Description
For contrarian with an investment horizon longer than two years, I believe Harley-Davidson (HOG) currently represents an opportunity to own a one-of-a-kind business that should appreciate significantly in intrinsic value over the next several years.
Harley-Davidson is the largest manufacturer of heavyweight motorcycles in the United States, with a 50% market share (heavyweight motorcycles are defined as those with an engine displacement over 651cc). The company also sells into international markets, where it is a smaller but still important player, with a 10% market share of the European heavyweight market and a 38% market share in Canada. The company generates approximately 75% of its sales from the U.S., approximately 15% from Europe and 10% from other foreign markets, primarily Canada and Japan. International markets are becoming more and more significant for Harley as global economic growth outpaced growth in the United States. For example, through September Harley’s international retail sales increased by 13% year-over-year, whereas U.S. sales fell by 4.7%. The company sells its bikes as well as aftermarket parts and accessories through a network of about 680 dealers, most of which are exclusive to Harley. The company is based in Milwaukee, Wisconsin and operates through six manufacturing facilities in the U.S. and two facilities abroad.
Before I explain why I think the stock offers compelling value, I’ll address some of the risks involved since there are many unanswered questions about Harley’s brand and its products. Harley motorcycles famously enjoy a feverishly loyal rider base within a certain segment of the American population, but demographic shifts – some perhaps reflecting of an aging baby boomer population – are raising many legitimate questions about the sustainability of Harley’s brand equity through future generations. The median age of the Harley rider has increased from 35 years in 1987 to about 47 today, according to the company. Today only about 15% of Harley buyers are under 35 years old. Younger motorcycle buyers presumably tend to prefer sportier, slicker bikes from Honda and BMW, and Harley has not successfully addressed this market (although its Buell line comes close). In the spirit of full and fair disclosure, I admit that I have never owned a motorcycle and that I have never actually ridden, or wanted to ride, a Harley. In other words, I do not have any special insights into the product.
In any regards, there are legitimate concerns that Harley’s trademark heavyweight motorcycles are suffering through a serious demand slump. It is not immediately clear (at least to me) whether that reflects a temporary fashion blip or, rather, a permanent shift it consumer preferences.
Then there is the economy. I won’t go into detail since I presume all of you read the news and know the facts.
This year has been a bad one for Harley-Davidson. Management has already taken down guidance twice this year, and has completely withdrawn its previous 2009 earnings guidance. They now expect 2007 earnings to be 4-6% lower than 2006 and grow only in the low-single-digits in 2008. After compounding earnings per share by 23% per annum for the past 17 years (since 1989), Harley seemed to have hit a wall in 2007. The stock is down 32% year-to-date vs. about a 5% gain on the S&P.
As growth slowed, the re-rating of the stock has been swift and severe. HOG shares traded at over 25x trailing earnings for most of the past 17 years. Today, it sells for 12.5x 2007 expected earnings. When a company goes from compounding earnings at over 20%, to low-teens to flat to negative over a four-year period (basically, HOG has in the period 2004 to 2007) growth and GARP investors dash really fast for the exits and then avoid the stock until they start to see growth again. But for more patient investors who are willing to average down and take marks in the near-term (since I think there is a high possibility of further downward revisions as we head into 2008), there is a lot to like about this company.
Perspective is important here. The table below shows Harley-Davidson’s earnings before taxes depreciation and amortization (EBITDA) and earnings-per-share (EPS) for the corresponding year:
|
|
|
EBITDA |
EPS |
|
1988 |
|
$82 |
$0.11 |
|
1992 |
|
$127 |
$0.18 |
|
1996 |
|
$340 |
$0.57 |
|
2000 |
|
$648 |
$1.07 |
|
2006 |
|
$1,838 |
$4.01 |
The compounded growth rate over the 18-year period displayed above is 19% for EBITDA and 22% for EPS. Over nearly two decades, Harley-Davidson was able to effectively double earnings-per-share every 3.5 years. This is pretty impressive.
