Yesterday, Gerry Harvey’s retailing firm, Harvey Norman Ltd [ASX: HVN] reported a 2.4% fall in net profit.
The news saw the retail stock fall 8% on the open, before it rallied.
What does that tell you about the business?
Well, today we’ll try to explain. We’ll show you the difference between good stocks and bad stocks. And contrary to what you may think, sometimes it can make sense to invest in bad stocks…
As an investor, we’re actually eyeing off the retail sector as an opportunity. Things are bad. But what if this is as bad as it gets?
If it is, there could be a bunch of cash to make buying out-of-favour retail stocks.
The problem is the retail sector isn’t a level playing field. By that we mean, not all retailers are doing it tough. Let’s show you an example using this chart…
The pink line is the Harvey Norman share price. The blue line is the Super Retail Group [ASX: SUL] share price.
If you’re not aware of it, Super Retail Group is the parent company for Supercheap Auto, Ray’s Outdoors, Rebel Sport, and a few others.
As you can see, since 2007, Harvey Norman shares have halved (and fallen even further from the October 2007 peak). While Super Retail shares have gained 75%.
So, what explains the difference? For a start, it’s not fair to compare them directly. Harvey Norman deals in big-ticket items such as whitegoods, furniture and big-screen TVs.
Super Retail deals in mostly pocket-change stuff: windscreen wipers, camping stoves, tennis shorts, etc.
But it does tell you that one business has done better for the past five years. You can see that in the earnings per share (eps) numbers.
Harvey Norman’s earnings per share has gone nowhere since 2005. By contrast, Super Retail’s eps has grown an average 27% per year since 2005.
The company’s dividend has grown even more. An average of 57% per year since 2005.
Whereas Harvey Norman’s dividend hasn’t changed much since 2007.
The question for investors is whether Super Retail can keep growing.
Super Retail is more expensive (in terms of price-to-earnings ratio) than Harvey Norman. That tells you investors have priced in further growth… and that they prefer Super Retail to Harvey Norman.
But. (A word of caution.) Meeting and beating investor hopes is a hard job. Just ask the folks at JB Hi-Fi [ASX: JBH].
Between 2004 and 2011 it grew eps by an average 96% per year. And has grown the dividend by an average 138% per year during the same time.
But sometimes investors expect more than the company delivers. So when JB Hi-Fi revealed slowing sales and profit growth, the share price took a hit.
It means that while sales, profits and dividends kept growing, the share price has halved since late 2009.
So, could the same happen to current retail darling, Super Retail Group? There’s a reason to think it could…
In general, a business will try to grow as much as it can organically. That means increasing the amount of products it sells to customers and finding new customers.
But a time comes when a market is saturated. In the case of retail businesses, it usually means it has opened as many stores as is economically possible, without it having a negative impact on the business.
That’s when management has a choice. Do they stop the business growing or do they look at other opportunities? Such as taking over another business.
Takeovers are frequently the last trick-in-the-bag for companies. Simply because they can be complicated and the benefits don’t always show up straight away.
In fact, a good indication of a market top is the increase in takeover activity as companies struggle to keep growing the business and the share price.
Royal Bank of Scotland’s takeover of ABN Amro in 2007/08 is an example (RBS is now majority owned by the U.K. government after it nearly went bust).
Rio Tinto’s takeover of Alcan in 2007 is another example of management looking too hard for growth. (By the way, the S&P/ASX 200 closed at its all-time high just two weeks before Rio secured 100% ownership of Alcan!)
In recent years, Super Retail has successfully grown the business. But this has involved a string of takeovers: Ray’s Outdoors and Rebel are the two most recent.
So, as an investor you have to work out if the business can keep growing. Because if it can, it should mean more sales and profits… and a bigger dividend.
But if it can’t… like JB Hi-Fi, look out below.
The most interesting thing from all this is whether it makes Harvey Norman a buy. After all, sales are stagnant… and the chance of profit growth appears limited.
But as Adele Ferguson wrote in yesterday’s Age:
“[Harvey Norman’s] plunging share price has got to the stage where its market capitalisation of $2 billion is $400 million higher than its investment property portfolio, which implies the rest of the business is worth barely $400 million, which is ridiculous.”
So despite the low growth and poor outlook, maybe this is the best time to buy.
Look, we’re not in a hurry to buy or recommend Harvey Norman shares just yet. We need convincing that Gerry Harvey has a plan to fire-up the business.
After all, buying something just because it’s cheap doesn’t always mean it’s good value. But it’s certainly a retail stock worth putting on your bargain-hunting watchlist.