New iPhone, new headphones
It's no coincidence that, a few days after Apple (NASDAQ:AAPL) started shipping its latest iPhones to customers, Harman International Industries (NYSE:HAR) introduced new wireless headphones. With iPhone shipments largely exceeding expectations, the controversial exclusion of a 3.5mm headphone jack has prompted audio equipment makers to emphasize bluetooth headsets.
Harman, which sells audio equipment under its JBL, AKG and Harman Kardon brands, is no stranger to the Apple ecosystem, having provided iconic audio accessories for Apple's products in the past. Of course, headphones for iPhones aren't Harman's only products - in fact, its biggest segment is 'connected car'. This unit provides audio solutions to luxury automakers such as BMW (OTCPK:BMWYY), Audi (OTCPK:AUDVF) and Porsche (OTCPK:POAHY) as well as mass-market automakers like Toyota (NYSE:TM), Ford (NYSE:F) and Hyundai (OTCPK:HYMPY).
In that sense, Harman is well-placed to take advantage of growth areas in lifestyle audio and 'connected' vehicles and investors looking for a high-potential dividend-paying stock to add to their portfolios have another one to consider.
While Harman's stock is down by 12.2% in the year-to-date, it's actually up by nearly 25% from its 52-week closing low in late June. On the face of it, Harman appears to have followed the fortunes of the auto industry and Apple - with the former seeing weakness in the current year and the latter only seeing a price recovery recently.
This is unsurprising considering that the products of both have a large impact on Harman's sales - though we would argue that any negative impact associated with the iPhone has more to do with slower smartphone sales overall and general economic weakness that has had a limiting effect on consumer spending.
Of course, a lower stock price has its benefits - Harman's dividend yield has improved from 1.49% at the start of the year to 1.74%. Thus, investors who purchase $10,000 worth of Harman's shares can expect to receive $174 in passive income each year they hold onto the stock. While this yield is lower than the current yield of the S&P 500, it is actually more than double the yield of Harman's peer group.
Given all this, should investors be looking to invest in Harman shares? Let's take a look.
Dividend and outlook
Harman had a good Fiscal 2016 (which ended in June). While it did miss Wall Street's earnings expectations in its fiscal third quarter (which ended in March), it rebounded smartly in the fourth quarter, bringing its cumulative earnings for fiscal 2016 to $6.25 per share compared to the estimate of $6.07 per share. This came on the back of a 12% expansion in its revenues and a 20% increase in its EBITDA.
In that sense, it's a little mystifying that investors have punished Harman's shares, especially since its guidance for Fiscal 2017 has been solid: 7% revenue growth accompanied by 10% EBITDA growth. We don't believe that it has anything to do with Harman's guidance - the stock has accelerated since the company reported its fiscal fourth quarter earnings and provided guidance - so much as the aforementioned narrative regarding Harman's sales to the auto industry and a slowdown in consumer spending.
Regardless, Harman's twin pillars of connected car systems and lifestyle audio products are expected to drive its growth, with the former expected to report a 7% increase in sales and the latter anticipated to be Harman's growth leader with a 10% sales jump. Of course, investors shouldn't ignore Harman's Connected Services unit, which provides Internet of Things capabilities to the infotainment units that it sells to automakers. This division is expected to see a 16% pick-up in its EBITDA, which is the highest among all of Harman's segments.
Meanwhile, if we assume that Apple sells 204 million new iPhones and 35% of buyers decided to purchase a new pair of Bluetooth headsets, the industry is looking at 71.4 million new headsets. At an average price of $50 per headset, that means potential sales of over $3.5 Billion. Harman isn't an especially large player in this market - Apple's Beats and LG account for 65% of sales - but if it were to grab another 3% of this market over what it already had, it could add $105 million to its annual revenues - enough to add 5% to its Lifestyle Audio segment's revenues.
Given the strength of Harman's lifestyle brands - Harman Kardon, AKG and JBL are generally regarded as quality audio names - we see no reason why it can't snatch a portion of the market away from LG and other players. Investors should also note that where Apple leads, the smartphone industry follows and other manufacturers are releasing devices without headphone jacks, which will only increase the potential market for wireless audio products.
Connected audio is a bit more difficult to measure since Harman doesn't provide unit measures - but with connected cars shipments expected to grow by 43% a year through 2021, it's reasonable to assume that Harman's Connected Car unit could more than double its revenues in the next five years. Indeed, Harman's recent sign-ups with Toyota and North American OEM position it well in this market - in fact, Harman's infotainment units were included in 7 new vehicle launches in the second quarter of 2016.
Investors who are concerned about Harman's ability to sustain its 'industry leading' dividend should note that its financial strength metrics are quite strong. In addition to having $1.59 of working capital for every dollar of its short-term liabilities, the company has just $0.36 of debt for every dollar of equity. In short, it's unlikely to encounter any difficulties with making continued dividend payments.
Harman is currently trading at just 13.2 times its trailing 12 months' earnings, which is a considerable discount to the 24.5-times earnings of the S&P 500. Given Harman's forward guidance of 10% EBITDA growth, we estimate that it will earn $6.88 in Fiscal 2017, which would imply a 12-times forward earnings ratio. This is likewise a significant discount to the S&P 500's forward earnings ratio of 18.3 times. Meanwhile, its peers are trading at 18.3 times their own forward estimates, even though their sales are contracting.
Considering Harman's growth and earnings prospects relative to the S&P 500's and its industry, we believe there is room for a compression in the valuation gap. Harman should be trading at closer to 14 times our current year's forecast, leading to a target price of $96.25 per share, which is in the range of the consensus forecast of $98.09 per share. This implies that Harman still has 16.4% upside against its current share price. If we add its dividend yield, investors are looking at an 18.1% total return.
All things considered, we don't understand why Harman isn't trading closer to our target price. The company has mostly surpassed expectations and is anticipating a solid fiscal 2017 - which we believe has upside if Harman can capture more of the iPhone 7's wireless converts and makes inroads with more automakers. To be sure, Harman's dividend isn't especially attractive - but it is far better than what investors can get from its peers.
Lastly, Harman is trading very cheaply relative to the market and its competitors. A stock that has better forward prospects and more robust financial fundamentals than its peers has no business trading this low. Investors should do themselves a favor and buy this stock.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HAR over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.