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Can Harvey Norman improve?

Harvey Norman (ASX: HVN) shares have rallied strongly over the past nine months, after the shares were oversold in December last year following months of profit downgrades from fellow discretionary retailers.

The shares touched a multi-year low of $1.74 on December 6 and have since recovered to over $3 yesterday. The future direction of the share price appears to be balanced on a knife’s edge, with UBS and Morningstar offering contradictory analyses of the company’s fortunes.

Morningstar is of the opinion that the recent share price growth is unsustainable based on the ongoing decline in revenue and profit, largely due to the shift to online retailers for electronics and white goods. The brand’s online presence has improved in the past year, but intense price competition from established and new online brands is expected to impact margins in the medium to long term.

The shift online sees Harvey Norman competing with other large Australian bricks and mortar retailers such as David Jones (ASX: DJS), JB Hi-Fi (ASX: JBH), Bunnings and Masters Hardware, as well as many international brands who ship to Australia directly.

Morningstar notes that Harvey Norman has achieved cost reductions in line with the decline in receipts from customers, but is unsure of where further cost savings will be achieved if revenue continues to fall. Closure of unprofitable stores should provide the biggest benefit, as Harvey Norman pays franchisees ‘Tactical Support Payments’ in times of low profitability or trading difficulty. These payments increased by $4.5 million to $128.5 million in 2012-13.

UBS is much more positive. It notes that Harvey Norman’s leverage to a housing and retail recovery are key and were buoyed by the positivity expressed by the company in the 2012-13 results. UBS believes that fashion retailers and department stores may continue to struggle but that a recovery in residential housing would lead to improved furniture and electrical goods sales for companies such as Harvey Norman.

UBS also believes the company will benefit from new product releases in 2013-14, leading to an increase in spending on game consoles and electronics. Finally, UBS believe that the online presence of Harvey Norman should act as a cushion for the company against the loss of sales to rival online retailers.

Foolish takeaway

Having risen 72% in the past nine months, and 25% in the past two months, the future of the share price of Harvey Norman is far from certain. UBS and Morningstar have starkly different views on the company’s future and have price targets of $3.30 and $1.70 respectively.

Investors should consider whether they believe shopping will continue to move online or if Australians will instead opt to head to shopping malls to purchase white goods and furniture. Harvey Norman is undoubtedly in a good position to benefit from an increase in retail spending but company success will rely on reducing margins to compete with online retailers.

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Motley Fool writer Andrew Mudie does not own shares in any of the companies mentioned.

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