Investor Snapshot: Harvey Norman

My investment thesis on Harvey Norman is that its shares offer very lucrative short term returns though in the long term the stock price is likely to fall as the accumulative consumer shift towards low cost online retailers indicates an overvaluation of Harvey Norman’s shares.

Bull Analysis:

On 10 Feb, Harvey Norman shares hit a three month high at $4.14. Harvey Norman’s significant outperformance of the market last month, where it reached its two month high of $3.78 while the ASX200 dropped 1%, indicates the positive effects from retail spending. Harvey Norman’s sales were strong in July to December, but surged after Christmas. The relatively weak consumer sentiment at the start of December last year could be due to a consumer expectation of post Christmas sales. This may impact on profit margins as retailers are then incentivised to provide larger discounts earlier, as seen through JB Hi Fi’s discounting competition with Dick Smith. However, competitors’ price deflations will see market share reductions and Harvey Norman could use this to their advantage to dominate once cyclical trends make a comeback. I believe this momentum will continue- the RBA’s recent decision to lower interest rates to 2.25% has positive internal and external corporate impacts. It will boost retail expenditure by fuelling consumer confidence, and also lower Harvey Norman’s cost of debt. This forecast extends globally. Depreciation of the Australian dollars means domestic retail suppliers increase market share as they are now more competitive than those overseas.

Whilst earnings revisions favor a downside, this is predominantly attributed to the resource sector due to the weak commodity prices. For Harvey Norman, falling commodity prices increases savings in the supply chain, thereby boosting corporate earnings.  Moreover, Harvey Norman’s standing as a furniture and entertainment store in the retail sector increases their leverage to outperform due to its strong connection with the housing market. Potential for continued high sales growth reminiscent of pre GFC housing boom growth where consumption of discretionary items soared (in particular flat screen TVs) remains likely.

Harvey Norman’s retail property ownership will continue to sustain a strong and consistent cash flow in case there are any cyclical downturns. It also ensures control over rental hikes during upturns. As the 2.3bn property assets supports the company’s value, it enables protection for shareholders against risky business ventures, thereby allowing Harvey Norman to adapt at a slower pace. The company’s debt to capital is 25.2%, making it undergeared and increasing the potential to return its $600m franking credits to shareholders. In general, there is good control over the company’s strategic approach due to share ownership for executives, which matches their interests with shareholders in terms of focusing on returns on capital. They are issued options at 3.02, which, given the currently strong share price movements, are valuable as incentives.

Bear Analysis:

However, Harvey Norman’s downside risks have more longer term, negative repercussions on stock price. Whilst its healthy $2.2bn balance sheet is indicative of long term growth, Harvey Norman’s brick and mortar retail model is under threat from the rapid adoption of online distribution channels. Scale advantages in retail are sourced from a powerful market standing to conduct negotiations with suppliers for larger volumes and lower costs. However, the rapid e-commerce growth means the consumer market expands to an international base, diminishing Harvey Norman’s scale advantage from its dominant domestic presence. Competitors including Kogan and AppliancesOnline operate on lower costs and therefore deliver products at a lower price by leveraging greater sales or lack of site costs which enables a 24 hour shopfront. This competitive advantage magnifies for such retail products due to their elastic demand being linked with the fluctuations of the business cycle. Moreover, as 97% of consumers use the internet as a research and sale mechanism, price transparency increases which reduces the significance of salespeople. The sector most affected by the availability and accessibility of consumer reviews and price comparison is electronics, which consists of 40% of Harvey Norman’s sales.

Whilst Harvey Norman is investing capital to focus on transitioning into integrated omni-channel retailing, whereby an online platform is included with their traditional store network, I predict its online sales to remain relatively subdued due to consumer perception of its brand as a high end retailer. To ensure this strategy is a success, the retailer must focus on what they are selling rather than how. Currently, selling mainly commoditised electronics, consumers will continue to display minimal distributor loyalty due to the accessibility of lower priced products. Amazon’s innovation in their distribution is likely to mean such a global giant will take the biggest cut of international sales.

Their high operating costs in supporting an extensive nation-wide franchise portfolio also makes restructuring inefficient when evolving the business model, as when Harvey Norman decides on closing stores in the long term, they would need to find another business to sell their stores to. I do not see management implementing any radical changes to the existing business model especially as it is likely they view any weaknesses in the market as a cyclical, macroeconomic downturn. Such structural threats means returns may slide below cost of capital.

Moreover, with the subdued Northern Hemisphere economy, their Irish capital investment needs to be addressed as it is consistently delivering losses since their housing market stall, with a 4% operating loss in 2014. However, management has stated a long term commitment to this expansion, though I believe it risks an opportunity cost of revitalising domestic profit margins as management wastes time and shareholder capital in offshore investments.  

