Like many auto components suppliers, Harman (NYSE:HAR) is seeing sales pick up as car sales rebound in the developed world and grow rapidly in emerging markets. The question for Harman investors, though, is whether the company can continue to convince OEMs to stick with their systems in lieu of internal development or partnerships with smart device manufacturers.
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A Solid Quarter, but No Blockbuster
Although Harman's quarterly numbers looked pretty strong, the quality of the beat was not quite as strong as it first appears.
Sales were up 16% as reported (and 19% in local currency), and that's legitimately good. Infotainment revenue increased 15%, helped by strong growth in China and the addition of Tata Motors (NYSE:TTM) as a customer. Lifestyle sales growth was also strong at 20%, while professional sales were up just 8%.
Margins are where things get a little more confusing. Reported gross margin showed just a 50 basis point improvement and reported operating income was up 12%. This seems misleading, though, as the year-ago period was boosted by a gain on sale. Strip that out, and reported operating income growth leaps to 60%, as the company saw great fixed expense leverage.
Looking at the segments, infotainment continues to be the relative laggard in operating margins, even though profits in the professional segment dropped sharply due, in part, to higher costs tied to neodymium. All in all, much of Harman's "beat" relative to analyst estimates was a byproduct of lower taxes.
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Fear the iCar?
In some respects Harman is well-placed to continue to gain share in the vehicle OEM market. While Harman may be best known for its audio offerings, its infotainment packages incorporate a variety of other functions including GPS control, voice control, in-car audio and video and so on. In many cases, competitors offer good options for one, but not both, aspects - Sony (NYSE:SNE) and Panasonic (NYSE:PC) are strong on the audio side, but less so on the controls, and vice versa for Denso (OTCBB:DNZOY) and Continental (OTCBB:CTTAY).
It's also true that Harman stands to benefit from not only the underlying growth in passenger vehicle sales in markets like China, Brazil, India, Vietnam and so on, but also from the increasing quality of the vehicles produced and sold.
Harman still faces some ongoing threats, however. OEMs like Ford (NYSE:F) and General Motors (NYSE:GM) have developed their own internal infotainment packages previously and almost any large car company could choose to do so. On the other end of the scale, the increasing sophistication and capabilities of smart devices from Apple (Nadsaq:AAPL) and Samsung create the risk that automakers will increasingly incorporate these devices as key components of the system, reducing Harman's significance and vehicle content.
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The Bottom Line
Harman is a curious stock from a valuation standpoint. The outlook for revenue growth over the next three to five years looks pretty good, and even modest improvement in free cash flow conversion would fuel double-digit free cash flow growth. Moreover, this is a company that has largely finished its cost rationalization process and sits with both a clean balance sheet and strong returns on capital.
While the competitive threats should not be underestimated, this may be a stock worth a closer look for investors looking to play the ongoing passenger vehicle growth cycle.
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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.