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Author: TMFBreakerWade Three stars, 500 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 89  
Subject: Watchlist Addition HOG Date: 7/11/2008 3:27 PM
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Harley Davidson

Why I like it

Harley doesn’t just sell a product. It promotes, supports, and endorses a lifestyle. When I think of a dominant brand, one with rabid consumer loyalty, Harley Davidson is one of the first that comes to mind. They also have a wide target audience, the average customer is a male 35-53 with a median household income of 84k per year. Harley has held the largest share of the heavyweight motorcycle market (think opposite of those little plastic sport bikes you see weaving through traffic), since 1986. Today, Harley controls 48.7% of this market in the United States.

Prices range from comparable to slightly higher than competitor models. This tells me that their product is more about quality (and the costumer’s willingness to pay for the brand) than it is about being a low cost provider.

It’s not just about Bikes, as Parts and Accessories make up 15.2% of revenue, GM 5.2% , and Financial Services around 7% of revenue.

In an effort to continue to build on the customer experience Harley has leveraged it’s brand into various programs like:

HOG owner’s group – Comprised of over 1 million Harley enthusiasts

Riders Edge – Started in 2000 with the purpose of teaching and attracting new blood

Harley Davidson Museum and Archive – Will open by July of 2008 in Milwaukee Wisconsin. The concept will have bikes on display, a restaurant, space for retail, and an area for rallies and other events. In other words, this will be heaven for the diehards.

International growth is starting to pick up. Last year, international sales increased 27%, while the year before was just 13%. On July 11th it was announced that Harley had purchased an Italian motorcycle maker (named Augusta) in an attempt to boost it’s presence in Europe and tap into the sports bike market.

Sportster models (think basic model) were up 11% YOY, and the company expects this group to be a catalyst for new growth. ¾ of Sportster purchasers are first timers (or better yet) come from competitors. Company research states that 80% of buyers intend to purchase another one, and 52% of all retail purchasers are previous owners. All of these metrics attest to the fact that Harley uses the Sportster (a more competitively priced bike), to attract customers to the brand. Then, once they buy, it’s a good bet they are a HOG for life.

Lastly, I like the fact that the company demonstrates size of scale by being the only major American motorcycle manufacturer. Competitors include names like, Honda, Suzuki, Yamaha, and Kawasaki. Customers will attest to the fact that if you buy Harley, you are buying an inherently American product.

Business

Harley Davidson was incorporated in 1981, at which time it purchased the Harley Davidson motorcycle business from AMF Inc in a management buyout. In 1986, HOG became publicly held. Trailing TTM sales were 6.25 billion with 37.7% gross margins and 14.9% net margins.

The business is broken up into 2 segments

The motorcycles and related products segment includes Harley Davidson (branded bikes and apparel) as well as the Buell brand. The way this business works is that the parent company designs, makes, and manufacturers the bikes, which it then sells to dealerships. Revenue is recognized when the bike is sold to the dealer. The exclusive sale of bikes makes up 80% of this segments revenue. The company makes five types of motorcycles, Touring, Dyna, Softail, Sportster, and VRSC (the VRSC models have liquid cooled engines as opposed to air cooled). The 2008 model year is comprised of 31 models of bikes ranging from $6700 – $23000. There is also a part of the business called the Custom Vehicle Operation and those bikes range from 25k – 35k.

The Financial Services or HDFS segment provides wholesale and retail financing along with insurance to dealers and customers. HDFS operates in the United States, Canada, and Europe. For the 2007 fiscal year, financial services brought in 416M in sales and 212M in operating profit. While the gross margins for the bike segment are around 37%, the financial segment has historically returned around 50%.

I consider these to be the drivers for the business

1. Continued brand excellence as evidenced by their Heavyweight market share of 48.7%.
2. Continued growth of international business, - 29% last year.
3. High profit margins
4. Inventory controls. Currently inventory is backed up, but in the first quarter Harley shipped 6% more bikes YOY while revenues from bike sales grew 14%. Bottom line, at least in the first quarter more bikes were sold than were built.
5. According to Capital Iq, the cash conversion cycle stands at 20 days – this is surprising low for a company whose primary business revolves around a big ticket item.

