I must be mad. Seriously.
I'm about to make a case for an investment in a retailer which allegedly 'doesn't get' the new world of online retail – despite fierce competition – and one suffering serious price deflation in some of its core product categories.
The cynic might suggest that description doesn't narrow the field much – after all, JB Hi-Fi (ASX: JBH), Myer (ASX: MYR) and David Jones (ASX: DJS) have all come into focus in recent months for failing to keep up with the changing consumer trends.
The latter was even taken to task yesterday, with a report in the Australian Financial Review that an online competitor had described DJs as 'fat, lazy and arrogant'.
However, with these 'usual suspects' out of the way, the remaining member of this rogues gallery is none other than Gerry Harvey's couches to computers retail offering, Harvey Norman (ASX: HVN).
Are you serious?
I fully expect some readers to dismiss the idea, just as they did when I suggested QBE Insurance (ASX: QBE) was good value back in early January.
The day I made that call, the shares closed at $13.32. As luck would have it, the shares dropped to a low of $9.88 a few days later when the company downgraded earnings.
They didn't stay there long, and when I announced on January 13 (when they closed at $11.00) that I was going to buy shares during the following week, many questioned my sanity and my judgement.
I've been fortunate that my thesis has (so far) played out quickly. With QBE shares now trading around $13.90, both recommendations are in the black – with the latter showing 25%+ gains (plus dividends).
I'm happy with such a quick outcome, but I wasn't planning for it. Instead, I was recommending a company that I believed was worth more than the current price – and I was content to wait for that belief to play out.
Who knows – the shares may yet fall back in the short-medium term – so I'm not claiming victory yet.
Pessimism reigns
It's in that vein that recent falls in Harvey Norman's share price piqued my interest. The current price around $1.98 is one-third below its one-year high, 60% off its three-year high, and a massive 72% below its all-time high of $7.25, set in 2007.
It's often been said that you shouldn't try to catch a falling knife… the metaphor for a falling stock that could keep dropping.
It's good advice, but I think it's likely that Harvey Norman is good value at the current price. Sure, it could keep declining in the short term, but I'm not looking out just weeks or a few months. I think the current price offers good value.
A price that suggests Armageddon
Harvey Norman earned profit after tax of $252m in the last financial year, and has a current market capitalisation of $2.05 billion.
That's a particularly undemanding price/earnings ratio of 8.1 times. Even if you back out some one-time gains (investment gains and asset revaluations) and assume a 'normalised' profit of closer to $218m, the P/E only moves up slightly to 9.4 times.
On an earnings basis (and assuming those earnings are sustainable), Harvey Norman is cheap.
It's when you turn to the company's balance sheet that things get interesting.
Harvey Norman, with a market capitalisation of $2.05b, has net assets of $2.26b. That is, you could (theoretically) sell all of the business' assets for cash, and still have surplus to return to shareholders.
Even ignoring intangible assets – goodwill, brands etc. – the so-called 'hard' assets are worth $2.17b – still more than the company's market cap.
Now it's fair to question how sustainable those values are – after all, much of it is the land and buildings that the retailer's stores occupy. If Harvey Norman was to suddenly leave those sites, perhaps tenants would be hard to find and rentals might be lower.
Still, we're not talking about a profitless business that we're buying just for the assets. Many good businesses have market caps that are multiples of book value – and rightly so. This is a business making a quarter of a billion dollars per year and which has $2b of net assets.
The kicker for investors is that an investment in Harvey Norman offers a trailing 5.5% dividend yield – fully franked – at today's price.
It's the internet, stupid
The elephant in the room is the internet.
While the cyclical spending downturn has hurt many discretionary retailers, there is structural change underway.
More people are shopping online. This is a real threat, but only for some of Harvey Norman's business; and for the foreseeable future, it will only take a certain percentage of those categories – perhaps between 10 and 20% over the next decade or two.
The rest of the business will be done through bricks and mortar retailers – and Harvey Norman still has the footprint, brand recognition and breadth of business to win the battle of 'the rest'. Of course, for the remainder of the business – things like lounges, bedding and flooring – the internet will have little impact.
Foolish take-away
A successful stock selection career can be built by being right 6 out of every 10 times – the winners more than make up for the losers.
There's no way to tell with certainty if an investment in Harvey Norman at today's price will echo the success of QBE, or leave me with egg on my face. Regardless, I'm convinced that most of the downside risk has been baked in, making Harvey Norman a very attractive investment candidate.
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Scott Phillips is a Motley Fool investment analyst. Scott owns shares in QBE, David Jones and Harvey Norman. The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691).
