Volume I, Issue 18 (released on October 13, 2014)
Below is a full investment research article that I wrote on HOG:
Harley-Davidson, Inc (HOG): Geared Up For A Strong Ride
- HOG dominates the motorcycle industry; its 50%+ U.S. market share increased steadily over the past five years and is near its all-time high, and this increase is highest with all-important young and foreign customers.
- HOG leveraged the Great Recession through a major restructuring that significantly increased productivity and reduced costs, while continuing to return value to shareholders.
- Economic recovery and improving consumer confidence will lift HOG going forward, in both U.S. and foreign markets.
- HOG is currently trading at a discount to its historical average valuation multiples, providing significant upside for long term investors.
I am very grateful for the assistance of Thomas Beevers, the CEO and founder of StockViews, who provided substantive suggestions that greatly improved this article. The fault for any errors or omissions is, of course, my own.
HOG provides an excellent long-term buy opportunity, presenting a 12-month price target of $68/share (+20.44%).
HOG is a great stock to own for at least the next two years, and perhaps longer if certain macroeconomic factors work in the company’s favor. Contrary to popular belief, HOG has significantly increased the strength of its domestic brand outside its “core customer” base (white males age 35+), particularly in the all-important category of young men and women ages 18-34, the next generation of American motorcycle riders. HOG dominated this “outreach” category with a whopping 47.30% market share in 2013, and this market share position alone fuels the company’s long-term success.
More importantly, HOG’s recently completed restructuring is already significantly helping the company’s bottom line, and HOG’s sales are riding the improvement in U.S. consumer confidence that has taken place over the last few years. Even though I consider HOG’s current price provides a solid buying opportunity, I also address both long-term risks and conditions impacting the timing of a potential entry in this article.
William S. Harley and Arthur Davidson of Milwaukee, Wisconsin, founded the “Harley-Davidson Motor Company” (incorporated as Harley-Davidson in 1981), and the company sold its first motorcycle in 1903. Today Harley-Davidson, which is still headquartered in Milwaukee, is famous for producing and selling heavyweight motorcycles (601cc+). In addition to the revenue it generates by selling street-legal Harley-Davidson motorcycles, general merchandise, and motorcycle parts & accessories (P&A) at wholesale to a network of independent dealers, HOG also generates revenue through wholesale and retail sales financing, licensing fees, and the operation of the Harley-Davidson Museum in Milwaukee.
Harley-Davidson operates through two separately managed business segments: motorcycles and related products (“Motorcycles”), and financial services. Harley-Davidson Financial Services (HDFS) offers a line of financing options, insurance products, and services to its customers. In the second quarter of 2014, HDFS had a 56.0% share (+2.2 pts. vs. Q2 2013) of U.S. Harley-Davidson new retail motorcycle sales, and originated $1.0 billion in new & used retail motorcycle loans, an increase of 10.5% year-over-year. HDFS has substantially increased its share of U.S. Harley-Davidson new retail motorcycle financing over the last few years (going from 47.9% in 2010 to where it is now). As of Q2 2014, Harley-Davidson had $6.94 billion in finance receivables outstanding (+9.5% vs. Q2 2013), which was comprised of $5.60 billion retail and $1.34 billion wholesale. HOG’s ability to offer financing services survived Dodd-Frank and financial reform, and it gives the company a significant competitive advantage over competitors who unable to offer similar financing arrangements. Notably, Warren Buffet saw the value in HDFS by infusing $303 million into HOG to help keep loans available to purchasers and dealers as credit markets sank during the Great Recession. HOG paid back the loan this February.
It is total motorcycle sales, not financing, however, that drives HOG’s stock price. HOG reached its all-time high of $75.50/share on November 22, 2006; about a year after new home sales in the U.S. reached their peak (new home sales reached a peak in April 2005 and a second peak in November 2005). HOG has not returned to its pre-crisis high: its current 52-week high is $74.13, which was reached on May 01, 2014. HOG thus trails the S&P 500, which is currently 20.95% higher that its pre-crisis intraday high of 1,576.09 (set October 11, 2007).
1. HOG dominates the motorcycle industry
HOG currently captures approximately 54% of the U.S. heavyweight motorcycle market. While that figure is quite impressive, it is even more impressive that “Harley-Davidson has 52% of the broad U.S. motorcycle market” (estimated by Robin Farley of UBS Securities). This compares to “a combined 3% to 5% for Polaris's Victory and Indian brands” and “…Honda Motor Co., Kawasaki Heavy Industries Ltd. and Yamaha Motor Co. all in the 9% to 11% range, while BMW AG and Ducati Motor Holding SpA are below 5%.”
a. Why is HOG so strong, and will that strength continue?
HOG’s 52% share of the broad U.S. motorcycle market, which IBISWorld Inc. estimates will generate $6.9 billion in revenue this year, didn’t happen overnight. It happened because HOG has established an extremely high level of brand loyalty. From attempting to trademark its motorcycles engine’s distinctive sound, to catchy advertising slogans (e.g., “The road starts here”) and model names (“Road King®”), Harley-Davidson has established itself as an undeniably “cool” company. As a result, Harley-Davidson has created an enormous, and extremely loyal, following.
I’m not quite sure how to label people who tattoo their bodies with a company’s logo, but the simple word “consumer” does not suffice. More than 700,000 motorcyclists belong to Harley riding groups in the U.S. and Canada, and a good many likely have a Harley-Davidson tattoo. These 700,000+ motorcyclists act as “brand ambassadors” who tout the benefits of riding a Harley to anyone who will listen. This community drives the Harley-Davidson brand by promoting a lifestyle, not just a machine.
HOG also has earned a reputation for genuinely caring about its customers. When, on October 16, 2013, HOG recalled 29,046 motorcycles due to issues with the bikes’ hydraulic clutch systems, the company not only immediately identified and promised to fix a problem, which did not even pose a significant safety risk, it also promised to transport their cycles to dealers for inspection then fixed them for free. That type of service is unique in the vehicle industry, and it gives HOG a significant competitive advantage by driving customer loyalty.
Brand and customer loyalty have helped HOG grow its market share in “outreach categories” just as quickly as in its core demographic in the all-important 601cc+ motorcycle market. The chart below demonstrates both this broad dominance, and its improvement over the past five years.
The chart above also shows that HOG has not only significantly increased its market share, in all five demographics listed in the chart above, it has also taken a significant amount of market share away from its biggest competitor.
b. HOG’s Pricing Power
HOG has capitalized on its brand, its customer loyalty, and its market share by driving price, resulting in improvement in revenue per unit (per motorcycle). This can be seen in the chart below:
Data Source: Harley-Davidson Inc. 10-K filings for the years 2001-2013
- Note: “Average Yearly Pricing Growth” calculated by taking average of “Yearly Revenue Per Unit Growth” figures for 2002-2013; (revenue per unit growth figure for 2001 was excluded and is thus labeled “N/A”).
Investors like to see a company effectively monetize its customer loyalty and dominant market share position. The above data demonstrate that HOG has been doing so for many years. Over the past twelve years, HOG has been able to increase its “revenue per unit” by an average of 2.84% per year, which effectively means that HOG achieves 2-3% pricing growth yearly on top of volume growth. Notably, HOG was still able to increase its revenue per unit every year throughout the Great Recession (circled in green). More specifically, from 2007 (when the U.S. housing market began its collapse) to 2010 (when total U.S. motorcycle sales bottomed) HOG was able to achieve an average of 3.57% pricing growth per year on top of volume growth. HOG’s ability to continually increase its revenue per unit demonstrates its ability to leverage market dominance.
Year-to-date, HOG’s “revenue per unit” reached a very impressive $16,113.18, a 6.04% increase year-over-year (HOG’s revenue per unit for H1 2014 was $15,195.77). If the 6.04% pricing growth (y/y) figure was an annual figure it would be HOG’s second highest pricing growth figure in the last 12 years, demonstrating that HOG has been accelerating its pricing growth rate.
