Can Harman Reach The High Note?

The name Harman-Kardon has been synonymous with good sound for many years. In 1953, Dr. Sidney Harman and Bernard Kardon started their own high-fidelity company, manufacturing and selling audio equipment for the home. Ahead of its time, business took off. With the exception of four years working for Jimmy Carter in the White House, the company has been Sidney Harman's main address.

It's hard to imagine Harman International (NYSE:HAR) without Sidney Harman, but as of December 3, Harman will retire from the Board of Directors and CEO Dinesh Paliwal will add the chairman's role to his responsibilities. Harman specifically recruited Paliwal to take the company to the next level. He has a long way to go.

Not A Good Year
In the past 52 weeks, the company's stock has dropped 70% with one piece of bad news after another. First, it announced September 21, 2007, that the deal it reached with Kohlberg Kravis Roberts and Goldman Sachs (NYSE:GS) to sell the company for $120 a share was terminated because the two buyers felt there was a material change in the company's finances. Rather than carry out a lengthy battle to recover the $225 million termination fee that the two investment groups would likely fight, Harman International got them to buy $400 million in 1.25% Senior Notes, convertible into Harman common stock at $116 a share.

However, the damage was done. On that fateful day, Harman's stock dropped $28, from $112 to just under $85. A few days later, Standard & Poor's lowered its outlook on the company's bonds, dropping the stock another $5 to $80. Finally, early this year, its stock dropped another 38%, or $26, to $43 after Harman lowered its 2008 full-year outlook. Talk about investors losing confidence in a stock. In less than four months, it slid $77 from the takeover price to its closing price on January 14.

Much Work Remains
On July 1, Harman started a 24-month improvement program that would shrink the company's manufacturing facilities, optimizing its global footprint while producing $400 million in annual savings in fiscal 2010 and beyond. This will help, but more action is necessary.

Harman's business model, in my opinion, is flawed. It is selling too much for too little. Since 2003, net sales have grown from $2.22 billion to $4.11 billion, almost doubling. In those same six years, operating income has slipped from $166.89 million to $138.5 million. Yes, the company did almost hit $400 million in operating income in 2006, only to backslide in the last two years. Operating margins have dropped by more than half. No wonder investors are unimpressed. Margins must recover for the stock price to have any hope.

A Better Plan
The company has three segments: automotive, consumer and professional. In the last year, operating margins in both the automotive and consumer segments have deteriorated badly. Only the professional division has managed to move ahead. In the fourth quarter ended June 30, the professional division's gross and operating margins were 41.9% and 19.6% respectively, up 270 and 330 basis points from the same quarter last year. These came on a 4% sales increase (excluding currency changes).

Compare those numbers with the consumer division, which saw sales drop 13% (excluding currency changes), with the gross profit margin falling by 250 basis points and the operating margin by 860. Almost as weak were the automotive division's results, which saw gross margins drop 910 basis points and operating margins drop 620, albeit on a 12% (excluding currency changes) sales increase. It's no wonder RBC Capital believes Harman is broken, no longer the growth stock it once was, due to lower margin contracts with vehicles downstream from the luxury market.

Bottom Line
If I was Mr. Paliwal, here's what I'd do to restore Harman's stock price. First, I'd get rid of the consumer division, licensing its brand names to a third party who can market the products to fickle consumers at places like Best Buy (NYSE:BBY), Circuit City (NYSE:CC) and other electronics retailers. Harman had operating losses in three of the last six years, and I don't see that changing. The consumer electronics business is too cutthroat. Get out while you still can.

Second, I'd abandon selling lower-priced products to the car companies. Either they can pay the going rate for Harman's excellent technology or find someone else to bottom feed.

Third, I'd keep doing what the company is doing in the professional area. It's this area that accurately portrays Harman's heritage as an innovator. You can't be all things to all people. Don't, and I'm sure the company's cost-savings program will deliver record-setting profits in the years to come. Continue to chase unprofitable business, and the stock will stay mired in the mud. It's that simple.