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Ticker: Harley-Davidson (HOG)

Secondary Tickers: Ford (F), Honda (HMC), Arctic Cat (ACAT), Polaris (PII)

Thesis:

Moving into 2013, we believe that HOG is looking like a great buy. We believe the stock should increase around 25% in the next twelve months as the stock has increased in value as the price has flattened for the second half of 2012. Future PE has come down to 14, which is below the 15 level that we look at as a place for good value. The company looks to have seen some solid sales momentum into the end of 2012. Goldman Sachs noted that retail sales were up 12% in October, showing good momentum continuing from September. What we like most about the company is that they have a strong economic moat that has been created by brand strength, a strong dealer network, and quality recreational products. While the company is hurt during rough economic times, we expect continued expansion for the company during 2013, and they have fared well even during rough conditions. For example, the company increased sales 6% during 2011 despite only 4% expansion in their industry. Additionally, the company was one of the only consumer discretionary companies to see expansion in Europe in 2011 as well.

Despite weaker results in North America in the latest quarter, international sales are very strong, and we believe that the company will continue to benefit from international expansion as well as restructuring operations that have helped the company increase margins despite lower sales. The company's large restructuring plan is really the key to HOG's success moving forward. They are taking a strong business line and making it more profitable and stronger. They are expected to incur around $490-$510M in restructuring costs to save around $325M in costs moving forward each year. In just two years, the company will make up for their incurred costs. This move makes HOG very attractive to increase its profitability. Some of the restructuring moves include revamping its production facilities to make them more flexible and have renegotiated labor contracts to bring down overhead.

Further, we like that the company is pushing full force to appeal to a new generation of riders. The company has released bikes like the Breakout and Seventy-Two, which are being built to appeal more to younger riders as the classic Road King has less appeal to a newer generation that will be the next life-long buyers of the company's bikes. As the company completes their restructuring, continues to increase sales in Latin America and Europe, pushes profitability higher, and builds newer, sleeker bikes ... we can't help but to jump on board.

Rating: Upgrade from Hold to Buy

Ticker

New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range

HOG

$62

$42

Buy

Hold

$49/$69

Price Target:

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

884

954

1100

1333

1692

Taxes

309

334

385

467

592

Depreciation

187

210

220

245

147

Capital Expendit.

-178

-200

-200

-200

-189

Working Capital

110

115

115

115

115

Available Cash Flow

474

515

620

796

943

For Harley, we have projected the company to see 50-75% growth in sales in the next five years along with continued increases in operating margins as costs continue to come down due to recent restructuring. The sales will mostly be driven by a resurgence of big-ticket item buying in North America along with continued expansion into Latin America and Asia. The company can see around a 100% increase in operating income as it looks to have its business as streamlined as possible.

Tax rates were configured with a 35% tax rate.

Depreciation should continue to increase for the company, but we dropped our 2016 target for depreciation as we believe around that time we will see the company do another major restructuring of factories.

Capital expenditures should stay fairly flat for the next five years.

Taking ten-year averages configures working capital changes.

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for HOG: 8.24%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9239

0.8535

0.7886

0.7285

*

PV of Available Cash Flow

498

440

489

580

*

* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out the residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.

Cap Rate for HOG: 4.24%

2016

Available Cash Flow

942.80

Divided by Cap Rate

4.24%

Residual Value

22236

Multiply by 2016 PV Factor

.7285

PV of Residual Value

16200

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

1946

PV of Residual Value

16200

Cash/Cash Equivalents

1795

Interest Bearing Debt

5874

Equity Value

14067

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

Equity Value

14067

Shares Outstanding

116.02

Price Target

$62

In the end, we have found that Harley-Davidson stock should be worth around $62 given a five-year pricing model. We believe our model is fair in its assessment and not too aggressive or conservative.

Profitability:

Q1-Q3 2012

Q1 - Q3 2011

Operating Margin

22.5%

20.3%

Gross Margin

35.6%

34.0%

Return on Equity

5.5%

5.1%

One of the most attractive aspects of HOG's business is its profitability capabilities, and we can see that 2012 is already showcasing some of the success of restructuring that is allowing for the company to bring down costs. As those margins continue to increase, they will offer a lot more equity value for the company, but how do these margins stack up against the competition?

Competitors for the company include Ford, Honda, Polaris and Arctic Cat. All four companies are auto manufacturers with various ranges of recreational exposure. Looking at these companies can give us a better perspective of how HOG is performing. For operating income, Honda's operating margin is just over 3%. Ford's margin is at 4%, ACAT is at 8%, and PII is at 14%. These figures are TTM, but they do show that HOG is outpacing a lot of competition in their ability to turn revenue in their industry into operating profits. ROE is probably the second-most important profitability margin, and HOG operates a fairly low ROE in fact. While it is improving, the company needs to improve this area. F has a 93% ROE (mostly due to tax breaks), ACAT is sitting at 21%, PII is at 50%, and HMC is at 8%. HOG definitely lags the competition in their ROE, which will improve as the company increases net income.

Value:

Current

Industry Average

P/E

16.9

23.1

Future P/E

14.2

N/A

Harley definitely lags much of the overall industry in PE, and they are a good value company. With their sub-18 PE and sub-15 future PE, the company is undervalued. With good growth happening abroad, restructuring done, and demand still strong at home, we believe HOG looks great and should be bought on this discount.

HMC operates with a PE of 14 and future PE of 8. F operates with a 2.5 PE and 6.5 future PE. ACAT operates with PE of 13.6 and future PE of 10.8, and PII operates with 20 PE and 16.4 future PE. HOG is fairly middle ground with its more direct recreational companies, which makes sense as they have better growth rates and margins than bigger names like Ford and Honda.

Source: Harley-Davidson: Best Buy In Auto Manufacturing, Should Improve 25% In 2013