Inevitably, HOG’s revenue per unit growth rate will slow as the company ships more low-cost motorcycles (under $15,000-$16,000), which will drive down the company’s average revenue per unit. As these lower cost units will help HOG appeal to a wider (and younger) base of customers, such a decline should not trouble investors, unless the company stops achieving 2-3% pricing growth yearly, on top of volume growth.
c. HOG’s Strength in Retail
Diving deeper into some of HOG’s data unveils additional strengths. Below is a table that shows HOG’s total annual motorcycle shipments from 2001-2013:
Source: Harley-Davidson Website (Investor Relations)
The table shows that HOG’s total annual motorcycle shipments peaked in 2006, in line with the industry’s pre-crisis peak in sales, and bottomed in 2010. Over the past three full years (2010-13) Harley-Davidson experienced 23.74% growth in the total number of units it shipped, which equates to a Compound Annual Growth Rate of 7.36% for the three year period (calculations exclude shipments from Buell).
During that same period of time HOG’s total worldwide retail sales grew by a total of 17.44%, which can be calculated using the data below.
Data Source: Harley-Davidson’s Annual Reports (10-K Filing)
- Note: Before 2013, Harley-Davidson labeled its retail sales figures as only applying to “Heavyweight (651+cc).” This did not affect the numbers reported in the table above, and Harley-Davidson only introduced that label change because it began to plan for the introduction of smaller (lower than 651cc) motorcycles.
This is not just a domestic story. Since 2010, HOG also has increased foreign sales at a much faster rate (3-year CAGR of 10.41%) than the company’s retail sales growth rate in North America (3-year CAGR of 5.38%). I discuss below the significance of HOG’s increasing international presence, which has contributed to the company’s faster unit sales growth rate.
The impressive part about HOG’s growth in number of units sold over the last three years is that the sales increase occurred when its dealer network actually decreased in size (by a total of seven retail locations). The total number of Harley-Davidson dealerships (separated by region) can be seen in the table below:
Data Source: Harley-Davidson Company Website (Investor Relations)
- Note: This table combines data related to three different types of dealers: “Full Service Dealerships,” “Secondary Retail Locations (SRLs),” and “Non-traditional outlets” into each cell to derive the total number of retail locations.
Together, the two tables above show that HOG significantly increased sales while slightly decreasing dealerships, reflecting strong “Same Store Sales” (SSS) growth over the last three years.
Although HOG does not release SSS growth figures, I decided to use the data above, and other data available in HOG’s financial statements, to approximate the company’s SSS growth by calculating growth in revenue per dealership, taking the company’s full-year total revenue (for the “Motorcycles” segment) and dividing it by total number of Harley-Davidson dealerships. After calculating HOG’s revenue per store for the past four years, I calculated HOG’s growth in revenue per store for each of the past three years. My calculations showed that HOG has averaged revenue per store growth of 8.18% a year over the last three years. Although this is not an exact approximation of Same Store Sales growth, because as a company expands its revenue per store growth will often lag same store sales growth (due to the fact that new stores take a while to begin operating at full potential), it gives analysts an indication that demand for Harley-Davidson products has significantly increased over the last three years.
2. HOG leveraged the Great Recession while continuing to return value to shareholders
A company with HOG’s history knows how to fight through adversity and emerge better than ever. HOG was one of two US motorcycle manufacturers that survived the Great Depression, and the company has fended off competition from foreign motorcycle makers (notably Japanese), overcome quality control issues, and avoided bankruptcy in the 1970s. HOG emerged from the financial crisis of 2008-09 with improved productivity, while still returning a strong dividend to its shareholders.
a. Improved productivity
In May 2009, HOG appointed a new CEO, Keith Wandell, who previously served as President and COO of Johnson Controls Inc. from 2006-09. Wandell’s experience running a large company (now #68 in the Fortune 500, with a market cap of $31 billion) gave him the experience HOG needed to execute a significant restructuring program for HOG. This four-year program reduced costs, eliminated excess capacity, and led to the exit from non-core business operations. It also was not cheap: in 2009-13 HOG spent approximately $479 million on restructuring – a substantial investment for a company HOG’s size.
Significantly, the restructuring program included the renegotiation of the company’s union contracts. HOG previously operated with very expensive unionized production, and HOG renegotiated its union contracts to allow for flexible workforce deployment, the consolidation of production facilities, outsourcing of distribution, and the exit from its “Buell” product line. HOG ultimately reduced its workforce by approximately 3,500 hourly production positions and approximately 800 non-production jobs.
Finally, the company implemented a new enterprise resource planning (ERP) system in Q3 2012 to streamline organizational processes and improve communication. Although HOG experienced some bumps, the company is now demonstrating enhanced tracking and forecasting, greater manufacturing productivity, and improved customer service and satisfaction. The effects of the ERP system have begun to show in the company’s “efficiency ratios.” For example, data from Morningstar.com indicates that HOG’s twelve-trailing-month Inventory Turnover ratio is now at 10.95, a significant improvement from its 2009 ratio of 8.01. This means HOG can more effectively manage its inventory levels, enabling the company to sell and replace its entire inventory in only 33.32 days, down from 45.54 days in 2008 (a 27% improvement). Similarly, I calculate the Asset Turnover ratio for HOG’s motorcycles segment as improving from 1.42 in 2009 (1.53 if one accounts for assets of discontinued operations in 2009 and 2008) to 1.90 in 2013 (a 25% improvement). (These turnover ratios were calculated by taking the Motorcycles segment’s net revenue in 2013 and 2009 and dividing each by the segment’s average total assets for each year respectively.) HOG’s improving efficiency ratios (Inventory Turnover and Asset Turnover) demonstrate the success of the company’s efficiency push.
In sum, company restructuring, improved union contracts, and the ERP system resulted in $310 million of restructuring savings in 2013, and the company projects annual savings of approximately $320 million beginning in 2014. Of this amount, the company projects 37% will come from reductions in operating expenses, and the remainder from reductions in cost of sales. In addition, “while motorcycle fixed costs were 20-25% of variable costs at the beginning of restructuring operations in 2009, the figure is expected to decline to 15-20% [in 2014].” This is a huge deal for the company, as these savings will translate directly into continued expansion of operating margins, strong bottom-line growth, and higher levels of ROIC.
b. Returning money to shareholders
HOG’s management team managed to increase the company’s market share, as noted earlier, while still returning money to shareholders through dividends and share repurchase programs.
HOG paid out its first dividend ($0.06/share) on August 16, 1993, which gave the company an annualized dividend yield of 0.55% (assuming a $0.06/share dividend for four quarters, and using HOG’s closing price on 8/16/93). Since then, the company has paid a dividend every quarter (including during 2008-09), giving HOG an extremely high level of “dividend predictability.” The company recently increased its dividend payment 30.95% to $0.275/share, which gives the stock an annualized dividend yield of 1.95% (as of 10/10/14). Although HOG’s current quarterly dividend payment is a big step up from where it was in 2009 ($0.10/share), it has still not returned to its pre-crisis level of $0.33/share.
HOG’s dividend still has room to grow, as reflected by an analysis of HOG’s future capital expenditure (capex) requirements, its future depreciation expenses, and its future required contributions to its qualified pension, SERPA and post-retirement healthcare plans.
Analyzing HOG’s future capex requirements: First, a quick excerpt from HOG’s 10-Q for Q2 2014: “The Company continues to estimate capital expenditures for 2014 to be between $215 million and $235 million. The Company anticipates it will have the ability to fund all capital expenditures in 2014 with cash flows generated by operations.”
Data from Morningstar indicates that the total amount HOG has spent on capital expenditures over the past ten years has ranged from $117 million (in 2009) to $242 million (in 2007), and the company has recorded an of $198 million in capital expenditures a year during that ten year period. As you would expect from a company in the Consumer Cyclical sector, HOG’s yearly capital spending loosely follows the state of the U.S. economy (i.e., the company demonstrates higher capex when the U.S. economy does well, and lower capex during recessions). After bottoming out at $117 million in 2009, HOG’s capital spending rose to $208 million in 2013 (the “Motorcycles” segment accounted for 95.7% of capex in 2013) and, in the past twelve months, the company’s has recorded $216 million in capital expenditures. Over the last ten years, HOG’s yearly capital expenditures have ranged from 2.44% to 4.26% of the company’s total revenue for the year, with an average of 3.63% per year for the whole ten year period.