Is this repeatable? Probably not. Aside from the law of large numbers, Harley’s growth in the 90s and early 2000s can be at least partially explained by the rising age and purchasing power of the core Harley buyer. The median household income of a Harley rider approximately doubled between 1987 and 1997, a static which itself can be explained by the fact that the median age of the Harley rider increased from 35 to 45 in the same period. In addition, the company’s finance subsidiary, HDFS, has been aggressively financing motorcycle purchases for years. Approximately 50% of all new Harley buyers finance their purchase through HDFS and the company’s receivables have roughly doubled from 2002 to 2006 (currently $2.6Bn). The company’s ability to continue to provide attractive financing to its customers is obviously highly dependent on its ability to access the securitization markets. It is also affected by the used motorcycle market and residuals. I am not currently aware of any problems the company has had with regards to accessing capital (in fact just last week it issued $500MM of MTNs at 5.28%). I have not spent enough time diligencing the pricing and demand environment for used motorcycles, but anecdotally I do know that the company did sell some repo’d bikes at a Manheim auction last month, and that the company was generally pleased with the results.
With the shares at $49, the company currently has a market capitalization of $11.8Bn. When looking at the balance sheet, you need to separate the finance subsidiaries (HDFS) from the manufacturing businesses (Motor Co). The Motor Co has a great balance sheet - $456MM of cash and no debt. Even with a unionized workforce, its pension plans are overfunded, and future OPEB obligations are minimal and serviceable. HDFS has a portfolio of consumer loans valued on the books at $2.6Bn, financed with $1.2Bn of debt and $1.4Bn of equity. In other words, Harley has $5.50 per share of HDFS book value. In essence, investors can buy Harley’s motorcycle business at an enterprise value, net of cash and the HDFS equity, of $10Bn. In exchange for $10Bn, investors are getting a business that last year generated $1.6bn of EBITDA and $1.1Bn of free cash flow – that equates to multiples of 6.2x EBITDA and 11.1x FCF. The numbers will come down in 2007, and maybe even go down further or stay relatively flat in 2008. On my 2007 estimates, the multiples are 6.8x EBITDA and 12.2x cash flow.
|
Share Price |
|
|
|
$49 |
|
Diluted Shares |
|
|
241.5 |
|
Market Capitalization |
|
|
11,833.5 |
|
|
|
|
|
|
|
(-) Manufacturing Cash |
|
|
456.7 |
|
(-) Book Value of HDFS |
|
|
1,338.3 |
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|
|
|
|
|
Net Enterprise Value of Manufacturing Business |
10,038.5 |
|
Per Share |
|
|
|
$41.57 |
|
Valuation: |
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|
|
@ 12/31/07 |
@ 12/31/08 |
@ 12/31/09 |
|
HOG Share Price |
|
|
|
$49.00 |
$49.00 |
$49.00 |
|
Shares Outstanding (assumes buybacks) |
|
241.5 |
232.2 |
218.6 |
|
Market Capitalization |
|
|
|
11,833.5 |
11,378.3 |
10,710.5 |
|
|
|
|
|
|
|
|
|
|
(-) Current Cash |
|
|
|
456.7 |
456.7 |
456.7 |
|
(-) Current HDFS book value |
|
|
1,338.3 |
1,338.3 |
1,338.3 |
|
|
|
|
|
|
|
|
|
|
Motorcycle Net Enterprise Value |
|
|
$10,038.5 |
$9,583.3 |
$8,915.5 |
|
|
|
|
|
|
|
|
|
|
Multiple to EBITDA: |
|
|
|
|
|
|
|
2006 |
|
$1,627 |
|
|
6.2x |
5.9x |
5.5x |
|
2007E |
|
$1,467 |
|
|
6.8x |
6.5x |
6.1x |
|
2008E |
|
$1,496 |
|
|
6.7x |
6.4x |
6.0x |
|
|
|
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|
|
|
|
|
Free Cash Flow Yield |
|
|
|
|
|
|
|
2006 |
|
$899 |
|
|
9.0% |
9.4% |
10.1% |
|
2007E |
|
$818 |
|
|
8.1% |
8.5% |
9.2% |
|
2008E |
|
$792 |
|
|
7.9% |
8.3% |
8.9% |
You can find quite a few companies trading at similar multiples, but most such companies operate in cyclical, mature industries, have very capital intensive businesses with razor-thin margins, and lack brand equity or any other sort of intangible competitive moat. Auto parts suppliers, airlines, commodity chemicals, and homebuilding are some industries where you can regularly find stocks trading at less than 6x EBITDA. On the other hand, Harley-Davidson has a tremendous competitive moat, mostly by virtue of its very unique and irreplaceable brand. Warren Buffett once said that if someone gave him $100Bn and asked to beat Coca-Cola in the soft drink business, he wouldn’t take the money because it’s simply not possible. Similarly, you couldn’t take $10Bn and expect to replicate Harley’s position in the motorcycle market. You could certainly replicate the manufacturing capability with enough capital, but you won’t have the Harley brand equity.