In conclusion, I believe the current macroeconomic trends including housing, interest rates, currency and retail conditions will boost Harvey Norman’s stock price performance, though unless the business model innovates to adapt to the shift of retail dollars to online platforms, Harvey Norman will face stock price deflation in the long term.

Sources: The Australian, Sydney Morning Herald

The Oil Price: Causes and Consequences

The significant reduction in the oil price is one worthy to write about given its far reaching implications, in both the economic and political world. In September 2013 a barrel of oil was worth $US110, with such a price extending to mid 2014 at $US107 per barrel. It has therefore fallen more than 50% over a six month period, with both the magnitude and the short time period taken creating notable ripples in the markets.

A Slippery Slope

I believe the oil price collapse can be primarily attributed to the price war. The high price of oil over the past three years has attracted higher-cost producers other than Saudi Arabia into the market. Naturally the competition encourages producers to develop existing facilities and make the most of technological advancements and efficient production techniques by undertaking exploration for further resources. In other cases, pressure from economic sanctions such as those imposed on the world’s 2nd global oil exporter, Russia, resulted in the highest output last year since the Soviet Union collapse. The increased oil supply around the world has therefore threatened the power of OPEC oil producers in dictating market prices. Furthermore the inflated price of $US113 per barrel shifted profitability towards renewable energy sources instead, such as solar, wind and LNG.

I also believe the market has focussed too heavily upon the supply side of the equation and trends in the weakening demand should not be overlooked. After all, the developing economy has demonstrated growth below the long term average since 2013. These factors overrode the presumptions of finite resources, a rapidly growing population and large wealth increases in Asia to trigger a downward spiral of oil prices.

Investor Issues

Such an oil price collapse raises questions in the Australian stockmarket. The ASX is traditionally energy intensive as Australians tend to assert greater reliance on the resource sectors than foreigners, given investor preference for lower currency and administrative risk (often experienced with direct investment in foreign stocks). Those investing in energy producer stocks (BHP Billiton, Rio, Santos, Woodside etc.) should be questioning how low will the price reach, and if any rebounds can be made from the low prices forcing out marginal energy players. While Middle Eastern producers can be sustainable with oil at $US30-40 per barrel, American and Eastern and Northern European producers are on different terms.

In fact, the oil price range settled upon also impacts other stocks in the market by encouraging the Central bank rates to remain low for longer, given the ability of commodity prices to pair low inflation with high consumption. Read more about the reasons and implications of the interest rate: 

http://financebymandm.blogspot.com.au/2015/02/the-interest-rate-explanations-and.html

However because the lower prices reduce business costs and consumer expenses, it acts as a stimulus to strengthen its own demand, and consequently oil prices. This market mechanism occurs whilst the higher-cost energy producers stall or cut back production to avoid losses, suggesting this outlook for the energy sector will change.

Despite this the OPEC cartel announced in 2014 that it will maintain the production levels (which had increased) regardless of the market price. According to Gaurav Sodhi, Intelligent Investor’s resource analyst, perhaps OPEC is aware that their unconventional sources such as shale oil and Canada’s tar sands deposits are presently undervalued. This can imply OPEC is attempting to force out competitors and subsequently allowing prices to return to $US60-70 in the interests of their own profit.

A Long Term Perspective

Therefore I believe investors who rely on a longer term strategy will profit from the oil price collapse. In the short term, there is an incentive for innovation in order to improve energy efficiency and productivity. However I am confident that in two to three decades, the demographics should change to favour these forward thinking investors, assuming any dysfunction in the political-economic sphere given global conflicts or government debts do not change the picture. It is true that there is a finite supply of commodities, coupled with a growing population and improved prosperity in developing nations. The UN forecasts the world population as 9.6 billion by 2050, suggesting that demand for resources including energy will rise by at least a third. The need for resources further multiplies as the population growth is more intense in areas of rising wealth.

Unlike manufactured goods and soft commodities like grain and dairy which are products from the development of arable land, hard resources such as iron ore, oil, gas and gold are unable to be replicated. Rather, the economics of natural commodities are a function of the cost of discovery and extraction and processing expenses, with the dollar and commodity price as variables. These costs can be easily observed through analyst reports. Also, as commodity prices drop, corporations are motivated to cut costs quickly, although based on past events costs rarely fall at the same rate as prices. Therefore low-cost producers such as BHP and Rio which specialise in iron ore should appeal to investors the most as costs are cheaper than the commodity and they hold significant cash on hand.