Given the relatively tepid demand for motorcycles over the past four years, it is no surprise that HOG has not significantly ramped up its production, which would cause its capital spending to increase by a relatively large amount. However, HOG’s total capital expenditures have increased by 21.64% over the past three years, reflecting an aggressive 2014 model lineup (“Project Rushmore”) that was its “largest scale new model launch in company’s 110-year history.” In addition, the company unveiled a fully electric motorcycle prototype (“Project LiveWire”), and it also recently introduced two completely new motorcycles (the Street™ 500 and the Street™ 750) (see below).
Taking these factors into account when evaluating HOG’s future capex requirements, I expect HOG to record, on average, $220 million in capital expenditures per year over the next five years.
Analyzing future depreciation expenses: This projected $220 million per year in capital expenditures is larger than the company’s average annual depreciation expense of $208 million for each of the past ten years. HOG’s total depreciation expenses have come way down over the past three years, primarily due to the success of the company’s restructuring program and its exit from the “Buell” product line; HOG has averaged approximately $168 million per year in total depreciation expenses over the last two years. (Note: HOG calculates depreciation on the straight-line basis over the estimated useful lives of its assets.)
Analyzing future required payments/contributions: HOG’s long-term obligations related to its qualified pension, SERPA and postretirement healthcare plans in 2013 included a $175.0 million voluntary contribution to its qualified pension plan (out of a total of $204.8 million in total contributions). HOG’s 2013 10-K stated there are no pension plan contributions required in 2014, nor does the company expect to make any voluntary contributions other than its on-going benefit payments for SERPA and postretirement healthcare plans.
Below is a table that shows the payments that HOG expect to make to the aforementioned employee compensation plans:
In summary, I do not see HOG’s future capex requirements, depreciation expenses, or a large future payment, as a major impediment to the company growing its dividend going forward, giving HOG’s dividend room to grow. Bloomberg agrees with this assessment, ranking the company #8 out of 25 in its Dividend Tip Sheet,” which ranks stocks based on how fast their payout ratios are growing. Given that HOG’s dividend yield was only 1.59% at the time the “Tip Sheet” was published on June 18, 2014, its current rating could be higher. If HOG grows its dividend at the rate Bloomberg predicts, it pay a quarterly dividend of $0.35/share, its highest dividend payment ever. Currently, HOG’s payout ratio (ttm) is 25%, with room to increase. I expect HOG will attempt to achieve and maintain a dividend payout ratio of approximately 35%, to approach its 10-year average payout ratio of 36.51%.
Even if HOG maintains its current payout ratio of 25%, investors will see the company’s quarterly dividend payments begin to increase substantially as HOG’s net income continues to grow at an extremely fast pace (HOG’s net income grew by an average of 71.10% per year over the last three years and even if it slows that will mean higher dividend payments going forward). Any news related to an increase in HOG’s quarterly dividend payments/payout ratio will be well-received by investors, who will correspondingly bid the company’s share price up. As I believe it highly likely that HOG will increase its payout ratio, I view this as a very positive intermediate-term catalyst for the company’s stock price.
ii. Returning money to shareholders through share repurchases
HOG has also done a great job returning money to shareholders through share repurchases. The company’s board recently authorized the repurchase of up to 20 million shares, in addition to existing share repurchase authorizations of approximately 8.6 million shares -- equaling a 28.6 million share repurchase program.
These steps were announced in February. HOG’s Q2 2014 10-Q filing shows that the company spent $223.7 million in the first six months of 2014 on share repurchases. This leaves HOG with 26.6 million shares remaining as of June 29, 2014. The total value of this repurchase program, based on HOG’s closing price on October 10, 2014, is approximately $1,582 million. If one compares the total value of the share repurchase program to HOG’s current market cap of $12.3 billion, it reflects the authorized repurchase of approximately 12.8% of the company’s total shares outstanding. As HOG also pays a sizeable dividend, HOG’s commitment to returning value to shareholders becomes clear.
But can HOG afford its dividend and its share repurchase program? Yes. Here’s why: With an adjusted weighted average number of shares outstanding of 219.2 million on June 29, 2014, and a quarterly dividend payment of $0.275/share, HOG is spending approximately $60.3 million a quarter (approximately $241.1 million a year) on its dividend. With the total value of the share repurchase program currently at approximately $1,582 million, and approximately $241.1 million in annual dividend payments, HOG is expecting to pay out at least $1,823 million.
HOG does not appear to spend more than $250 million a quarter repurchasing shares, so the entire repurchase program (at its current level) could take 6-7 quarters to complete. If we assume that HOG takes 7 quarters to complete its repurchase program, then the total amount of money that HOG will be returning to shareholders will be approximately $2 billion over the next 7 quarters (with HOG paying out less in total as a dividend each quarter as the total amount of HOG’s shares outstanding decrease due to the repurchase program).
HOG had $999.3 million in cash and cash equivalents on June 29, 2014. Data from Morningstar.com indicates that HOG’s FCF (ttm) is $942 million, so the company should be able to generate over $1.6 billion in FCF in 7 quarters even if its FCF growth rate was at 0%. If HOG is able to maintain (or increase) its current FCF growth rate, which is very likely, the company can finance both its dividend and its share repurchase program without dipping into cash reserves.
HOG’s management team could not have announced the huge share repurchase program at a better time. Many investors believe that the market is long overdue for a correction and, if a correction occurs, HOG’s share repurchase program will provide a great hedge against future downside (management teams generally accelerate the rate of their stock buybacks as their companies’ stock prices decline). Given the fact that HOG is currently setting new 52-week lows, I believe that it is highly likely that the company’s management team will accelerate the rate at which it repurchases shares of the company. If HOG’s management team does indeed begin to accelerate the rate at which it repurchases shares, then investors will need to wait longer for the company to raise its dividend again. Regardless, it is likely HOG will increase its dividend significantly over the next two years.
3. Economic recovery and improving consumer confidence will lift HOG
a. HOG sales are strengthening
The financial crisis of 2008-09 hit the motorcycle industry hard, particularly in sales of heavyweight motorcycles. The Motorcycle Industry Council (MIC) estimated that in 2008 total unit sales of motorcycles were 879,910; in 2009, the MIC reported a 40.8% drop in year-over-year estimated sales. The industry bottomed in 2010, and is only now beginning to recover:
Source: Statista.com (motorcycle sales since 1990)
- Note: Data derived from Motorcycle Industry Council (MIC). Sales numbers include on-highway and off-highway motorcycles, scooter, and dual sport cycles.
As a luxury item, heavyweight motorcycles experience rising demand as consumer confidence and disposable personal income increase. Buyers have put off purchases due to economic uncertainty and rising unemployment. However, HOG’s sales are rising faster than the industry, as reflected in following chart of HOG’s total motorcycle sales from 2001-13:
Data Source: Harley-Davidson’s Annual Reports (10-K Filing)
b. Rising consumer confidence will drive continued improvement
Consumer confidence and higher levels of consumer spending are directly related to labor market conditions. Simply put, consumers will be more confident, and spend more, if they have a job. By many standards, labor markets in the U.S. have shown significant improvement over the past five years, and this has directly translated into higher levels of consumer confidence and consumer spending.
Simply put, consumers are more confident, and spend more, if they have a job. By many standards, labor markets in the U.S. have shown significant improvement over the past five years, directly translating into higher levels of consumer confidence and consumer spending. This, and the correlation between these two economic indicators and motorcycle sales, can be seen in the two charts below:
- Note: Data derived from U.S. Bureau of Labor Statistics (2000-14). Unemployment Rate figures are reported monthly; Unemployment Rate was 6.2% in July 2014.
Source: Tradingeconomics.com (Consumer Spending)
- Note: Data from U.S. Bureau of Economic Analysis (2000-14), in billions of U.S. Dollars, and is reported quarterly.
The data above demonstrate the obvious: a strong labor market is positively correlated with higher levels of consumer confidence and consumer spending.
