Harley-Davidson has been in the news a bit lately.
Two weeks ago, rumors started flying around that private equity firm KKR might buy out the company – the stock price jumped 20%.
What would make Harley-Davidson an attractive long-term investment?
Let’s take a look.
INVESTMENT THESIS SUMMARY
- Wide Economic Moat Driven by Brand Loyalty, Rider Community, and HOG’s Dealer Network
- Strong Free Cash Flow Generation and Consistently High Return on Equity
- Capable Management
Harley-Davidson Inc. (“Harley-Davidson”, “Harley”, “HOG”, or the “Company”) is a leading global manufacturer and seller of heavyweight (i.e. 601+cc) motorcycles. With operations dating back to 1903, the Company pioneered the “cruiser” and “touring” categories of the on-road motorcycle market. Today, the Company is the dominant player in the heavyweight motorcycle market, accounting for over 50% of all new heavyweight motorcycle registrations in the U.S. in 2015 (note: the heavyweight segment accounts for 85% of the total motorcycle market in the U.S.).
The Company operates through two business segments:
- Motorcycles & Related Products (89% of 2015 Revenue / 75% of 2015 Operating Income): Designs, manufactures, and sells Harley-Davidson motorcycles, as well as a line of motorcycle parts, accessories, general merchandise, and related services.
- Financial Services (11% of 2015 Revenue / 24% of 2015 Operating Income): Provides financing and insurance programs primarily to Harley-Davidson dealers and their retail customers.
The Company’s products are sold through a network of independent dealers, the majority of which exclusively sell Harley-Davidson motorcycles. These dealers also sell related Harley-Davidson products and merchandise and perform service on Harley-Davidson motorcycles. As of FYE 2015, the Company had 1,435 dealers in 95 countries. 74% of total revenue is generated in the U.S. and 12% is generated in EMEA, with most of the remainder generated in Canada, Australia, and Japan.
CURRENT SITUATION AND MARKET VIEW
Prior to the buyout rumors on July 1st which sent the stock price up to $54 (currently $48), HOG’s stock price had fallen 40% since May 2014 (compared to +9% for the S&P 500), from a high of $72.68 to the $42 range. 2015 total revenue, operating income, and net income were 4%, 10%, and 11% below 2014 figures, respectively. Although Q1 2016 revenue was up 5% YoY, operating income and net income were down 5% and 7%, respectively. Equity analysts have focused on the following headlines for the Company:
- Harley’s market share of the U.S. heavyweight motorcycle market has been declining recently, from 54.9% in 2013 to 50.9% in Q1 2016, driven by market share gains by lower priced foreign competitors, such as Honda, Yamaha, and Kawasaki.
- Harley’s core customer group (white men over the age of 35) includes baby boomers, who will eventually age out of the activity of riding a motorcycle. The Company must increase sales to younger riders and in overseas markets in order to make up for this decline.
- These concerns are addressed in the Risk section.
I believe that these concerns are reasonable, but overblown when taking a long-term ownership perspective.
WIDE ECONOMIC MOAT DRIVEN BY BRAND LOYALTY, RIDER COMMUNITY, AND HOG’S DEALER NETWORK
- Harley-Davidson is a classic American brand and the Company sells a certain lifestyle/image (e.g. personal freedom, rebelliousness, high quality, strength, American culture) just as much as it sells motorcycles.
- Harley-Davidson has been able to attract fiercely loyal, lifelong customers through its promotion of the Harley lifestyle and its cultivation of its rider community. Many Harley riders don’t just own the motorcycle, they also wear the t-shirt, the jacket, the hat, and have the tattoo.
- The Company’s Harley Owners Group (H.O.G.) is the industry’s largest company-sponsored motorcycle enthusiast organization with ~1 million members worldwide. H.O.G. sponsors motorcycle events, including rallies and rides, for Harley enthusiasts throughout the world. The Company also runs the Harley-Davidson Riding Academy (which offers rider education experiences and has trained over 445k riders), offers Harley-Davidson Authorized Tours, and operates the Harley Davidson Museum in Milwaukee, Wisconsin.
- The Harley-Davidson rider community creates a beneficial network effect for the Company: as the number of Harley owners grows, the community strengthens and becomes more valuable to other Harley owners. This is a unique differentiating factor for a premium brand like Harley, where increased ownership would normally dilute the value of the brand; in this case, the opposite is true.
- The Company’s customer loyalty and brand presence is evidenced by its historical 50%+ market share of the heavyweight motorcycle segment in the U.S. According to Statistica, Harley has a 35% share of the overall motorcycle market, compared to #2 Honda (15% share), #3 Yamaha (13% share), #4 Kawasaki (9% share), and #5 Polaris (5% share). According to Harley-Davidson’s website, the market share differential is even greater for its core customer segment (white men, age 35+): 55% for Harley compared to 6% for its nearest competitor.
- The Company’s customer loyalty and brand presence allows it to price its products at a premium compared to competitors.
- Harley’s economic moat is also strengthened by its dealer network, the majority of which exclusively sell Harley motorcycles. The Company has 1,435 dealers worldwide and 764 dealers in North America (compared to ~450 in North America for one of the Company’s main U.S. competitors, Polaris, whose brands include Victory, Indian, and Slingshot).
- The dealer network helps promote the Harley experience by offering a high quality retail experience and by engaging the local community (e.g. “garage nights” for women to learn about the mechanics of their bikes; poker tournaments to benefit local charities).
- CEO Matt Levatich notes: “The distance that we have at retail in our industry is incredible… Because customers experience Harley-Davidson at the dealership. And they’re not just doing a transaction. They’re not just going to buy a bike and leave. They’re coming back for rides on the weekends, for events, for bike nights. The dealership is the clubhouse. The epicenter of the community of Harley riders. That doesn’t exist anywhere else in the industry.”
- These dealers are independent and most exclusively sell Harley products. Consequently, the dealers are also fiercely loyal to Harley and the Company does not have to incur capital expenditures to maintain them. The size of this network and the close relationship the dealers have to Harley would be difficult and expensive for a competitor to replicate.
STRONG FREE CASH FLOW GENERATION AND CONSISTENTLY HIGH RETURN ON EQUITY
- The Company’s premium positioning and efficient manufacturing processes result in historically strong free cash flow generation. The Company has generated approximately $4Bn in cumulative free cash flow over the past 5 years (16% of total revenue on average).
- This strong FCF generation is supported by the Company’s low capital expenditure requirements (despite being a manufacturer) and very minimal working capital needs.
- Return on equity has averaged 28.4% over the past 5 years and 24.9% since 2003. In the past 2 years, ROE has exceeded 30%.
- In 2007-2010, during which annual registrations of new heavyweight motorcycles in the U.S. fell 50% (from a high of 543k to a low of 260k) and the Company’s total revenue fell 20%, Harley still generated over $1Bn in cumulative free cash flow.
- Matt Levatich became CEO in May 2015. Mr. Levatich is a Harley veteran and has been with the Company for