Participants in Australia’s consumer discretionary sector reported mixed results in 2015-16. At the bottom end of the scale, the market has witnessed the high-profile collapse of Woolworths’ disastrous Masters Home Improvement chain, while retailers exposed to the continued strength of the Australian consumer saw their earnings rocket.

Two retailers that continue to reap the benefits of the “wealth effect” gravy train are Harvey Norman and JB Hi-Fi. Not dismissing growing concerns that residential property prices may have peaked or that interest rates will eventually normalise, the short-term macro environment is still conducive, especially heading into the busiest time on every retailer’s calendar – Christmas trading.

So, which company is set to bring yuletide blessings for investors this season?

Company overviews

Harvey Norman is an ASX 100 company, founded in 1982 by Gerry Harvey and Ian Norman. From humble beginnings it has expanded across international borders. With 192 franchises in Australia and 85 company-operated stores at home and abroad, Harvey Norman is one of the nation’s largest diversified retailers.

Fellow ASX100 company JB Hi-Fi was founded in 1974 by John Barbuto as a specialised discount retailer of hi-fi equipment and music. Today it is one of Australia’s most successful consumer retailers. Since the ’80s, JB Hi-Fi has innovated and adapted its business model.

In September 2016, JB Hi-Fi decided to buy The Good Guys store network. Post-acquisition, the combined entity is expected to become the predominant player, with an estimated 24 per cent market share in consumer electronics and 29 per cent in home appliances. Harvey Norman has market share of 15 per cent and 24 per cent respectively.

Financial Health

Harvey Norman and JB Hi-Fi both exhibit strong financial health ratings, according to our methodology at Lincoln Indicators. We believe both are exposed to manageable levels of financial risk, supported by a strong earnings profile, balance sheet and operational cash flows.

Harvey Norman’s balance sheet is more robust than JB Hi-Fi’s, as indicated by a total liability to total tangible asset (TLTAI) ratio of 0.40 vs 0.65 respectively. This difference is largely due to Harvey Norman’s sizeable property portfolio, which inflates its total tangible asset base, reducing the score. Companies with a higher TLTAI ratio are often limited in their ability to absorb shock; but though JB Hi-Fi’s higher TLTAI ratio is disadvantageous, the company’s strong cash generation provides a buffer to any short-term liquidity needs.

Another measure of strong financial health is positive and persistent cash flow. In this regard, Lincoln prefers to use operating cash flow to total tangible assets. At the end of 2015-16, Harvey Norman and JB Hi-Fi produced a ratio of 0.10 and 0.20 respectively. For reference, a ratio of above 0.05 is strong, so both companies are well capitalised to fund their next stage of growth.

Winner: Tie. Both companies are “strong” in terms of financial health and exhibit robust balance sheet and cash-flow ratios.

Management assessment

Harvey Norman’s operating revenue (exclusive of property revaluations) grew 9.5 per cent in 2015-16, to deliver a normalised net profit after tax of $323.9 million vs $261.8 million in the previous corresponding period.

Total Australian franchise sales rose to $5.3 billion vs $5.0 billion – up 7.6 per cent on the previous corresponding period. Growth was underpinned by residential property as well as the RBA’s expansionary monetary policy. International markets contributed positively, as demonstrated by the Asian business, with a profit of $11.4 million vs a loss of $6 million in the previous corresponding period.

Return on assets improved from 8.5 per cent to 10.3 per cent, highlighting management’s continued ability to extract further value from the current asset base. Operational gains translated to underlying earnings per share growth of 21.8 per cent to 29.14¢ per share.

In the same period, JB Hi-Fi delivered revenue growth of 8.3 per cent to $4.0 billion on the back of improved sales momentum in the Australian business, offsetting profitability falls in New Zealand. Growth in the top line was driven by a combination of organic and acquisitive growth, noting comparative sales growth of 5.4 per cent.

In terms of efficiency, ROA increased from 21.9 per cent to 22.0 per cent plus underlying EPS growth of 11.5 per cent.

Winner: Harvey Norman. While JB Hi-Fi achieved positive revenue and earnings growth, the quantum of these increases trailed Harvey Norman’s.

Outlook and forecast

Harvey Norman reiterated favourable trading expectations amidst a volatile retail environment. Management views current macroeconomic conditions (such as record low interest rates and a retailer-friendly federal budget) to remain supportive in the near-term. However, there are potential headwinds, especially as the Australian property market returns to a state of steady growth. And increased competitive pressures are building after South African retailer Steinhoff International made a bid for Fantastic Holdings in October 2016.

JB Hi-Fi provided 2016-17 revenue guidance of about $4.3 billion, which suggests future top-line growth of about 7.5 per cent. The structural tailwinds that contributed to 2015-16 are flowing into 2016-17, with July 2016 sales growth of 13.4 per cent (vs July 2015 of +7.6 per cent) and comparable sales growth of 9.5 per cent (vs July 2016 of 5.7 per cent). The biggest catalyst to growth in 2016-17 will come from acquiring The Good Guys. With improved scale and potential for material cost synergies, JB Hi-Fi should maintain its advantage when it reports in 2017.

Winner: JB Hi-Fi. The acquisition of The Good Guys represents a major growth catalyst in 2016-17, giving JB Hi-Fi greater scale in consumer electronics and home appliances market share.

Share price value

Both companies trade at close to their intrinsic values. Harvey Norman is trading on a price/earnings ratio of 15.43 times, while JB Hi-Fi is trading on a ratio of 16.54 times. While both companies trail the industry average of 17.6 times, we believe the current multiples are close to fair value for a discretionary retailer.

Winner: JB Hi-Fi. The company’s P/E ratio may not be a true reflection of its quality. Earnings are expected to grow significantly post-acquisition of The Good Guys and, given its price/earnings ratio is a discount to that of the market average, this may present an opportunity to value investors.

Total returns

Both Harvey Norman and JB Hi-Fi have maintained stable dividends, which have benefited income-oriented investors by providing consistent above-market yields.

We believe both companies will retain above-market dividend yields, earnings stability and high levels of dividend distribution, so both are covered as Stock Doctor Star Income Stocks – those suitable for investors looking for income as a priority from their investments, and who want the comfort of investing in quality businesses.

Harvey Norman announced a fully franked final dividend of 17¢ a share, bringing the total distribution for 2015-16 to 30¢. The company’s ordinary dividend represents a grossed up yield of 8.62 per cent. JB Hi-Fi declared a fully franked final distribution of 37¢ a share, bringing total dividends for 2015-16 to 98.79¢. This dividend represents a grossed up yield of 5.64 per cent.

Over the past 12 months, Harvey Norman delivered a total return (inclusive of dividends) of 43.72 per cent, while JB Hi-Fi returned 73.68 per cent. Over a longer-term horizon, Harvey Norman achieved a total return of 25.88 per cent and 25.02 per cent over three- and five-year periods, while JB Hi-Fi returned 17.21 per cent and 20.38 per cent a year, respectively.

Winner: Tie. From a dividend yield view, Harvey Norman trumps JB Hi-Fi by providing investors with a higher current dividend yield. On a total return basis, both are comparable and have outperformed the market.

Verdict

Both companies performed strongly in the past 12 months and appear well-placed going into the Christmas trading period. The future outlook of both ranks shoulder to shoulder, hence we deem this contest to be a tie.