradistribution and marketing costs.Globalisation of retail through the internetmeans we have a no moat rating.

HVN´s domestic business is run on afranchisor business model. It owns theunderlying building and franchisees rundifferent segments such as furniture, whitegoods, electrical or computers. HVNcharges the franchisee a clip of profits,marketing expenses, access to finance andstore rental. HVN juggles its relationship

with the franchisee through subsidisingthem in cyclical downturns or chargingmore in affluent times. Successfulfranchisees can makes millions and soattract industry´s top sales talent.Non-performing franchisees get closeddown and replaced. Competition and thehunger for profits means franchisees areexceptionally focused and vigilant tochanges in customer demands andrespond appropriately.

Valuation (Last Updated: 10/08/2011)

HVN delivers volatile returns depending oneconomic activity within Australia. We useconservative mid-cycle revenue forecastsof mid single digit growth. We assumeprofit margins to remain under pressure ascompetition from online entities makespricing more transparent. We use a cost ofequity of 10.3% to calculate our fair valueof $2.22

Risk (Last Updated: 12/05/2011)

Retailers are inherently leveraged toconsumer cycles, shop rent represents anoff balance sheet debt which must be paidno matter how well the business is doing.This means when profits exceed fixedcosts, returns on capital quickly expand,while losses quickly lead to the demise ofnon-performers. HVN will not run itsfranchisees out of business but rathersubsidise rents during cyclical weakness,enabling market share gains.

A risk to the electrical retail market is thecommoditisation of products. HVN reacts tothis by having a very competitive culturefocused on finding the next big-tickethousehold item. Competitive culture hasled to the merging of a number of the audiovisual and computer franchisees to offer anew range of integrated digital services forcustomers.

Succession planning is perceived as a risk.Mr Harvey is now distant from the day today hands on role of running operations.There is strong experienced managementteam in place. This team has the skills tocontinue the strategic plan of international




expansion while maintaining a focus ondomestic growth.

Strategy (Last Updated: 12/05/2011)

HVN strategy is to leverage its scale to buyin bulk and derive higher margins. Scalealso enables HVN to offer uniquepromotional activities for its customers. Thestronger A$ and GST excemptions onimports has seen a rapid rise in internetcommerce. HVN is developing acentralised online website to act as areferral type system and re-direct onlinesales to local stores to deliver product.International expansion remains the wildcard which could deliver significant returnsor absorb large amounts of managementtime and capital. Ireland continues to underperform while the UK mainland has beenhinted at as a potential next move.

Bull Points

• Insatiable appetite for new technologymeans manufacturers are designingnew innovative products to attractcustomers back to the stores.

• The franchisees business modelmotivates and makes its businessowners hungry and exceptionallyfocused to ensure they have theproducts in stock which customerswant.

• HVN´s investment in advertising meansit now has one of the most recognizedAustralian brands. This differentiatesHVN from competitors as the place togo for purchasing premium qualityproducts and the best service.

• If HVN is successful in exporting itsbusiness model into Europe then thiswill open a new leg of potential earningsgrowth.

Bear Points

• HVN does not have the scale of Colesor Woolworths to offer the lowest pricesfor a commoditised product. Flat Screenretail values have fallen from $15,000 to$400 in just a few years. This meansHVN needs to sell more screens to get

the same margin. Commoditisation canresult in consumers becoming lessaware of brands and seek the lowestprice.

• HVN has flourished in an environmentof weak competition while the heavyweights, Coles and Woolworths havebeen embroiled in fighting larger battlesin the supermarket and departmentstore arena. The rapid emergence of JBHiFi shows a new electric retailer isable to enter the market and gainmarket share by offering competitiveprices and customer service.

• Many Australian companies have lostmillions of dollars trying to take theirbusinesses offshore. HVN is consciousof this and is keeping its exposuresmall. International growth adds to therisk profile and could lead to morevolatile returns.

Financial Overview

GrowthGrowth will be under pressure for the nextthree years as consumers reign inexpenditure after an extended period ofspending.

ProfitabilityA key component to profitability is thefranchisee margin. In times of economicweakness HVN subsidises its franchiseesand spends more on advertising whichmeans lower margin. In times of prosperityHVN can take away subsidises and chargemore to lift returns.

Financial Health

Mr Harvey has always been in favour orraising equity rather than gearing up thebalance sheet. This strategy means in aneconomic weakness HVN has the balancesheet reserves to take on debt to buildmarket share. Gearing (net debt/equity)remains relatively low at 22%.