Other corporations that are capable of purchasing assets at the current discounted prices and have sufficient reserves to support any price collapses are New Hope and AWE. These companies are valued at less than twice their cash value, despite New Hope having $1 billion in cash and the oil producer, AWE, likewise being profitable with prices at these levels and having rejected a takeover in 2014. (None however in the worst recessions the optimal stocks to purchase would be ones valued at even less than their cash stockpile).

If oil prices do rise, investors in Santos and Origin Energy should also benefit. Their major LNG projects scheduled for this year runs for decades and therefore should produce large profits, at least more than that expected by those who over emphasise the low prices today.

Overall I am confident that investors can capitalise on the price collapse with highly selective opportunities. What is certain though is that these oil market machinations will certainly change the composition and strategy of portfolios.

Sources:

Money Magazine, Wall Street Journal, Financial Times, Sydney Morning Herald

The Interest Rate: Explanations and Predictions

An Economic perspective

On Tuesday the RBA cut the cash rate to 2.25 percent, creating a historic low since they gained independence. Glenn Stevens justified this with “below trend” economic growth and weak domestic demand as these result in a higher unemployment rate. Therefore it is implied that this Friday’s economic update will involve a markdown in economic growth forecasts for 2015 (set at 2.5-3.5 percent). Had the RBA maintained the 2.5 percent cash rate they would certainly fall further short of their forecasted growth as the markdown includes the anticipated macroeconomic expansion. The slower forecasted rate of real economic growth should also imply delayed progress in raising interest rates and closing the output gap.

Although such stimulus does depend on whether the cut is fully passed to consumers and owners of SMEs; despite a downward trend of cash rates since October 2010, credit card rates remain around 20 percent. Furthermore 76 percent of CBA customers are ahead on mortgage repayments, with a record level of ANZ customers paying back more than their minimum amount. This suggests that despite Australians currently holding more disposable income than in the past, they are using it to relieve debt rather than boost consumption. Low petrol prices instead should influence their real incomes and therefore spending levels.  

Interestingly, however, the ASX RBA rate indicator placed a 63 percent chance on a cut of 25 basis points on Tuesday, up from a 16 percent chance last week. The Australian dollar responded with a drop of 1.59 US cents to 76.57 US cents as the Australian dollar became an unattractive investment. This should improve Australia’s export competitiveness and hence prevent the weak terms of trade from reducing income growth albeit slowly. Goldman Sachs predicts that “foreign exchange will be neutral in the first half, but should add 2 per cent to industrial earnings over the second half.” Both Treasurer Joe Hockey and Glenn Stevens still maintain that the exchange rate is overvalued, particularly when key commodity prices are taken into account. The financial markets have therefore conformed to a 100 percent probability of another cut by May with a 44 percent probability it will arrive as soon as March, on the basis of overnight index swaps data from Bloomberg.

On a side note, the RBA seems to have shifted out of its normal territory to influence the currency rather than primarily focus on unemployment and inflation. Glenn Stevens seems to have taken into consideration the actions of his global central bank contemporaries, whom have created programs specifically intending to depress currencies. Furthermore Australia still offers a relatively high yield compared to zero and negative rates elsewhere in other developed nations hence the impact of interest rates is questionable.

However I believe further cuts are unlikely if this cut fuels further risk of a housing price bubble. For instance the ME Bank immediately reduced their flagship mortgage rate to 4.62 percent and the three year fixed home loan rate offered by Greater Building Society is 4.44 percent. Mortgage rates have never been below 5 percent since the 1950s. Coupled with the downswing in petrol prices, this is great news for households (Joe Hockey states the benefit is equivalent to a cash rate reduction of a whole 1 percent). Nonetheless APRA’s role in containing the associated economic risks to house prices is essential to ensure that households do not respond to a housing bubble collapse by reducing consumption levels from declines in wealth.

On the other hand, head of research at CoreLogic RP Data, Tim Lawless, contends the economic boost may be slightly less influential on the housing market than previously experienced. Factors that assist in its moderation involve low consumer confidence, tighter serviceability and lending conditions and minimal rental yields. This fuels speculation that rates will be cut again in March to promote further balanced growth, a reasonable effort to improve domestic demand and shift the Australian dollar to its fundamental value before rates rise in response to the considerable momentum of the global economy in the later quarters of 2015.

An Investing perspective

In response to the rate cut the ASX 200 closed at an almost seven year high of 5707.4, with an increase of 82.1 points, whilst All Ordinaries surged by 79.7 points to 5666.2. Due to these rate cuts and also anticipations for further reductions, I believe the sharemarket offers attractive opportunities to grow one’s income. Traditionally telecommunications, infrastructure, utilities and consumer staples, banks and property groups such as Dexus benefit. The rise in their share prices is compatible with the market wide jump in stocks of high yield as investors, particularly those in their pension stage, seek more attractive yet sustainable yields than those offered by bonds or cash.