Management

While I would consider most of the management team to be new, (ie CFO and other key executives), the CEO James L Ziemer he has been with the company for 39 years. He is however, a fairly new Ceo taking over the post in 2005. Applying MDP OATS principles, I assess management as the following:

Ownership – Less than 1% of insiders own shares. While it’s true that HOG is a rather large company, (8 billion dollar market cap), I would like to see more insiders with financial ties to overall performance.

Allocation – Harley Davidson has an extremely high ROE (35.3%) and a high ROIC (20.5%). If we factor in a WACC of 7.8% the company is effectively creating about 13 cents for every dollar of shareholder value.

Tenure – While Mr Zeimer is a relatively new CEO, I am comforted by the fact that he has been with HOG for 39 years.

Stewardship – I believe that management is fully aligned with shareholders. Stock based compensation sits at 2.32% and over a three year (CAGR) period – the company has bought back shares at a 5.68% clip. At the same time, management has aggressively increased the dividend at a 10 yr rate (CAGR) of 32.3%. While the current dividend yield sits at 3.68% the payout ratio is only 29.9% so this sizable dividend has room to grow. In a perfect world, HOG would find new avenues at which to reinvest the excessive amounts of cash into their core businesses. However, I am happy to see that they are not destroying their operation by investing money into projects that will not create future shareholder value. Since it is clear that Harley Davidson is on the downward slope of their growth cycle, management is (one way or another), returning money to shareholders and not to their own pockets or on wasteful ventures.

Risks

1. The company sells at wholesale and must rely on the dealers to manage the distribution of the products. Their abilities (or their lack thereof) could seriously damage the business.
2. It’s clear that a slowdown in the greater economy is hurting sales. Prolonged economic duress will hurt Harley.
3. Competitors both inside and outside the country have greater financial resources. If price becomes more of a competitive advantage, then Harley’s margins will be squeezed and profitability will be lost.
4. HOG must continue to be successful diversifying the core audience by marketing to women and ethnically diverse riders. They must continue to try to introduce new blood into an aging demographic.
5. Must be able to continue to protect this brand. If the brand becomes damaged, the company will be in serious trouble.
6. The financial services segment is dependant on accessing capital markets at an attractive rate. Recently Harley’s credit rating was downgraded which caused a 40% drop in profits. This rating must be maintained.
7. Inventory controls, Ceo James Ziemer has recently promised to get excessive inventories under control. While he was able to make some headway in the first quarter, this could be an issue that damages margins over the long term and adversely affect operations. It’s critical that inventories are being monitored and reacted too when necessary.

Valuation

By all traditional valuation measures Harley appears to be a steal. P/S, P/E are all way below their 10 year averages. If you look at the current Owner Earnings yield, it stands at a ridiculous 12%. The Price to SFCF ratio is below 7.5 and P/FCFe is below 5. If you run HOG through a DCF with an 11% discount rate, assuming that it has a couple negative growth years on the horizon, then normalize that growth rate back to positive territory, - it’s still worth about $38 dollars a share. There is no doubt about it, this company is downright cheap. Heck, I would have no problem paying 8 billion just for the Harley Brand, would you?

Conclusion

Harley Davidson has earned itself a nice spot on my watchlist where, (per my process), I will get a feel for how and why it moves. So after all of this why am I not aggressively buying? I simply believe that there is no rush to jump into a position at this time. Quite frankly, I still have some concerns that need to be addressed. First, growth rates need to start to improve before I commit capital. While not a hard and fast rule, I like to see a company growing even in the short term as opposed to not. Second, I would like to see management build off their first quarter success and control their high ticket inventories. Third, I want to see margins expand as oppose to contract. Fourth, I want to see how Harley’s relatively new Ceo reacts to a prolonged tough business environment. Over time, I am confident that Harley will be able to maintain customer loyalty and offer purchasers the ability to upgrade their rides. In fact, I believe that diehard HOG’s have no problem spending on multiple bikes, my stepsister owns 3! So once Harley Davidson put’s a couple of these short term issues to bed, (thereby preventing them from becoming long term trends), I will have no problem adding shares. In the meantime it will occupy a spot on my watch-list.

Still, this price is tantalizing…
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