Recent financial performance for the motorcycle business (excluding HDFS) is as follows:
|
Manufacturing Business Financials: |
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|
2003 |
2004 |
2005 |
2006 |
2007E |
2008E |
2009E |
|
Revenue |
|
$4,624 |
$5,015 |
$5,342 |
$5,801 |
$5,433 |
$5,542 |
$5,985 |
|
% Change |
|
13.0% |
8.5% |
6.5% |
8.6% |
-6.3% |
2.0% |
8.0% |
|
|
|
|
|
|
|
|
|
|
|
EBITDA |
|
1,178 |
1,387 |
1,507 |
1,627 |
1,467 |
1,496 |
1,646 |
|
% Margin |
|
25.5% |
27.7% |
28.2% |
28.1% |
27.0% |
27.0% |
27.5% |
|
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|
|
|
|
|
|
|
Capex |
|
227 |
214 |
198 |
220 |
200 |
250 |
250 |
|
% of Sales |
|
4.9% |
4.3% |
3.7% |
3.8% |
3.7% |
4.5% |
4.2% |
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|
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|
EBITDA-CX |
|
951 |
1,173 |
1,309 |
1,408 |
1,267 |
1,246 |
1,396 |
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Cash Flow Calculation: |
|
|
|
|
|
|
|
|
|
EBITDA |
|
1,178 |
1,387 |
1,507 |
1,627 |
1,467 |
1,496 |
1,646 |
|
Capex |
|
(227) |
(214) |
(198) |
(220) |
(200) |
(250) |
(250) |
|
Cash Taxes |
|
(353) |
(422) |
(469) |
(509) |
(449) |
(454) |
(502) |
|
FCF |
|
598 |
751 |
840 |
899 |
818 |
792 |
894 |
|
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|
|
|
|
|
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|
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|
Motorcycle FCF/Share |
|
$1.96 |
$2.53 |
$2.99 |
$3.39 |
$3.30 |
$3.41 |
$4.09 |
|
% Change |
|
71.1% |
28.9% |
18.2% |
13.3% |
-2.7% |
3.5% |
19.9% |
The company consistently generates EBITDA margins in the 27-28% range, which reflects tremendous pricing power. In addition, the business itself is surprisingly capital light, with capital expenditures amounting to less than 4% of annual revenues. The result is very high levels of free cash flows. Since the beginning of 2005, the company has used its free cash flow to return $3.6Bn to shareholders through $500MM of regular dividends and $3.1Bn in share buybacks. Share count has been reduced by approx. 18% since the beginning of 2005, and Harley has already spent over $1Bn on share repurchases in 2007. In my modeling, I expect the company to continue to buy back stock to the tune of $800MM per year going forward (this compares to an average of $1.1Bn per year spent on buybacks since 2005). The company should be able to repurchase about 10% of its outstanding shares over the next two years without spending the cash pile it has on the balance sheet. Were the company lever itself up to 2x EBITDA, for example, it would be able to repurchase 24% of its shares. Since management is generally conservative, I don’t see such recapitalization happening any time soon; still, I do think doing so would be highly accretive.
