Saturday, September 15, 2012

Harley Davidson Equity Analysis

It’s hard to find a purer play on consumer discretionary spending then Harley-Davidson $HOG and it’s always useful to look at it as a kind of barometer for spending trends in the global economy. In terms of growth prospects, brand recognition and sheer love, the HOG has few rivals as a brand and it has the opportunity to grow sales internationally.

However, its growth will vary from region to region and I’m not just referring to macro issues. Simply put, energy guzzling recreational vehicles are not the flavor of the month in every country round the world. As for the US, growth prospects are due to a mix of trends in discretionary spending and credit availability.

What Happened with the Latest Results? 

The results were slightly below analyst estimates but I think there are a couple of mitigating factors.

Firstly, estimates may have been too high thanks to other stocks in the discretionary vehicle segment reporting blowout numbers recently. Namely, Polaris Industries (NYSE: PII) and Arctic Cat (NASDAQ: ACAT). Interestingly, the latter recently beat estimates with revenues rising 49% in the quarter. In addition, Polaris is also doing very well with North American retail sales rising 17% in the last quarter. Both these stocks beat estimates so it is not surprising that expectations were high for Harley-Davidson. Perhaps too high?

Secondly, in common with so many other weather-sensitive retail stocks, sales were pulled forward in to Q1 due to the unusually warm weather in the winter. This has likely caused too much optimism to be baked in. No matter, sales were pretty good and management noted that credit losses were at their lowest levels for 10 years. The US consumer continues to deleverage and adjust to more sensible and sustainable lending. Gross margins saw a slight rise but management expects them to fall in the second half, primarily as a consequence of a strengthening US dollar. In order to demonstrate the latest numbers and how they fit into the long-term picture I’ve graphically demonstrated some data here.

Management clearly believe it is a "pull forward" effect, because they didn’t adjust their guidance for global sales of between 245-250k motorcycle shipments. A breakdown of motorcycle related revenues by halves illustrates the underlying strength.

In terms of market share Harley is doing well in the US although it noted pricing competition from Honda in Japan.

Growth Prospects Outside of US Motorcycles

US discretionary spending is not only linked to things like employment gains and GDP growth; it is also a function of credit availability. I doubt anyone wants to go back to mid 2000’s levels of credit issuance, but there is a real case for saying that credit companies are being too conservative right now. As Harley-Davidson pointed out, its loan losses are at historic lows and financial services income is starting to kick in here.

I would expect these improvements to continue. Moreover, Harley has earnings growth potential from productivity improvements and the implementation of its new ERP system. However, the real wild card here is international sales.

Theoretically, this slice of Americana should be ripe for a massive expansion overseas and the company is certainly planning for it. My concern is that it maybe focusing on the wrong areas. It is de rigueur to target China and India but thus far the Chinese have been assiduous in insisting on fuel efficient vehicles and promoting their own electric and solar powered vehicles. Frankly, I don’t see this changing anytime soon. As for India, motorcycles are already part of life there and Harley will face pricing competition from local competitors. The one area that I’m confident Harley will see very strong growth in future is in the Middle East.

It is puzzling why management don’t focus more on this region in their commentary or plans. If there is any region on this earth that is immune to fuel efficiency concerns and has the highways and moneyed populace in order to buy Harleys, it is the Middle East and Gulf. In addition, Americana and the Harley-Davidson brand are extremely popular amongst the educated parts of the population. Unfortunately, it is not the largest region to target but nevertheless the growth potential is very strong.

Where Next for Harley-Davidson?

The underlying indications are rather positive for Harley-Davidson in the short term, however in the long term the question remains over its compatibility in a world of rising oil prices and consumers desiring fuel efficiency. I suspect for these considerations the stock will remain relatively cheap.

In the mid-term investors can look forward to better US credit conditions leading to increased contributions to profitability from the financial services division. In addition, the ERP implementation appears to have been made successfully so working capital and margins should improve going forward. I suspect international sales growth will be mixed with southern Europe a particular concern.

In conclusion, if we look across the sector, US consumer discretionary spending seems to be doing ok. At least it’s a lot better than the headline makers in the media are suggesting.

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