Not all economic indicators present quite as positive a view. For example, the Labor Force Participation Rate has dropped significantly over the last decade, and the decline accelerated significantly in the wake of the financial crisis. This metric suggests that U.S. labor markets still have quite a long way to go. Likewise, while some believe that slow wage growth is keeping inflation low, it also hurts consumer confidence and undermines higher levels of consumer spending. While the recovery has improved the incomes of the top 1%, that demographic does not typically purchase motorcycles. Because members of the middle class are not seeing their disposable personal income increase significantly due to slow wage growth, they are not buying new motorcycles.
When will wages finally increase? U.S. labor market conditions are increasingly tight, due to reduced supply, as demonstrated by the “Quit Rate” – the rate at which employees voluntarily leave their jobs. In normal labor market conditions, rising wages drive a larger number of “quits,” in turn increasing supply. Flat wage growth, in contrast, reduces employees’ incentives to leave their jobs for better positions, tightening the supply of labor when economic conditions are otherwise improving.
To get a better view, one can look at the private (non-governmental) quit rate, given the segmentation in the market between the largely stable and unionized public sector and more dynamic private sector hiring. Because real wage growth has not followed the improvement in the economy, it is no surprise that the private quit rate remains suppressed. This can be seen in the chart below:
Source: Bespoke Investment Group
The suppressed quit rate from 2007 to 2013 reflects bad news for middle class Americans, because it reflects the fact that businesses have not been willing to pay more to attract new employees. The recent uptick in the private quit rate reflects that it is only a matter of time before wages increase. In addition to overall economic improvement, there is pressure to increase wages at the bottom of the wage spectrum, which would have a ripple effect. Although the federal minimum wage remains stuck at $7.25/hour with no foreseeable change, state minimum wage rates are increasing – and when a state’s rate exceeds the federal rate, workers must be paid the higher amount. Five states are increasing (or have already increased) their minimum wage rates in 2014, and efforts exist in an additional 14 states to do likewise. As wage growth eventually increases to attract labor off the sidelines or out of current positions, demand for big ticket luxury items (e.g., motorcycles) will also increase.
c. HOG’s Long-term Growth Prospects
i. Market share and demographics
Will HOG continue to dominate its market? HOG looks to build growth among young adults, women, Hispanics, and African-Americans beyond its traditional core customer base. The population trends can be seen here:
Source: Harley-Davidson Website (Investor Relations)
As noted above, HOG’s current market share figures dispel the notion that HOG is only popular with an aging generation of motorcyclists. HOG’s sales in the “Young Adult Men and Women, 18-34” category grew at more than twice the rate of sales to "core" customers -- Caucasian men over age 35.
HOG has focused its advertising and customer acquisition efforts in recent years on this risk, by trying to make its motorcycles appear to a wider range of people. More specifically, the company has created focus groups, opened “learn to ride” clinics, allowed more test-runs for new products, and even held “garage party evenings” aimed at teaching women the basics of motorcycling. In addition, beginning in 2011, HOG focused its research and development on products targeting the young demographic. In June 2014 the company introduced the “Harley-Davidson Street” 500cc and 750cc models, the company’s most affordable bikes in years, and its first lightweight motorcycle in decades. The models formed a part of HOG’s lower cost “Dark Custom” collection, first introduced in 2008, which have proven extremely popular with young adults and new motorcyclists.
HOG also plans to reach this group through “Project LiveWire,” an all-electric motorcycle that accelerates from zero to 60 mph in less than four seconds. HOG is currently taking a prototype in a demonstration tour across the country. This motorcycle reflects a significant departure from the company’s standard models, and the most obvious difference by far is the motorcycle’s sound. The rumble of Harley-Davidson’s V-twin engine, which Harley fans believe sounds like “potato, potato, potato,” is replaced by a sound likened to a “fighter jet on an aircraft carrier.”) While traditional customers would not be interested, the prototype offers a sound and look far different from the typical heavyweight cruiser – and far more enticing to new (and young) riders.
The “Live Wire” motorcycle still faces challenges, most importantly in the battery charge – currently limited to a 53 mile range – and an absence of docking stations. HOG is not the only company introducing electric models, and some of HOG’s competitors already have numerous models available. However, HOG’s entry demonstrates the company’s commitment to seeking growth in the young adult market.
Going forward, I expect the “Harley-Davidson Street” and “Dark Custom” lineups to continue to boost HOG’s market share in the young adult category. Additionally, with many analysts expecting that sales of electric motorcycles will skyrocket over the next decade, Harley-Davidson’s Project LiveWire comes at a perfect time for the company because it further demonstrates the company’s ability to innovate.
ii. HOG’s expansion into foreign markets
HOG has also focused on international growth, particularly in the last five years. HOG has added 125 new international dealers since 2009, significantly boosting the company’s sales. HOG sought this expansion to increasing Harley-Davidson’s presence abroad, and capturing market share in foreign motorcycle markets, and the effort succeeded. As of FY 2013, HOG had the #2 market share position in Europe in the 601cc+ motorcycle market, and it is the market leader in Brazil, Japan, and Australia. Furthermore, its year-to-date retail sales in the Asia Pacific Region have grown by an impressive 10.1%, which was primarily driven by strong demand in emerging markets and India in particular (the new “Harley-Davidson Street” motorcycles were made available in India earlier this year and they have been extremely popular).
HOG company now sells motorcycles in 89 countries and, year-to-date the company’s international retail sales have grown by 4.2%. Foreign markets provide significant room for growth, and HOG is definitely looking to capitalize on this growth opportunity going forward. The chart below shows that HOG has significantly grown the international portion of its total motorcycle shipments over the last 28 years:
Data Source: Harley-Davidson Website (Investor Relations)
Going forward, I expect that HOG’s international retail sales growth will accelerate as sales of the company’s new products, such as the “Street” motorcycles, begin to pick up.
d. HOG compares well to its competitors
HOG specializes in motorcycles, while motorcycle sales account for a relatively small portion of its direct competitors’ total revenues. For example, Bayerische Motoren Werke AG ADR (OTCPK: BAMXY), more commonly known as simply BMW, saw only 2.18% of its total revenues in Q2 2014 come from motorcycle sales, which compares to 2.15% for Q1 2014, 1.63% for FY 2013, 1.63% for FY 2012, and 1.75% for FY 2011. Some of HOG’s other publicly traded competitors include Honda (NYSE: HMC), Polaris Industries Inc. (NYSE: PII), Kawasaki Heavy Industries Ltd. (OTC: KWHIY), Suzuki Motor Co. (OTCPK: SZKMF), and Yamaha Motor Co., Ltd. (OTC: YAMHF). Many of these companies do not trade on a formal U.S. stock exchange; however, they are available for trade Over-The-Counter (OTC) and many of them are listed on the Frankfurt Stock Exchange. Only two of HOG’s main competitors, Honda and Polaris Industries, are traded on a formal U.S. stock exchange. HOG also has a few privately held competitors, such as Ducati Motor Holding SpA and Triumph Motorcycles Ltd.
Of all these competitors, analysts most frequently compare HOG to Polaris Industries, even though motorcycles accounted for only 6% of Polaris’ total sales for FY 2013. The main segments of PII’s business, as described in its 2013 10-K, are: off-road vehicles (67% of FY 2013 sales), snowmobiles (8%), motorcycles (6%), small vehicles (3%), and parts, garments and accessories (16%). Polaris sells two brands of heavyweight motorcycles: Victory and Indian. Polaris entered the heavyweight motorcycle market in 1998, with a Victory motorcycle that belonged to the “cruiser” segment (Victory Motorcycles is the motorcycle manufacturer and Polaris is the parent company, Victory Motorcycles was founded in 1997), and the company later purchased the Indian Motorcycle brand in 2011. The Indian Motorcycle brand is the oldest motorcycle brand in the United States (founded in 1901), and it is the only brand that has been around longer than Harley-Davidson (founded in 1903). Polaris revived the Indian Motorcycle brand, which used to be owned by an independent company initially known as the “Indian Motorcycle Co.,” after its founding company eventually stopped production when it went bankrupt in 1953.
i. Overall comparisons with competitors
Comparing Harley-Davidson to any of its competitors, even Polaris Industries, is difficult because no other company of HOG’s size focuses only on motorcycle manufacturing. Although analysts often compare HOG to PII, the comparison is inadequate because motorcycles accounted for only 6% of PII’s total revenue in 2013, and PII’s two brands (Victory and Indian) only capture 3-5% of the broad U.S. motorcycle market. To provide additional context, therefore, I compared HOG’s financial metrics against three different companies; PII, Bayerische Motoren Werke (BMW), and the German luxury car manufacturer, Daimler AG (manufacturer of Mercedes-Benz cars):
Data Source: Morningstar.com
- Notes: All figures indicated with “ – ” show a percentage change figure using negative numbers as basis points (“ – ” was also used to denote that both BMW and DAI have negative FCF yield figures). All percentage figures were rounded to the nearest tenth, except for the FCF Yield (ttm) and Dividend Yield figures.
