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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
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 over 20 years in multiple roles, including president and COO.
Levatich is a mechanical engineer by training and I believe he has a good handle on the Company’s manufacturing and dealer network.
However, I have been more impressed by (i) his focus on the customer and the customer experience; (ii) his long-term perspective, especially in handling the recent discounting by competition and his commitment to continuing to develop Harley’s electric motorcycle project, which he classifies as a “non-negotiable”; (iii) and his focus on clear communication with stakeholders (and the Company’s transparent financial reporting).
Management has committed to returning excess cash to the Company’s shareholders, both through consistently increasing dividends since 2009 and through discretionary share repurchases. The Company repurchased $1.5Bn worth of stock in 2015; half of this amount was funded via a $750MM issuance of debt, a signal to the market that management believes the Company’s stock is significantly undervalued. However, unlike other recent debt-fueled share repurchase plans by public companies, I believe this capital allocation decision was made prudently.
PRICING PRESSURE DRIVEN BY FOREIGN COMPETITION AND A STRONGER U.S. DOLLAR
Since 2014, the U.S. dollar index has increased by 20-25%. The stronger dollar has impacted the Company in two ways:
Direct impact on revenues: As a U.S.-based manufacturer, a stronger dollar means that every sale the Company makes overseas comes back as fewer revenue dollars but with the same dollar costs. The Company estimates that without the impact of changes in F/X rates, the Motorcycle segment’s gross profit in 2015 would have increased by 2% (instead of decreasing by 4%).
Indirect impact on competition: The stronger dollar results in higher profits for Harley’s foreign-based competitors such as Honda, Yamaha, and Kawasaki. With lower shipment volumes compared to pre-recession, many motorcycle manufacturers have excess manufacturing capacity. The stronger dollar allows the foreign manufacturers to reduce pricing, increase volume, and increase utilization. As a result, Harley has lost market share.
Because of its premium brand positioning, Harley is both unable and unwilling to reduce pricing to match its competitors (which would likely result in a price war and erode most of the industry’s value). Management is instead taking a long-term view, willing to sacrifice units this year in order to sustain its brand positioning.
The recent decline in Harley’s market share is more palatable once we recognize that it has largely been driven by recent F/X movements.
I’m comforted by the fact that management is not responding to pressure from Wall Street analysts with short-term perspectives, and instead is taking the right steps regarding pricing.
Although the EUR/USD exchange rate is still ~0.90/USD (compared to below 0.75/USD before mid-2014), the JPY/USD exchange rate has declined significantly since 2015 and at ~102/USD is in-line with early-2014 levels (the exchange rate had risen to as high as ~125/USD in 2015). As a result, aggressive discounting by the Company’s Japanese competitors should let up throughout the remainder of this year.
NEED TO TARGET NEW DEMOGRAPHICS FOR GROWTH AMID AN AGING CORE CUSTOMER BASE
Harley-Davidson’s core demographic is white men over the age of 35. The average Harley customer is an upper-class 47-year-old white male, with the average age of Harley riders increasing by 6 months every year for the past 20 years.
As Baby Boomers get older, they will increasingly “retire” from motorcycle riding.
Harley must attract other demographics in order to replace these lost customers.
The Company has identified key demographics that it will focus on as its “outreach” (or non-core) customers, including white women (age 35+), young adults (age 18-34), African-Americans (age 35+), and Hispanics (age 35+). One of the Company’s 5 key objectives for 2016 and beyond is growing its outreach customer base at a faster rate.
2015 marked the 8th straight year that Harley-Davidson was the number-one seller of on-road motorcycles (of all cc-types) in the U.S. to its core customer segment and each of its outreach customer segments. In fact, Harley is the dominant player in each of its core and outreach segments, and its market share in each segment has increased substantially since 2008:
With its brand presence and significant share of the overall market, Harley-Davidson has the bully pulpit needed to influence prospective customers in all demographic segments to start riding.
Harley-Davidson is also taking the industry lead on developing an all-electric heavyweight motorcycle (Project LiveWire). Although this electric bike is not expected to be commercially viable until 2021, it will likely attract new younger riders when it is released.
Although the Company’s core customer is continuing to age, Baby Boomers are expected to remain very active late in life and many will continue to ride.
Management notes that Harley-Davidson has sold more motorcycles to today’s younger generation than it did when its core customers were the same age.
So, does all this mean that you should go out and buy a ton of Harley-Davidson stock?
Well… we must keep in mind that in the end the real attractiveness of an investment lies in the relationship between its price and its intrinsic value.
I thought the stock was a good buy when it was trading around ~$42. At that price, the company was fairly valued assuming a “no future growth” scenario – i.e. (i) global motorcycle sales stay flat and (ii) the Company is unable to increase its market share. (Note: you could run the same valuation analysis I did by calculating a normalized FCF number assuming slightly reduced marketing and R&D expenses, no changes in working capital (no sales growth), and no growth capex, and then plugging that number into the present value of a perpetuity formula).
With this no growth valuation, it was just a binary decision as to whether or not you thought the company would grow. In my opinion, while we are still a long way off from the pre-recession peak level of new heavyweight motorcycle registrations (543k in 2006 in the U.S. vs. 329k in 2015), I believe the industry will continue to grow steadily (barring another global recession) as new demographics (driven by the industry’s marketing outreach efforts) and millennials (driven by increasing disposable income) will pick up riding.
I also think that assuming no growth is overly harsh, as I believe the Company’s market share is currently at a trough due to F/X movements and will increase to more historical levels within the next several years (this will happen more quickly in the U.S. and more slowly in Europe).
However, as I mentioned above, the company was just fairly priced when the stock was trading in the ~$42 range. At ~$48 per share, I think the stock looks much less attractive. It should also be noted that the jump in the stock price was driven by short-term speculation regarding the KKR buyout rumors – so it might be best to take a step back for a bit.
That being said, Harley-Davidson will be releasing its Q2 2016 earnings on 7/28/16. I’ll definitely be keeping my eye on the stock for the next several weeks. I definitely think you should too.
What do you think of Harley-Davidson, either as a company or as a long-term investment? Let’s hear it in the comments section below!