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

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

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

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

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

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

Top 5 Substantial ShareholdersMaple Brown Abbott Limited 6.1%

Previous Research

14/10/2011 Price trigger adjustment02/09/2011 Trading conditions deteriorate further in July30/08/2011 Price deflation squeezes profit margins10/08/2011 Clive Peeters and Rick Hart get axed12/05/2011 Online a material threat to high street retail08/03/2011 Price deflation crimps profits25/02/2011 Franchisees build market share in weak environment30/11/2010 Not damaged, severely damaged21/10/2010 Rapid technology deflation hits flat screen retail07/09/2010 Clive Peeters to drive FY11 earnings growth27/08/2010 Margin expansion on soft sales drives profit growth28/07/2010 Deflation, stimulus effect hit 4Q revenues09/06/2010 Retail on sale21/04/2010 3Q sales weak02/03/2010 Franchisees deliver26/02/2010 Strengthening domestic housing market drives

demand for furniture27/11/2009 Gerry Harvey confident of a strong Christmas

Principals & DirectorsPrincipals

Company Secretary Mr Chris Mentis

Directors

Mr Gerald Harvey(Executive Chairman)

Ms Kay Leslie Page(Chief Executive Officer,Executive Director)

Mr John Evyn Slack-Smith(Chief Operating Officer,ExecutiveDirector)

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)

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Research Methodology

We seek undervalued stocks with amedium to long-term investment timehorizon. Companies that make the bestinvestments tend to be those able to growearnings per share year after year andwhich are able grow at rates above theaverage of the market. Earnings growthsupports a solid and growing dividendstream which is the essence of shareholderreturn.

In searching for the best businesses in themarket, we want to see an ability to turnrevenue into profits and a record of strongreturns to equity. The ability to generatestrong free cash flow is critical as this iswhere the funds come from to paydividends or to invest in new growth areas.The greatest free cash flow generators willhave strong margins, good controls overworking capital and limited requirement forcapital expenditure. The best businesseswill also have robust balance sheetsincluding a not onerous level of debt. Webelieve in strong, experienced anddisciplined management.

Recommendations

Our qualitative recommendations aresimple and easy to understand:

• 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

Economic Moats

The pursuit of high quality businesses iscentral to our investment philosophy.These offer the greatest gains to the longterm investor, so long as they are bought ata reasonable price. The concept ofeconomic moats is valuable in assessingthe quality of a business, with the phrasepopularised by Warren Buffett and CharlieMunger. Just as wide moats protectedcastles from invaders in medieval times,businesses with wide economic moatshave strong defences against their profitsbeing competed away.

We ascribe a moat rating to each stockresearched: Wide, Narrow or None.

The moat is the competitive advantage thatone company has over other companies inthe same industry. Wide moat firms haveunique skills or assets, allowing them tostay ahead of the competition and earnabove-average profits for many years.Returns on their invested capital willexceed the cost of that capital. Without amoat, highly profitable firms can have theirprofits competed away. Other companieswill see how attractive the market is and tryto move in to reap some of the rewardsthemselves.

Sources of economic moats includeinnovation skills or first mover advantages,a superior cost position, the ability toprovide a range of products to suit theneeds of a variety of markets, highswitching costs or locking out ofcompetitors.

The moat rating is just one of theingredients used in determining whether acompany is undervalued, though it isobviously an important one. We are notsaying that no-moat companies should beavoided. Simply, the very best long terminvestments are in wide moat firms boughtwhen they are undervalued.

Intrinsic Value

Intrinsic Value (otherwise known as Fair orUnderlying Value) is the analyst'sinterpretation of what the stock is worthtoday. The stock is considered to beundervalued when the quoted price isbelow this point or overvalued where theprice is above it.

Whether to invest in a stock will depend onconsideration of the prospective return andthe risk undertaken. Prospective returnincludes both share price moves anddividend yield. Our analysts incorporate thestock's risk in their intrinsic value. Otherthings being equal, lower risk stocks willhave greater intrinsic value than higher riskones. A stock becomes a buy when thequoted share price is at a discount tointrinsic value that provides a sufficientprospective return.


Business Risk

Business risk encompasses alloperational risk and financialrisk. Companies with lowbusiness risk have the mostreliable earnings streams. Achange in business conditionsmay reduce earningspredictability and thereforeincrease risk. Examples aremarket entry of a newcompetitor, unfavourable shifts inthe economy, changes in keymanagement personnel, majorinvestment in an uncertain newventure or acquisition, andincreased interest burdencaused by higher debt levels orraised interest rates.

Pricing Risk

Pricing risk reflects the premiumor discount implied in the currentprice of the shares. Many growthstocks trade on high earningsmultiples giving them high pricingrisk though they may have lowbusiness risk.

Investors should consider theirrisk tolerance before investing inthe share market. Manyinvestors will decide to have onlylow risk stocks in their portfoliothough others will accept higherrisk levels in order to pursuehigher returns.



Harvey Norman Holdings Ltd

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