As seen above, HOG significantly outperforms all three companies in every metric except revenue growth (3 year average), Debt/Equity ratio, and dividend yield. While HOG’s three-year average revenue growth trails those of PII and BMW, HOG achieved significant growth in its bottom line (net income) while seeing much smaller growth in its top line, which signifies an improving margin structure. While HOG’s current Debt/Equity ratio is slightly higher than those of the three other companies in the table above, it HOG has significantly de-leveraged over the past three years, and the company’s Debt/Equity ratio went from 2.05 for full-year 2010 to 1.14 for full-year 2013.
ii. Comparisons on key financial metrics
Three of HOG’s financial metrics deserve further discussion: (1) operating margin; (2) EPS growth (3 year average); and (3) FCF yield.
HOG’s operating margin of 21.3% is extremely high, far better than the operating margins obtained by every other motorcycle manufacturer. For example, HOG’s operating margin is higher than the operating margins (ttm) obtained by all of HOG’s competitors in the motorcycle manufacturing industry (listed at the beginning of this subsection); Honda (6.4%), Kawasaki Heavy Industries Ltd. (4.7%), Suzuki Motor Co. (6.5%), and Yamaha Motor Co., Ltd. (6.3%). In addition, HOG’s operating margin (ttm) is much higher than the respective operating margins for every single major car manufacturer; General Motors (0.9%); Toyota (9.0%); Ford (3.3%); Volkswagen (6.1%); Nissan (4.8%); and Audi (9.9%).
Notably, HOG’s Financial Services segment has a higher operating margin than its Motorcycles segment (e.g., 16.6% for Motorcycles vs. 19.6% for the company as a whole in 2013). This 16.6% “core” margin still outperforms competitors, and HOG expects it to increase to 17.5-18.5% in 2014 (reaffirmed in 10-Q filing for Q2 2014). This improvement derives directly from the expected $320 million in annual benefits from the recently completed restructuring program.
HOG’s EPS growth also has been absolutely outstanding over the last three years. As seen in the chart above, the company has managed to grow its EPS by an average of 74.25% a year for the last three years, with much of that increase coming right after motorcycle sales bottomed in 2010 (i.e. HOG experienced unbelievable year-over-year EPS growth in full-year 2011). As one would expect, HOG’s EPS growth has slowed somewhat and the company managed to grow its EPS by a much smaller, yet still substantial, amount (20.59%) in full-year 2013. HOG’s EPS growth rate has accelerated in the first half of 2014, with the company recording a diluted EPS growth rate of 28.18% (y/y) in H1 2014 and a diluted EPS growth rate of 33.88% (y/y) in Q2 2014. In addition to the company’s improving operating margins, there are two main reasons for HOG’s accelerating EPS growth rate: 1) as previously mentioned, the company is now receiving the full $320 million in annual savings from its restructuring program (a $10 million increase over last year’s savings) and 2) the company has been buying back shares as part of its substantially increased share repurchase program. Simply put, the company has done a phenomenal job growing its bottom line over the past three years, while its top line has grown at a much slower pace – suggesting the turbo effect of even a slightly faster paced improvement to sales.
HOG’s FCF yield also is outstanding. Free Cash Flow (FCF) yield, calculated using the free cash flow per share divided by the share price, reflects the money a company generates from operations after accounting for capital expenditures. FCF provides the cash often used to pay dividends, repurchase shares, and reinvest into the company’s operations. Additionally, FCF is used in the “free cash flow to equity” approach to performing a discounted cash flow (DCF) analysis, a method often used to calculate a firm’s “fair value” (or “intrinsic value”). HOG did a great job growing its FCF in 2013, increasing it 25.65% year-over-year (seen in table above). If the company is able to maintain its current twelve-trailing-month FCF figure ($942 million) for the rest of this year, it will record its highest full-year FCF number in the at least the last 10 years.
Appendix 1 provides a table comparing HOG to the same three companies as above using additional key metrics. HOG underperforms PII in Return On Assets (ROA), Return On Equity (ROE), and Return On Invested Capital (ROIC). I attribute PII’s strength in these three metrics to the fact Polaris’ diversification into less expensive vehicles (such as ATVs) enables it to generate a higher return on assets, equity, and invested capital. Sales of PII’s lower cost vehicles (~$2,000) recovered far faster than sales for HOG’s heavyweight motorcycles (at ~$20,000).
The inclusion of BMW and Daimler in the comparison allows investors to see how HOG compares to fellow luxury goods manufacturers – and HOG’s financial metrics dominate those of BMW and Daimler. Notably, BMW, and Daimler also offer financial services.
HOG’s Financial Services segment certainly affects some of the company’s financial metrics. As of December 31, 2013, HOG had $9,405 million in total consolidated assets, of which $2,793 million (29.70%) were held in the Motorcycles segment while the rest ($6,612 million or 70.30%) were held in the Financial Services segment. This compares to HOG’s figures at the end of 2012, when HOG had $9,171 million in total consolidated assets, with 30% in the Motorcycles segment and 70% in the Financial Services segment.
For full-year 2013, HOG generated $734 million in net income after eliminations, which predominantly came from the Motorcycles segment of its business (the Motorcycles segment of HOG’s business generated 76.30% of the company’s total net income, after eliminations, in 2013). Return On Assets (ROA) is calculated by taking a company’s total net income (after eliminations) and dividing it by the company’s average total assets (total assets at end of year plus total assets at end of previous year, with the result being divided by two). In 2013, HOG as a whole generated ROA of 7.90%, which is calculated by dividing $734 million (HOG’s net income after eliminations) by $9,288 million (HOG’s average total assets). However, a closer look demonstrates that the Motorcycles segment of HOG’s business generated a ROA of 20.20%, while the Financial Services segment generated a ROA of only 2.67%. (Note: The data used in the calculations above come from either page 98 or 99 of HOG’s 2013 10-K.)
A ROA figure of 20.20% for the Motorcycles segment of HOG’s business is very strong, and a ROA of 2.67% for the Financial Services segment favorably compares to the ROA generated by many major financial services companies. For example, three of the largest companies in the Credit & Debt (or “Credit Services”) industry by market cap; JPMorgan Chase, Bank of America, and Citigroup, all had ROA figures of less than 1% for full-year 2013 (0.70%, 0.47%, and 0.72% respectively).
In addition, the ROA of 20.20% for the Motorcycles segment of HOG’s business is relatively close to PII’s ROA of 23.79% for full-year 2013. PII does not have a segment of its business dedicated to financial services; however, the company recorded $45.9 million in income from financial services for full-year 2013, which was primarily due to “Income from Capital One, Sheffield and GE Bank retail credit” ($22.5 million) and “Income from Securitization Facility” ($15.2 million) (page 30 of PII’s 10-K filing for 2013).
Ultimately, HOG’s excellence in critical financial metrics (margins, EPS, FCF growth, and FCF yield) indicate that going forward HOG is well positioned to financially outperform Polaris and the other two luxury goods manufacturers compared to HOG in the table above.
4. HOG is trading at a discount to historic multiples
HOG is currently trading at a very attractive valuation, when one compares the stock’s current valuation multiples to its historical average valuation multiples. Appendix Images #2-7, in the “Appendix” section of this article, present a wide array of HOG’s valuation multiples and compare HOG’s current valuation multiples against both HOG’s historical multiples and PII’s current and historical valuation multiples. Those six images show that HOG is currently “undervalued,” from a historical multiple perspective, in terms of its current Ev/EBITDA (ttm), P/E (ttm), P/FCF (ttm), P/S (ttm) and P/B multiples.
