Harvey Norman’s 19% fall in 1H24 EBITDA is likely a trough in earnings. As sales stabilise, we forecast EBITDA to increase 4% in 2H24e. While sales should stabilise, we expect very modest growth in its two largest markets – Australia and NZ. Profit margins should improve, albeit margins are on track to be above pre COVID-19 levels by June 2024 limiting the pace of earnings growth over the next two years. One encouraging sign is reduced inventory in its franchising business. Inventory is back to pre COVID-19 levels.

Harvey Norman provided a trading update informing the market that sales are in decline, profit is down almost 50% so far and it will consider buying back shares. Harvey Norman is undergoing a rapid reset of earnings post COVID-19. The concern on our mind is the loss of market share in Australia and NZ over the past four years. The unknown is how much of its weaker sales and earnings is a function of excess inventory. Earnings are likely to trough this year, but the recovery may underwhelm, particularly as its retail property is revalued lower.

There is much to debate about when retail sales slow, how far sales drop and how much margin downside will be associated with the sales weakness across the sector. We think the central driver of the debate is how quickly and far interest rates rise. In our base case (67% probability), the RBA reaches 2.5% cash rate by December 2022. In our downside case (33% probability), the cash rate reaches 4.5% by June 2023. There is downside risk to earnings for retailers over the next 18 months. We expect a volatile 12 months and advocate caution.

Harvey Norman delivered a solid 1H22 result with sales down 6% and profit before tax down 21%, excluding property revaluations. Earnings improved in the final two months of the half as lockdowns eased. The company has good control on costs and inventory levels are lean, but not short. We forecast FY22e PBT down 15%, which implies a smaller 2H22e earnings decline.

Harvey Norman provided an encouraging AGM trading update with recovering sales trends in the past two months and continued strong profit margins. Australian sales improved from -19% in July-August to -6% for September-November. Profit margins are holding up well with three-quarters of the gains seen in FY21 retained in 1H22e so far.

We initiate coverage of Harvey Norman. The company’s earnings have benefited from elevated demand and tight cost controls over 2020 and 2021. Earnings will fall over the next three years, but we expect margins to remain higher than pre-COVID-19 levels given market structure, store rollout and cost management. In Australia, we expect margins to remain firm given the more concentrated market structure, tight product supply and stringent control on costs the company has maintained over the past two years. The company’s sprawling retail network overseas now accounts for one-quarter of its group earnings and with further rollout in each major country, its share of earnings will rise over the next three years. Offshore stores will rise from 107 today to 121 by FY24e.