By Amrit Tewary
Many of the comforts of the Information Age home have found their way into the automobile. Major carmakers now offer "infotainment" systems in a growing number of models that include functions such as audio and video entertainment, voice-activated phones, climate control, and Internet access, along with auto-specific features like navigation and diagnostics (see BW Online Special Report, 09/04/03, "High-Tech Cars").
And that's a key reason we at Standard & Poor's Equity Research like Harman Intl. (HAR; recent price, $74). We think it has a strong competitive position in what we consider an underpenetrated market: supplying these high-end systems to carmakers. We're attracted by its high revenue visibility because Harman's infotainment gadgets are already scheduled for installation in several models over the next few years.
In addition, we believe the shares are undervalued, based on our discounted cash-flow and historical price-to-earnings analyses. The stock carries S&P's highest investment recommendation of 5 STARS, or buy.
For more than 50 years, Harman and its predecessors have created loudspeakers and electronic audio products. Its Consumer Systems Group (83% of sales in the quarter ended December 31, 2003) designs, manufactures, and markets audio and electronic systems for vehicle, home, video, and computer applications. Its products are sold worldwide under brand names including Harman/Kardon, Becker, JBL, Infinity, Revel, Lexicon, and Mark Levinson.
Harman's Professional Group (17%) designs, makes, and markets loudspeakers and electronics used by audio professionals in concert halls, stadiums, airports, and other buildings, as well as for recording, broadcast, cinema, and music-reproduction applications. Professional products are sold worldwide under brand names including JBL, AKG, Crown, Studer, Soundcraft, Lexicon, Digitech, and dbx.
In fiscal 2003 (ended June), approximately 62% of sales were to automotive customers, with DaimlerChrysler (DCX ) accounting for 26% and BMW 10% of total net sales.
In our view, Harman's key competitive strengths include its portfolio of well-recognized brands, as well as its technology and market-share leadership in its key product categories. We believe it enjoys a significant first-mover advantage in creating a digitally integrated infotainment system -- built on a single proprietary technology platform -- for cars.
In addition, we're encouraged by Harman's commitment to research and development. We believe that planned outlays in the next few years should help bolster Harman's already strong technical expertise in designing and integrating acoustics, navigation, speech recognition, and user interfaces into unique infotainment systems built for specific car models.
Management recently stated that with increasing levels of integration, Harman can greatly expand the functionality of its infotainment systems at no increase in cost. In addition, Harman said it has the capability to reduce the cost of the present set of features it offers by as much as 30% to 40% over the next 24 months. We believe these capabilities will give Harman significant leverage in contract negotiations with existing and potential original equipment manufacturer (OEM) customers. By Amrit Tewary
Harman has major growth opportunities with its automotive OEM customers, in our view. Within its current customer base, we think Harman can spark growth by achieving increased user acceptance of products offered in existing models -- and boosting the number that offer its audio systems as an option. It could also benefit from supply agreements with additional auto makers. Finally, Harman could achieve its goal of increased "per-vehicle content" by providing integrated infotainment systems in vehicles from a wider number of manufacturers and through additional hardware and software licensing agreements for other potential content offerings.
In recent years, Harman has successfully launched infotainment systems for a number of automobile models. Based on the current pipeline, we estimate its automotive OEM business will generate upward of $900 million in additional annual revenues over the next three years, which should help it achieve annualized growth rates in the mid-teens. We expect Harman to generate significant revenues from system installations in new luxury cars such as the Mercedes Benz S Class, C Class, and SLK, the Audi A6, and the BMW 3 Series and 1 Series.
We believe our growth projections could be conservative if Harman can expand beyond its stronghold in the European luxury-car market, and gain a larger presence with North American and Asian manufacturers, especially the volume-driven OEMs. We are encouraged by Harman's integration of its RB4 system in the Dodge Ram pickup and by the planned rollout of its equipment in General Motors' (GM ) Buick and Ford's (F ) Mercury models in coming years.
On Jan. 28, Harman reported December-quarter earnings per share of 60 cents, vs. 41 cents in the year-earlier period, which is 5 cents ahead of our estimate. Total net sales rose 24%, paced by a gain of 28% in the consumer segment. We were impressed by the better-than-expected sales growth and a significant improvement in gross margin.
For all of fiscal 2004, we estimate that revenues will advance 21%, on a 24% increase for the consumer segment -- bolstered by sales to automotive OEM customers -- and a 7% gain for the professional business. We expect operating margin to widen 124 basis points as the higher-margin automotive OEM business should grow as a percentage of overall sales. We project fiscal 2004 EPS of $2.15, vs. $1.55 a year earlier. We see capital spending increasing moderately from fiscal 2003 levels. For fiscal 2005, we see EPS of $2.79 on 16% top-line growth and a further widening of operating margin by 84 basis points.
We think Harman will likely use free cash flow and the $218 million of cash on its balance sheet primarily to pay off debt over the next few years. In addition, it will likely repurchase shares, make selective acquisitions, reinvest in operations, and fund its cash dividend.
We believe Harman's quality of earnings is relatively high. On a per-share basis, we see Standard & Poor's Core Earnings of $2.13 in fiscal 2004 and $2.77 in fiscal 2005. We think the shares are attractively valued. Our discounted cash-flow model suggests roughly 20% appreciation potential for the shares to our intrinsic value calculation.
Our 12-month target price of $95 is based on our historical p-e model and assumes a target multiple of about 34 times our fiscal 2005 operating EPS estimate of $2.79. Since fiscal 2002, Harman shares have traded in a p-e range of 17 to 41 times current-year operating EPS, with an average peak multiple of 34. We believe a target p-e of 34 is warranted given our EPS growth estimate of 39% in fiscal 2004 and 30% in fiscal 2005.
We think the market will continue to assign the stock a premium multiple to the S&P 500, given what we see as above-average growth expectations and the high degree of revenue and earnings visibility. In addition, we note that Harman has beaten EPS estimates by a wide margin in recent quarters, and we would not be surprised by continued outperformance in future quarters.
DOWNSIDES TO WATCH.
Potential risks to our investment recommendation and our target price, in our view, include: the deterioration of the overall economy and the global markets Harman competes in; the loss of business from key customers or the inability to win business from potential new customers; and insufficient market acceptance of new products.
Other risks include, in our opinion: adverse changes in currency exchange rates, raw material prices, or interest rates; increased competition; and Harman's inability to generate sufficient cash flow to fund internal growth, acquisitions, ongoing operations, share repurchases, pension-plan contributions, and payment of debt obligations.
Analyst Tewary follows consumer electronics stocks for Standard & Poor's Equity Research