The chart below summarizes the results from all six of the charts in the appendix and gives a consolidated view of how HOG’s current valuation multiples compare to its average historical multiples, PII’s current valuation multiples, PII’s average historical multiples, and the average historical multiples PII and HOG combined:
Data Source: Gurufocus.com
- Notes: “Current” means that the valuation multiples were calculated using both stocks’ most recent closing prices (closing prices as of 10/10/14). The “average historical multiples” are calculated by taking each stock’s average valuation multiple for the last 15 quarters.
If HOG was to rise until it reached its historical average multiples then it would need to rise 33.12%, 37.50%, 27.55%, 4.02%, and 14.75% respectively. Even though HOG’s current P/S (ttm) multiple (1.99x) is only slightly below its historical average multiple (2.07x), I believe that HOG cannot be accurately valued on a Price-to-Sales ratio basis. I believe this is the case because investors are likely to accept that HOG is trading at a relatively high P/S multiple now (relative to its historical average) because the company’s margin structure is much higher now than it was in the past (meaning it is earning more from every dollar it earns now than it would have done in the past). This also applies to the fact that HOG’s P/B multiple is relatively close to its historical multiple, because investors are taking into account that the company’s return on capital employed (ROCE) is sustainably higher now than it was in the past.
If one looks solely at HOG’s Ev/EBITDA, P/E, and P/FCF multiples (i.e. excluding HOG’s P/B and P/S multiples due to changes in operational performance metrics) then it would appear as though HOG is approximately 32.72% “undervalued.” I reached this conclusion by doing a “mean-reversion,” which simply means that I took the average change in price needed for all three multiples to reach their historical average. These calculations support a “fair value estimate” of approximately $75. However, when I was calculating my target price I decided to use a “discount rate” of 9.5%, which ended up giving me my target price of $68 (I was fairly conservative when doing the calculations to come up with my price target). I believe that the calculations above show that long-term oriented investors are buying HOG with a significant “margin of safety.”
In addition, the charts show that HOG is trading at much lower valuation multiples than PII is right now. Every single one PII’s valuation multiples is higher than both HOG’s respective multiple and PII’s average historical multiple for the last 15 quarters. I believe that HOG presents a much more attractive buying opportunity than PII at their current prices. (When deriving a fair value estimate, I focused solely on HOG’s historic valuation multiples and I only included PII’s multiples to add additional context.)
a. Timing entry: 2014 performance
In addition to the comments earlier in this article on consumer confidence and the analysis above on HOG’s current valuation, timing an entry depends on two major factors: HOG’s outlook for the rest of 2014, and technical analysis charts. I discuss these both in turn below.
i. HOG’s performance to date in 2014
For the first half of 2014 (H1 2014), HOG derived $3,726.7 million in revenue, a 10.73% increase over the same six-month period last year. Additionally, HOG’s diluted EPS for H1 2014 rose 28.18% (y/y). HOG’s most recent earnings report (Q2 2014) was very positive, and the company’s EPS of $1.62 significantly beat analysts’ estimates by $0.16, while its revenue of $1.84B (+12.9% Y/Y) for the quarter was in-line with estimates.
HOG’s Q2 2014 earnings report was not all positive. HOG lowered its previous guidance of shipping 279,000-284,000 motorcycles in 2014 to shipping 270,000-275,000 motorcycles, up 3.5-5.5% year-over-year. Additionally, HOG stated that while its motorcycle shipments in the U.S. rose 8.9% through June, retail sales increased by only 1.1%. This highlights the difference between retail sales and unit shipments, because retail sales represent the number of motorcycles sold by dealers, while unit shipments are the number of motorcycles shipped by HOG to its dealers. HOG attributed the cut in shipments to an unusually cold winter and continued constraints on consumer spending, which seems reasonable given that economists blamed the first quarter’s 2.1% contraction in U.S. GDP on similar factors.
HOG’s Q2 2014 also would have been better if not for delays in shipments of Street motorcycles, which were supposed to arrive in May but did not appear in dealer showrooms until June. These shipment issues limited product availability and affected unit sales numbers for H1 2014, which contributed to the lower unit sales projections for FY 2014. Moreover, as consumers decided to wait for the Street motorcycles, volumes for Harley’s Sportster line-up also remained weak. In addition to expectations for the Street motorcycle lineup, there was also mounting expectation that Harley-Davidson would announce the return of the popular “Road Glide®” motorcycle. That expectation was accurate and, on August 1 HOG announced its return. Road Glide provided about 10% of HOG’s U.S. retail sales in Q2 2013, which affected HOG’s Q2 2014 year-over-year unit sales performance.
ii. HOG’s outlook for the rest of 2014
All these factors look to resolve in the remainder of 2014, especially the bottleneck in supply of Street motorcycles. In addition, due to the return of the Road Glide and all the new models being introduced to customers in Harley-Davidson’s largest new model launch in its entire history, HOG should see its U.S. retail sales rise substantially in the remainder of the year.
Summary: HOG is set to end 2014 strongly, and there is even a pretty good chance that the company will exceed its recently revised full-year shipment projections. In particular, the removal of bottlenecks in the supply of Street motorcycles should increase sales significantly, and unit sales for the Sportster line-up likewise should strengthen. Additionally, I expect HOG’s 2015 model lineup to be a smashing success, primarily lead by the return of the Road Glide motorcycle. HOG began shipping motorcycles from its 2015 model lineup to its dealers on August 26, 2014, so the company will recognize revenue from these shipments through the rest of the year.
b. Timing entry: technical analysis
Technical analysis indicates support for beginning entry in HOG, scaling into a long-term position:
Data Source: Stockcharts.com
- Note: All data is as of September 29, 2014
HOG’s recent selloff has finally brought its price down to a point where it will soon begin encountering numerous long-term support zones. This offers a great buying opportunity for long-term oriented investors, because the combined inputs of having price be technically “oversold” (as evidenced by the values of the RSI and MFI) and near strong long-term support give investors a higher probability of a positive outcome. HOG’s recent correction, which has taken the stock from its 52-week high ($74.13) all the way down to a new 52-week low ($56.46), has been primarily due to short-term negative fundamental factors and that I believe will change course over the next six months (as I stated in the section above). Some of these negative factors, like HOG’s recent motorcycle recall, are relatively rare occurrences and are very short-lived.
HOG is significantly “oversold” on both its daily and weekly charts, and this coupled with the fact that HOG is currently near four long-term support levels provides a nice buy opportunity for both short-term traders and long-term investors. It is also a very positive sign, for both short and long-term investors, that the Money Flow Index (MFI) indicator is showing a positive divergence, because this means that investors have been begun to buy more shares of HOG as its price has declined.
Potential Entry Strategy For Long-Term oriented investors: Given the fact that HOG is in a short-term downtrend channel (drawn in red in the chart above), long-term oriented investors who are looking to initiate a position in HOG may be served best by starting off with a small position (only a portion of what each individual investor considers to be a “full-sized” position) and then adding more if HOG’s share price continues to weaken. This strategy helps investors decrease the “average purchase price” of their position, and it can only be used by an investor who will not become worried if his or her position begins to go “under water.”
c. Is now a good time to buy?
I believe that now is a good time for long-term oriented investors to begin a position in HOG. I base this conclusion on two factors: HOG’s ability to continually surpass analysts’ estimates and the seasonality of HOG’s price action.
i. HOG has an excellent history of surpassing analysts’ estimates
Over the last 15 quarters, HOG beat analysts’ EPS estimates by an average of 6.09%, and beat revenue estimates by an average of 5.65%. Over the past 15 quarters, HOG’s price increased by an average of 1.41% one day after each earnings report, which outperformed the S&P 500 by an average of 0.91%. If one uses past performance as a guide for the future, this data shows that HOG has a positive short-term catalyst in the near future (HOG’s Q3 2014 earnings report is released on October 21, 2014):
Data Source:Seeking Alpha (“Breaking News”)
- Note: The “Average Revenue Performance” figure was calculated using data for every quarter listed except Q2 2011, which is labeled “N/A.”
ii. HOG’s price action trends seasonally, and increases at the end of the year
HOG’s price action, relative to the S&P 500, trends up toward the end of the calendar year. The chart below is a monthly price “seasonality” chart, which compares HOG’s performance to that of the S&P 500 over the past 20 years:
- Note: As defined by Stockcharts, “the seasonality tool calculates two numbers: the percentage of time the month is positive and the average gain/loss for the month… the number at the top shows the percentage of time the security closed higher for that month... the number at the bottom shows the average gain/loss for [the selected time period].” The data in this chart is updated daily, and because the chart works in monthly time intervals the data for October 2014 is not complete (because it is only October 12th). Therefore, the 4.1% price outperformance figure and the 70% monthly price outperformance figure are projected for October.
