Pigs Get Fat, What About HOG?

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 |  About: Harley-Davidson, Inc. (HOG)
by: Ockham Research

Harley-Davidson (NYSE:HOG) is surging nearly 10% higher thanks to RBC Capital Market’s analyst lifting his price target on the stock from $32 to $36. The research note points to the fact that Harley has lagged behind many other leverage-dependent consumer stocks, and they have faith in the restructuring plan in place. That being said, the stock has been on an absolute tear of late, jumping more than 25% since the beginning of March; more than quadrupling the return of the S&P 500 index. Part of the optimism is due to a rumored private equity buyout, but those rumors have failed to materialize into anything concrete as of yet.

This particular analyst note caught our eye because at a price of $36, we would almost certainly downgrade Harley to our overvalued stance. As it currently stands, we have a neutral or Fairly Valued rating on HOG, but we have to acknowledge that the price appreciation has come in the absence of any real improvement in fundamentals in the last month. The stock has been the subject of buyout rumors and received analyst attention, but they have notHOG raised guidance or shown that business is going better than expected. Coincidentally, it brings to mind the old warning to investors, “pigs get fat, and hogs get slaughtered.”

Looking at the way the market has historically valued Harley-Davidson, it appears that the valuation is starting to get just a bit too rich based on our methodology. For example, over the past ten years (with the more recent years weight more heavily) HOG has traded for 11.1x to 23.7x cash earnings per share, and the stock currently sits near the high end of that range given current estimates. We anticipate Harley will earn about $1.45 in cash in fiscal 2010 when stripping out non-cash expenses such as depreciation, amortization, etc. This cash earnings figure represents quite a rebound from fiscal 2009 where the company missed consensus analysts’ estimates in all four quarters, badly in three of them. As an interesting aside, a historical study of price-to-sales actually signals the opposite, as the current metric stands at 1.8x at the low end of the historical range of 1.8x to 3.3x. We would be surprised to see the market continue to reward HOG with a premium price-to-sales multiple in this environment with sales still sluggish.

As of this week’s report, we are reaffirming our Fairly Valued stance on Harley, but we will know more when the company reports 1Q earnings on April 20th. Harley-Davidson has already said they expect shipments to be down 24% to 30% from the first quarter a year ago. Much attention will be paid to the performance of Harley Davidson Financial Services unit, which has been a major source of losses since the downturn began. However, the amounts of losses have been shrinking and in the fourth quarter were just about $7 million, if HDFS can turn a profit it would provide a boost to the stock.

The problems with Harley’s business model are well documented. An aging target market and consumers’ lack of disposable income from disappearing home equity loans have hurt sales greatly. Perhaps the biggest issues we see for HOG is the balance sheet deterioration that has occurred over the course of a few years. Long term debt has more than quadrupled in the last three years as they have restructured the company. A debt ramp up such as this would not be such a concern if it was offset by rising sales, but in fact it is just the opposite; sales have continued to slide since their peak in 2006. These concerns over the balance sheet makes this stock look even more risky than just our valuation concerns. This is a red flag for any investor and a condition that cannot continue indefinitely. Any further price appreciation in the short term (barring a major upside surprise in 1Q) will make us strongly consider a downgrade.

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