However the weak earnings growth outlook limits the options of equities for investors. For instance, although the retail industry typically experiences profit from improved consumer sentiment due to the wealth effect from lessened mortgage debt, given the downward series of rate cuts since October 2010, this recent cut should not create a significantly adequate difference.

Telstra nevertheless noticeably benefited, closing at $6.67 on Tuesday, a 14 year high. I believe this can be attributed to its dominance of the mobile industry, as well as its 4.5% dividend yield. Telstra also announced the day before the rate cut that they were considering a sale of its Trading Post business. Despite having paid $636 million a decade ago for its purchase analysts reckon that Telstra is likely to sell it for less than $10 million. Nonetheless it acts as a signal that Telstra is going to focus all its resources into telecommunications now. These therefore should be factors that determine its performance in the sharemarket although Telstra’s revenues in 2015 are only 10% higher than in 2005, suggesting it actually experiences relatively low growth. Therefore I conclude the most significant driver influencing Telstra investors is its steady dividend yield, seeked by SMSFs particularly.

Bank shares also tend to rise in such situations. For instance, CBA is valued 23 percent higher than its competitors given its forward price-to-earnings ratios (these use forecasted earnings). CBA closed on Tuesday with a peak of $90.40, up 0.8 percent, outperforming the ASX200 by 30 percent. (Despite this their forecasted dividend yield is still 4.6 percent before franking credits this financial year. I believe this can be explained by the pressure on banks to accumulate and hold capital. I will write about factors influencing dividends later on). However one may question the profitability of bank shares, as low interest rates should reduce their profit margins. Such yield is from the bank’s interest earning loans i.e assets being greater than its deposits i.e liabilities due to banks repricing their mortgage rates by less than the reduction in the cash rate. Therefore only when banks cut rates on both loans and deposits by the same amount do their profit margins tighten. In reality, the lower interest rates signal that banks are saving more on interest expense than they lose on interest income. In addition, the banks’ provision for doubtful and bad debts are at a minimum level since two decades ago. Clearly this can be attributed to borrowers’ reduced repayments resulting in fewer bad debts for the banks, which encourages credit growth. The below graph demonstrates this correlation:

Source: CBA, Macquarie Research

Such an outlook however does conflict with my previous research on expected consumer behaviour; the preference of the majority of consumers is to pay back debt, and tighter lending conditions to housing investors for banks means asset growth may be slower than typically expected with rate cuts. There is also the question of whether the 2.25 percent risk free rate leads to an accurate valuation; ceteris paribus, assets are valued higher with the risk free rate being lower. Overall I doubt the level of gain for the ASX 200 will be maintained into 2016 and therefore this strong rally may even cut into future capitalisation. There should be larger reductions in WACC to continue the rate of growth in investor incomes from lower funding costs for corporations. Nonetheless a high single digit growth figure is still a positive sign for things to come.

Sources: 
Financial Times, Bloomberg Business, Sydney Morning Herald, ABC News

Big Data: Pros, Cons and Solutions

The exponential growth of Big Data- large collection of data sets that can be analysed to improve decision making- highlights its increasing relevance to all economic stakeholders, though it may come at moral and legal risks. Nevertheless, I believe the value created can create mutually beneficial solutions.

Improvements to the type of data collected or a different approach to data analysis is becoming a significant competitive advantage for companies. For instance, exploiting the volume of high frequency nature of data collection enables retrospective metrics such as consumer sentiment to be ‘nowcasted’, that is, calculated and tested in real time. Company decisions based on such information will improve operating margins. For example, institutional investors who possess the computing capabilities to perform Big Data analyses on consumer product reviews are able to determine stock price directions following the introduction of a new product rather than use traditional sale figures. According to Gerard Tellis and Seshadri Tirunillai, the more negative reviews, the bigger the likelihood of a stock price drop, though positive news lacks a statistically significant impact. Portfolios based on their findings outperformed the market by up to 8% on an annualised basis. I believe such data analysis can be extended to produce inferences regarding investor behavioural psychology. Given the asymmetric effects on stock prices from positive vs. negative reviews, it highlights the risk averse nature of investors in general. Nevertheless, it may also mean positive information from marketing campaigns have already been fully reflected in the stock price.