Appendix 8 provides a similar chart, using calculations based on HOG’s total return performance.
The data above shows that HOG has historically outperformed the S&P 500 during Q1 and Q4 (roughly circled in green) while historically underperforming the S&P 500 during Q2 and Q3 (roughly circled in red). Put another way, over the past 20 years HOG’s price has outperformed the S&P 500 over the last three months of the year and the first four months of the year by an average of 1.83% per month (calculated by taking the average of the seven percentage figures circled in green), and it has underperformed the S&P 500 between May and September by an average of 0.06% per month (calculated by taking the average of the five percentage figures circled in red). These figures were calculated using the given percentage outperformance figure for October, even though the month is not yet complete.
d. HOG’s current risks
I now turn to the risks associated with an investment in HOG; I do not discuss risks faced by all companies in the Consumer Cyclical sector (e.g., the possibility of a significant economic downturn). I also do not address risks typically mentioned in 10-Q and 10-K filings, as such risks are readily available to all investors.
i. Risk #1: HOG’s revenue recognition principle and its implications
Generally Accepted Accounting Principles (“GAAP”) require that companies use Accrual Accounting (or “Accrual Basis Accounting”), and this accounting basis allows companies like HOG to legally recognize revenue when they ship a unit to a dealer instead of when that unit is actually sold to a customer. Some investors consider this a risk because companies that book accruals can encounter problems when accruals are booked near the end of a quarter or year, because it may appear as though the company is intentionally “inflating” its revenue by shipping a lot of units right at the end of the period. Companies known for booking a lot of revenue at the end of a quarter or year, often called “aggressive accrual accounting,” often attract shareholder derivative litigation.
Counterpoint: HOG has worked to balance shipping volume with demand. The table below illustrates the fact that, over the last seven years, the company has actually shipped a smaller number of Harley-Davidson motorcycles than the total amount of Harley-Davidson sold at retail:
Data Source: Harley-Davidson’s Annual Reports (10-K Filing)
This table helps counter a suggestion that HOG inflates revenue by shipping more motorcycles to dealers than it actually expects to sell. It also helps to show that demand for Harley-Davidson motorcycles has been very strong over the past seven years, and the independent Harley-Davidson dealerships are doing a very good stimulating demand for Harley-Davidson’s products. HOG’s “Quality of Income” ratio also helps to provide supporting evidence for my conclusion that HOG’s revenue recognition principle is not something to be overly concerned about. The Quality of Income ratio is calculated by taking a company’s total cash flow from operating activities (CFO) and dividing it by the company’s total net income. “A quality of income ratio higher than 1 usually indicates high quality earnings, while the ratio lower than 1 is considered to indicate low quality earnings.” Companies with a large amount of accruals can sometimes have a quality of income ratio less than 1, because they will recognize revenue due to the accrual accounting basis (higher revenue = higher net income and a higher denominator in the quality of income ratio) but not actually receive cash yet for the good or service they provided (not receiving cash yet = lower cash flow from operating activities and a lower numerator in the quality of income ratio). HOG’s quality of income ratio (ttm) is 1.35, which is good for a company that has a high amount of “accruals,” and this is significantly better than the company’s quality of income ratio for full-year 2006 (0.73). Furthermore, HOG’s quality of income ratio has been over 1.00 for the last five years, which aligns itself very well with the shipment and retail data presented above.
ii. Risk #2: Failure to differentiate products and to innovate
HOG’s future success depends on the company’s ability to develop innovative products. HOG needs to continue to produce high-end motorcycles that are very appealing to customers or HOG could begin to see consumers buy another company’s motorcycles instead. Continual innovation is particularly important for HOG, because the company has been able to charge a premium for its products for a very long time due to the company’s long-lasting brand and market dominance.
Counterpoint: HOG has a consistent track record of innovation, and the company has continually done a great job enticing new customers to buy its products. As previously mentioned, HOG’s 2014 model lineup (“Project Rushmore”) was its “…largest scale new model launch in company’s 110-year history,” and the company’s 2015 model lineup, which included the Street 500, the Street 750, also offers a huge selection of new motorcycles. In a news report dated August 26, 2014, PR Newswire made the following statement in regards to HOG’s 2015 model lineup: “Combining world-class aerodynamics, exhilarating audio performance and dialed-in ergonomic fit, Harley-Davidson expands its diverse offering of motorcycles and gives riders more ways than ever before to lead their own pack to the open road.” In addition to its new motorcycles, HOG is also introducing “eight new paint colors” and “hundreds of new Genuine Motor Parts & Accessories.” HOG has always done a great job creating innovating new products, and there is no reason to believe that will change any time soon. The final point that I would like to make is that the competition Polaris Industries provides with its Indian and Victory motorcycles will probably end up being a good thing for HOG, and prospective Harley-Davidson motorcycle owners, because “competition breads innovation.” Harley-Davidson didn’t get to the top of the motorcycle industry by accident, and the company will fend off all competitors in order to stay there.
iii. Risk #3: Effect of a recall on HOG’s stock price
This risk is simple: if HOG issues a recall it will negatively impact the company’s stock price. Case in point: HOG issued two separate voluntary recalls on September 27, 2014. One of these recalls was for its “model year 2014 Touring, CVO Touring, CVO Softail, and Trike motorcycles because of a potential problem in the hydraulic clutch system” (this was reported to total “126,978 motorcycles” although it was originally reported as being only 105,000), and the other was for “1,384 Street bikes that have the possibility of a leak in the fuel tank.” HOG dealers are correcting both problems at no cost to owners, and no serious injuries have been reported as a result of the recalls (although 19 low-speed tip overs and three minor injuries resulted from the problem with the hydraulic clutch system). HOG’s stock price closed 1.98% lower the first trading day after the news about its recall broke, which underperformed the S&P 500 by 1.73%.
Counterpoint: Like major car manufacturers, motorcycle manufacturers sometimes produce new motorcycles that encounter slight defects. HOG, like every other major motorcycle manufacturer, is prone to doing this, and the company’s stock price will usually suffer marginally as a result. While this is indeed a fact, it is not necessarily something for investors to be significantly worried about, because it is not something that any investor can plan for or anticipate. HOG’s most recent recall has helped the stock trade at an even better valuation than it would have traded at otherwise, and it is very unlikely that the company will see a long-lasting negative impact on either its brand image or its stock price as a result of this recall. I believe this is the case simply because issuing voluntary recalls (almost all the recalls that HOG has issued in past have been voluntary) have not significantly hurt HOG in the past. The chart below shows Harley-Davidson’s stock price performance over time after eight (nine if you count the most recent one as two) different recalls that were issued by the company over the past five years:
- Notes: The recall data above derived from numerous websites, while the price performance data was taken from Yahoo Finance (interactive charts). Price performance was calculated by comparing HOG’s closing price, on the trading day before the first mention of the recall found online, to its closing price the following trading day. Some of the price performance data may be inaccurate due to debatable timing of when news about the recall reached market participants (for example, I found a report about a recall on a Harley-Davidson motorcycle blog that was dated approximately 24 hours before a report about it was published by a major financial news website). Likewise, some of the total number of units recalled data might be inaccurate because a larger number of recalled units could have been reported after the initial reporting date. The two recalls announced on September 27, 2014, were combined into one cell for simplicity. All of the averages do not take into account the most recent recall’s data, so that comparisons can be made.
