By Jaime M. Katz, CFA
Harley-Davidson (HOG) faces demographic headwinds, an uncertain global economic environment, and increasing competition, which could make for a choppy ride in the near term. Still, we think the motorcycle manufacturer is set to see decent profitability growth once consumers recover from the economic downswing and are willing to once again spend on big-ticket items. We believe the shares are currently about fairly valued, but given a wide enough margin of safety, we would be buyers as we start to see stability in the employment and overall economic picture.
We believe operational changes are key to improving profitability over the long term. Management has made great strides in creating a best-in-class manufacturing process. Its new lower cost structure provides additional flexibility, which allows Harley to adapt production to marketplace demand and outsource processes when it makes competitive sense to do so. The company's restructuring is expected to yield savings of $300 million annually--equivalent to 7% of the total expense base. Harley's transformation strategy also includes two brand-boosting goals: improving brand acceptance by extending customer outreach, and maintaining leadership in the cruising and touring segments by increasing loyalty through innovative products and services.
The company's high-level financial objectives seem reasonable. Management aims to outperform the S&P 500 over time, increase earnings at a faster rate than revenue, and run a high-margin, high-return business. A few years ago we might have doubted these targets, but since CEO Keith Wandell took the helm in 2009, the manufacturing business has undergone major changes which, in our view, reset the company's earnings potential trajectory. The focus on increasing revenue through introducing new products and reaching a wider audience via international expansion makes us feel better about potential top-line gains over the longer term.
While shipments have reset to lower normalized levels, Harley can still squeeze out decent margin gains. Motorcycle demand remains soft, but we think management has taken appropriate steps to keep the company strong. Domestic shipments in the most recent reported quarter were still off more than 40% from the peak--there were 273,000 bikes shipped domestically in the trailing four quarters ending December 2006 and 146,000 bikes shipped in the trailing four quarters ending September 2011. But the company is still quite profitable, and the operating efficiencies that it has implemented will further rightsize the manufacturing capacity for market demand that might remain depressed for at least a few more years. We expect operating margins will return to their 10-year historical average of 21% in 2012, up from 4% in 2009.
Closer to Customers With Efficient Manufacturing
The restructuring that began in 2009 has allowed Harley to have a greater focus on the product with a lower cost structure. The workforce has become significantly more flexible, with all four lines at the York, Pa., manufacturing plant moving onto one production line and the company operating in an "any model, any line, any time" mindset. Also, a bigger proportion of the workforce is flex rather than full time. A surge shift that will be implemented at York when demand rises provides additional flexibility. We like the changes to the workforce, as this moves Harley away from the traditional unionized labor schedule it has historically employed and puts its labor cost structure more in line with some of its nonunionized competitors.
These manufacturing changes allow Harley to adapt more easily to its customers' preferences, which should help the maker maintain its strong leadership position. The company is using a multipronged approach to getting closer to the customer--especially as each bike becomes more like a customized order--and is striving to better accommodate the Harley rider while enriching the dealer base.
The company has strengthened its dealer base by mapping it on a very granular level, which allows it to focus on getting weaker dealers into a better position, which will then improve profitability across the board at the dealership level, while ensuring the brand is presented in the proper light at each location. Management has also focused on getting closer to its customers by using more customer and dealer input in product planning and reducing time to market with a new leaner engineering platform and more concentrated focus on product development. In the end, this all folds into delivering the right product in the right place at the right time in the right mix, which should also keep inventory balanced at the appropriate volume at the dealer level.
Harley's financing division has also seen a nice turnaround by carefully providing credit lines to dealers. Harley Davidson Financial Services has recovered quite nicely through the economic cycle and has implemented a number of support resources to ensure that dealers are able to continue to meet the needs of customers across the full credit spectrum. HDFS has done this with greater risk management, balancing risk and reward in each transaction; an increase in the dealer pre-owned business, which gets repossessed bikes back on the market; and a direct hand in floor-plan financing, with about $2 billion in credit lines available to dealers. Still, independent of how stringent or controlled HDFS becomes, when an economic slowdown occurs delinquencies will almost always increase, and that is a risk that Harley needs to take to ensure its customer financing doesn't disappear in tighter credit periods, when third-party credit providers can pull out.
Generally speaking, we find Harley's progress impressive, thanks to the dedication and focus of the management team. Motorcycle segment operating margins expanded from about 7% at the end of 2009 to 19% at the end of the third quarter, and the profitability of the overall company is projected to further improve through revenue growth and expanded gross and operating margins, which we believe is possible, considering the drastic steps the company has taken to rightsize the manufacturing business. Cash flow in the business is recovering from the low point of the recession, and the company increased the dividend 25% in April and repurchased 2.5 million shares in the most recent quarter.
Not So Easy Riders
Demographics are a key risk for Harley long term. The lion's share of bikes are still purchased by Harley's traditional rider, who is male and nearly 50 years old. While the outreach to different segments of the domestic market seems successful, these pieces represent a much smaller portion of the pie, and we remain concerned that a shrinking core consumer demographic might work against the company over the next 5-10 years.
We are concerned that the crucial 40- to 49-year-old domestic male demographic is forecast to shrink and then stagnate over the next 10 years. As these men move into the 50-59 demographic, we fear they might not be as inclined to replace their bikes as they may have been in the past.
Management's outreach effort has worked domestically, with Harley capturing share in the Hispanic, women, African-American, and young adult segments in 2010. But despite the recent success, we don't think this initiative will improve sales or profitability all that much, even if executed on a global level as management expects. Ultimately, the core male demographic remains the key driver in sustaining profitable growth.