The main issue facing Harley today is growth going forward. The consensus estimates on the street have been creeping lower for the better part of this year, and are now at a point where most analysts do not see real growth in 2008 and only modest growth in 2009. The Reuters consensus revenue estimate for Harley in 2009 is $6.18Bn, which implies zero growth over the next two years. This assumption doesn’t completely jive with data on new motorcycle registrations, which have been growing consistently over the past two decades. North America new registrations of heavyweight motorcycles have grown at a compounded annual growth rate of 12.4% since 1992, and Harley has essentially kept pace as shown in the following table:
| North America New Motorcycle Registrations |
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| |
|
1992 |
1994 |
1996 |
1998 |
2000 |
2002 |
2004 |
2006 |
|
CAGR |
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|
|
|
|
|
|
|
|
| New Registrations (in thousands) |
|
112.0 |
150.4 |
182.7 |
246.2 |
365.4 |
475.0 |
530.8 |
578.8 |
|
12.4% |
| % Change |
|
NA |
16% |
10% |
16% |
22% |
14% |
6% |
4% |
|
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|
| Harley New Registrations |
|
56.0 |
69.5 |
86.3 |
116.1 |
163.1 |
220.1 |
255.8 |
281.6 |
|
12.2% |
| % Change |
|
NA |
11% |
11% |
16% |
19% |
16% |
8% |
5% |
|
|
| % Market Share |
|
50% |
46% |
47% |
47% |
45% |
46% |
48% |
49% |
|
|
I am assuming that Harley can grow revenues at about 8% going forward, although as mentioned above 2007 will be below 2006 and it is possible that 2008 will be another disappointing year. Beyond that, however, I model Harley growing through a 4% annual increase in unit volumes and 4% through price to get to my 8% estimate.
Fair Value
Looking out to 2009, I think the upside to Harley stock is somewhere in the $80-$100 range, or 60-100% over today’s price. Harley’s earnings power in 2010 is roughly $2Bn of EBITDA, and I am using 8-10x multiple to get to my valuation range. I can already see some of you questioning the validity of any stock idea that requires multiple expansion, given that Harley today trades at less than 7x. I agree that multiple expansion is not something to hang one’s hat on, but Harley’s low capital intensity means that even at 10x EBITDA the effective unlevered pre-tax free cash flow yield is close to 9%. With the ten-year treasury hovering around 4%, I think a 5% risk premium on an unlevered, high quality company is pretty attractive.
|
2010E EBITDA |
|
|
|
|
$2,064 |
$2,064 |
$2,064 |
|
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Multiple |
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|
8x |
9x |
10x |
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Enterprise Value |
|
|
|
|
$16,509 |
$18,573 |
$20,636 |
|
Net Cash at 12/31/09 |
|
|
|
|
457 |
457 |
457 |
|
Equity Value at 12/31/09 |
|
|
|
|
16,966 |
19,029 |
21,093 |
|
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Shares Outstanding at 12/31/09 |
|
|
|
|
219 |
219 |
219 |
|
|
|
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|
Share Price |
|
|
|
|
$77.62 |
$87.06 |
$96.50 |
|
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Implied EV / EBITDA less Capex |
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|
|
|
9.1x |
10.2x |
11.4x |
|
Implied Unlevered Pretax FCF Yield |
|
|
|
|
11.0% |
9.8% |
8.8% |
At the end of the day, I think some of the concerns about Harley’s growth prospects going forward are a little overblown. Over the long term, I see Harley growing unit volumes in the mid-single digits, in-line with the heavyweight motorcycle market. With its pricing power, Harley should be able to generate high-single digits revenue growth. With some financial alchemy, it should be able to deliver mid-teen growth in earnings per share. In two or three years, earnings power should approach $5/share, with FCF approximating earnings. I haven’t really touched on the growth opportunities that exist for the company in international markets, but those are pretty exciting, especially given Harley’s U.S.-dollar-based cost structure in a falling dollar environment. As to the Harley-Davidson brand, I take some comfort from the fact that licensees paid Harley $45MM in royalty fees for the use of the brand on anything from t-shirts to toys and even a restaurant (in Vegas). This is a uniquely American brand that you really can’t re-create with any amount of money.
Catalyst
Harley shows some signs of growth once again
Continued healthy free cash flow generation and share buybacks
M&A (there were some rumors a few months ago that Honda was interested. I don’t really have a view on it but I think it becomes more likely the more this stock goes down)
Improving investor sentiment about the U.S. consumer and the economy