Clearly, the biggest challenge is ensuring timely exploitation. Timely exploitation is vital, as highlighted by the success of the institutional investors’ model portfolio. Companies, particularly those with diverse business lines, must ensure data is shared between these departments. Financial institutions who fail to share data from their financial markets to their lending or money management lines are preventing themselves from developing a more comprehensive and coherent understanding of relationships and trends in customers or financial markets.

Big Data projects require high infrastructure costs to support the real time capture of such large quantity of data points. Incompatibility of formats and legacy systems challenges effective data integration and analytics application, emphasising the need to create a technology stack through analytical software apps.  However, the unclear return on investment (ROI) hinders guaranteed funding. Through actual Big Data projects, core business figures can be used to measure ROI, though pitching a business case with an accurate ROI initially is difficult which slows adoption. Research implies only 25% of CIOs are prepared to launch tech agendas and Big Data IT expenditure for 2015 is forecasted to consist of only 22% of IT spending. I believe companies should not narrow their focus on building their up front ROI, instead find scalable, low cost infrastructure such as the Cloud to configure and store their data architecture. The Cloud Dashboard’s tracking of KPI metrics from multiple databases can boost business transparency and therefore improves decision making.

Even when new infrastructure is set up, the need to interconnect a complex number of data sources also slows work. CIOs can also adopt an incremental approach to the business case- instead of pooling their entire data source into one data warehouse, they should find value in using data of individual data sources- an ‘analytics approach’. In identifying key data in each data source, CIOs can avoid the risk of generating noise and allow specialised infrastructure to maintain the data they were built to.

When data channel amalgamation is relatively easy to implement and benefits override its costs, an organisation can magnify its potential from Big Data. This is because the more data available, the more patterns can be recognised and therefore predictive analysis is increasingly useful. The US healthcare system’s data channels include clinical, claims, pharmaceutical research and patient records, each presently managed by individual constituencies. However if they implemented reforms to integrate the databases to analyse costs and health outcomes of medical treatments, physicians could be guided to the optimal treatment in terms of cost and outcome, thereby boosting productivity of the health sector. In fact, President Obama is currently developing a Precision Medicine Initiative, where genomic sequencing of patients is to be made accessible to researchers, who are then able to develop a new generation of personalised medicine especially targeting genetic variants.  

However, acceleration of biomedical research and development requires public support for the sharing of patient information. Steps to ensure greater transparency over the use of medical data and incentives such as criminal penalties for data misuse will improve public trust. Greater transparency will demonstrate the benefits of these initiatives- though this does not address the risk that the sheer volume of data from different data sets increases potential identification of anonymous patients which may lead to employer discrimination against individuals’ medical history. This highlights the need to implement consent declaration, despite this eroding the overarching unbiased data accumulation feature of Big Data analysis.

Others argue the need to balance the socio economic value generated by Big Data with social values of equity, fairness and privacy still circumvents the bigger picture. Quantification is an important tool though improper use of data is worse than having no use of data. Yahoo’s performance reviews of employees (ranked from 1 to 5) aimed to motivate though had opposite effects- talented employees no longer wanted to be a team, and employees lacked motivation to be mobile as this increased the possibility of a lower score. This demonstrates quantification boosts bureaucratic power and overly values short term impacts due to their ease of measurement. To ensure quantitative techniques remain objective in their analysis, judgments must be made on information that balances context, incentives and other factors.

Nonetheless, despite the condemnation of data collection techniques due to its apparent moral hazards, the ultimate solution is not to restrict the selectivity criteria of data to be collected, but to educate how data can be fairly used. Almost all large organisations have real time data warehouses, which, combined, contains more up to date information on our economy than all our government agencies. A public-private sector partnership will enable the government to use such private sector data warehouses to create more knowledgeable decisions regarding fiscal and monetary policy. In fact, Google encourages government regulators to stop deleting google searches as using their trends, they were able to track the flu outbreak even before health agencies could. Thus, condemning data is condemning knowledge. Take pharmaceuticals as an example- their reticence to social media platforms means they are failing to exploit a Big Data opportunity, as they are ignoring patient information shared online. If pharmaceutical companies employed data scientists to mine such qualitative real-world data, it could add to their information sources on drug side effects and their effectiveness. Now is never a better time to benefit from Big Data, particularly due to the availability of tech vendors who automate social media analytics such as Treato, Liquid Grids and IMS (branched into social media in 2014 as a result of their acquisition of Semantelli), who each minimise the burden on companies’ central objectives.  

Ultimately, Big Data must be developed in a system which addresses matters such as public-private data sharing agreements, frequency of meta data updates, transparency and technical standards. That way, value can be created not only for commercial companies, but for the public sector and collective societal well-being.

Sources: 

Financial Times, Ivey Business Journal, Time, Wall Street Journal , CIO, BioTech IT