Although it is clear from the chart above that a recall negatively effects HOG’s price in the short term, it is also clear that the effect on HOG’s price is not extremely severe in most cases. HOG actually sold off significantly harder (even if one accounts its current beta of 1.05) after its most recent recall than it did after the previous recalls listed in the table above (if you look at the average price performance numbers). HOG’s hard sell off after its most recent recall was probably due to the fact that investors are worried about how the recall may affect the company’s recently lowered shipment projections for full-year 2014. As I mentioned earlier in this article, I believe that there is a high probability that HOG will exceed analysts’ expectations for the rest of the year, and I do not believe that HOG’s recent recall significantly affect that analysis. HOG’s consumer base is very loyal, and the company has built itself a great reputation for customer service, so the company’s recent recall is unlikely to affect consumers’ opinions. Furthermore, even though Harley-Davidson has issued a fair amount of recalls in the last five years (the nine recalls listed in the table above are all of the company’s recalls that I found reports of over the last five years), the number is still less than the number of recalls that other motorcycle manufacturers have done (for example, BMW has done at least 10 motorcycle-related recalls in the last five years).
iv. Risk #4: HOG’s aging core customer base and demand from millennials
This is probably the biggest risk to Harley-Davidson in the long term, although it likewise is a risk that need not be solved immediately. Investors have been worried that HOG’s “core customer base” (Caucasian men age 35+) is getting too old to ride, or their desire to upgrade to a new bike will fade, or both. Part of the problem is that the average Harley-Davidson motorcycle is still very expensive, making younger consumers (ages 18-34) either avoid a purchase or seek to buy or lease a used Harley-Davidson motorcycle from a non- affiliated dealer. A large part of the long-term “bear” thesis for HOG centers on this risk.
As discussed earlier in this article, (see subsection titled “market share and demographics”) HOG has actively sought to broaden its consumer base. That discussion addresses the company’s attempts to win over a younger generation of riders, so I address here only the aging of HOG purchasers. HOG stopped reporting the average age of its customers after 2009, at a time when the average age of a Harley-Davidson customer was 48. In 2012 Harley Marketing Director Mark-Hans Richer stated in an interview with Reuters that for the first time the average buyer was 47. Although this appeared to indicate a positive trend, UBS analyst Robin Farley, who has covered HOG for more than a decade, published a note with calculations that supported her belief that the average age of a Harley-Davidson customer was actually 50 – and subsequently reported a call from a senior manager who claimed that the real number was 49 years and 6 months, a statement HOG then officially refuted. This took place in mid-2013, and it is probably safe to assume that the average age of a Harley-Davidson customer remains between 49 and 50. Analysts continue to disagree whether Harley-Davidson will be able to overcome this risk.
Counterpoint: I do not believe that this will be a significant risk for HOG over the next 1-2 years, my proposed investment timeline. The company’s recent additions to its “Dark Custom” lineup, especially the Street 500 and the Street 750, demonstrate the company’s significant commitment to addressing the problem. The Street 500 and the Street 750 (the Street 500 in particular) have great potential to reach a younger generation of consumers all over the globe, for two reasons: 1) they are sold at significantly lower prices than any of HOG’s other motorcycles; and 2) they are sportster motorcycles that are great for using in urban environments. I think that the Street 500 is really the more exceptional of the two Street motorcycles, and I believe that the Street 500 will end up being a major winner for the company going forward. Even though the motorcycle’s name implies that it has a 500cc engine, the Street 500 actually has a 494cc engine and this enables the bike to meet the required two out of three criteria of the Motorcycle Safety Foundation” (with the other criteria that the bike fulfills being its low seat height). This will help the company see demand from riding academies. The two Street motorcycles have the ability to penetrate foreign markets in a way that Harley-Davidson was never able to do before, because they will be lower priced and maneuverable enough to be ridden easily in busy cities. In summary, I believe that HOG is working hard to counteract the fact that it has an aging “core customer” base, and I believe that the all of the company’s new models demonstrate that its future new product lines will be targeting a much young consumer (the “next generation of consumers”).
v. A Debatable Risk: HOG’s high institutional ownership and low insider ownership
An incredibly large portion (figures range from 83% to 90% depending on the website) of HOG’s outstanding shares are currently owned by institutions & mutual funds, while a very small portion (figures range from 0.08% to 1% depending on the website) of HOG’s outstanding shares are currently owned by insiders. HOG’s institutional & mutual fund ownership is very high compared to that of most other companies. High institutional & mutual fund ownership may make some investors uneasy for two main reasons: 1) Individual institutions often own huge amounts of shares and when they decide to sell some (or all) of their shares they can sometimes cause a “sell off” due to the sheer number of shares sold, and 2) A low insider ownership can mean that a company’s management team does not have its “goals” aligned with those of shareholders.
Counterpoint: High “Institutional Ownership” is only bad when institutions & mutual funds decide to sell huge amounts of shares all at once, which they have not been doing recently in HOG. High institutional & mutual fund ownership is considered a good thing by many investors, because institutions and mutual funds are often considered “smart money” due to the fact that they often have huge numbers of analysts on their pay roll to research companies that the firm could invest in. Additionally, once institutions & mutual funds initially invest in a company they will usually not sell their stake for quite a long time, and they are much less likely to get scared by a stock’s decline than retail investors are. The picture below shows HOG’s 10 largest owners (all of which are obviously either institutions or mutual funds), and the change in their positions during the most recent quarter, as well as short summary of the “latest institutional activity”:
The data in the picture above shows that, in the last quarter, HOG’s “Top 10 Owners” have collectively added more shares than they’ve sold. The picture also shows that some institutional investors have been buying HOG as its price declined over the last few months. Third quarter institutional and mutual fund ownership data will be released soon, and will be important to watch going forward.
Small insider ownership is generally considered more concerning, but it does not appear to be a real problem for HOG. In the subsection above entitled “returning money to shareholders,” I discussed that HOG recently increased its dividend by 30.95% and instituted a large share repurchase program, and neither would have happened if the company’s management team was not seeking to please shareholders. Indeed, HOG’s management team must be aware that a huge portion of the company’s outstanding shares are held by institutions and mutual funds, which often look to hold shares of companies that consistently return money through dividends and share repurchase programs. This focus on dividends and share repurchases offsets the relatively lower insider ownership.
HOG dominates the motorcycle industry, and its approximate 52% share of the U.S. motorcycle market gives the company substantial revenue growth potential if consumer confidence and disposable personal income continue to improve in the United States. HOG’s recently completed restructuring program is expected to save the company $320 million annually, while also reducing the company’s cost of operations, and this will significantly help the company’s bottom line going forward. HOG is currently trading at a discount to its historical average valuation multiples, which signals that there is currently a nice “margin of safety” when looking to buy at HOG’s current price. As a result, I believe that HOG’s current price is a great entry point for long-term investors who are looking to begin creating a position in the stock, or who are looking to buy what may end up being a significant “dip” in price.
Appendix 1: Harley-Davidson vs. Competitors and Similar Companies (additional financial metrics)
Data Source: Morningstar.com
Appendix 2: Ev/EBITDA for HOG
Data Source: Gurufocus.com
Appendix 3: Ev/EBITDA for Polaris
Data Source: Gurufocus.com
Appendix 4: P/E Multiples for HOG and Polaris
Data Source: Gurufocus.com
Appendix 5: P/S Multiples for HOG and Polaris
Appendix 6: P/B Multiples for HOG and Polaris
Data Source: Gurufocus.com
Appendix 7: P/FCF Multiples for HOG and Polaris
Data Source: Gurufocus.com
Appendix 8: The Seasonality of HOG’s Price Action (total return)
Source: Stockcharts.com (“Seasonality Charts”)
- Note: As defined by Stockcharts, “the seasonality tool calculates two numbers: the percentage of time the month is positive and the average gain/loss for the month… the number at the top shows the percentage of time the security closed higher for that month... the number at the bottom shows the average gain/loss for [the selected time period].” The data in this chart is updated daily, and because the chart works in monthly time intervals the data for October 2014 is not complete (because it is only October 12th). Therefore, the 5.5% price outperformance figure and the 70% monthly price outperformance figure are calculated as though the month of October is already over.
If you have any questions about this Issue of my Financial Newsletter please fill out the form below. I also appreciate receiving any comments you might have about what you just read, and I encourage you to send me ideas for topics that you would like to see me write about in the future. Thank you for reading!