Harley-Davidson Q2 2007 Earnings Call Transcript

| About: Harley-Davidson, Inc. (HOG)
Wall Street Breakfast

Harley-Davidson Inc. (NYSE:HOG)

Q2 2007 Earnings Call

July 19, 2007 9:00 am ET


Mark Van Genderen - IR

Jim Ziemer - CEO, President

Tom Bergmann - CFO

Larry Hund – CFO, HDFS


Hakan Ipekci - Merrill Lynch

Craig Kennison - Robert W. Baird

Tim Conder - AG Edwards

Felicia Hendrix - Lehman Brothers

Robin Farley - UBS

Ed Aaron - RBC Capital Markets

Bob Simonson - William Blair

Tony Gikas - Piper Jaffray



I would like to welcome everyone to the Harley-Davidson conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Mark Van Genderen, Director of Investor Relations. Sir, you may begin your conference.

Mark Van Genderen

Good morning. Welcome to Harley-Davidson second quarter 2007 conference call. Over the course of the next hour, we will comment on our second quarter financial performance, Harley-Davidson motorcycle retail sales, the introduction of the 2008 model year motorcycles and other thoughts about our business.

Harley-Davidson's CEO, Jim Ziemer, will speak to you in a moment, followed by CFO Tom Bergmann, who will share the financial highlights of the quarter and the outlook for the rest of the year. Tom will be followed by Larry Hund, CFO of Harley-Davidson Financial Services, who will talk about the performance of that business unit. Jim Ziemer will wrap up our prepared comments, sharing his thoughts on our outlook for the future. We will then open up the phone lines for questions.

Before we begin, I would like to remind you that this call is being recorded and a replay will be available after 11 am Central Time this morning. Please dial 973-341-3080 and enter PIN number 8942410, followed by the pound sign. The recording will be available through July 26th. It is also being webcast live on Harley-Davidson.com. The webcast will be available for replay throughout the next several weeks before being archived on the Investor Relations section of the Harley-Davidson website.

Our comments today will include forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters we have noted in our latest earnings release and filings with the SEC. Harley-Davidson disclaims any obligation to update information in this call.

Now I would like to turn the call over to the CEO and President of Harley-Davidson, Inc., Jim Ziemer.

Jim Ziemer

Good morning and welcome to our second quarter conference call. Tom, Larry and I returned just last week from Nashville, having spent four days at our summer dealer meeting with approximately 5,000 representatives from our worldwide dealer network. There is no doubt that they are fired up about the new 2008 model year motorcycles we introduced to the marketplace a week ago Monday.

Before I get ahead of myself and tell you about the additions and enhancements to our motorcycle line up, I would like to turn the call over to Tom, who will share in more detail the financial and retail performance of the quarter.

Tom Bergmann

Thanks, Jim. Good morning, everyone. We are very pleased with the financial results of the quarter and the retail sales at our dealerships in the international markets. As you can imagine, we are disappointed in the retail sales performance in the United States, which I will touch on shortly.

Revenue for the quarter was $1.62 billion, or up 17.7% compared to the year-ago quarter. Net income was also up at $290.5 million, an increase of 19.3%. Earnings per share were $1.14 or up 25.3% and during the quarter, the company bought back 6.7 million shares of our common stock at a cost of $430 million.

Now turning to the second quarter of 2007 results for the motorcycles and related products segment compared to the second quarter of 2006, wholesale Harley-Davidson motorcycle shipments were 95,117 units, an increase of 19.2%. Looking at shipment mix in the second quarter; touring volume was 36.5% for the second quarter of 2007, compared to 34.3% in the second quarter of 2006. Second quarter 2007 custom shipment volume, representing our Softail, Dyna and VRSC motorcycles, was 41.3% compared to 46.0% for the second quarter of 2006. Sportster motorcycle mix was 22.2% of the total mix for the quarter, compared to 19.7% during the second quarter of last year.

Domestic shipments of 67,951 units for the quarter were up 17.1% from the second quarter of 2006. This shipment volume represented 71.4% of the total volume shipped to dealers, down from 72.8% from a year ago.

International shipments of 27,166 units were up 24.9% compared to the same quarter last year. These international shipments represent 28.6% of our total second quarter shipment volume, compared to 27.2% in the second quarter of 2006.

As we have previously stated, we expect that on annual basis our international shipment growth rate will continue to increase at a faster rate than our domestic shipment growth rate to support our dealers’ strong international growth.

When combining first and second quarter 2007 shipments, you see that our shipment growth rate is 2.2% for the first half of the year, despite the strike at our York facility in the first quarter. This increase in shipments in the first half of the year was primarily due to two things, and they will both have an impact on shipments in the second half of 2007.

First, as previously mentioned, due to the strike we added a week of 2007 model year shipments compared to 2006 model year shipments in last year's second quarter. This will result in one fewer week's worth of shipments in the third quarter of 2007 compared to 2006.

Second, Harley-Davidson's fiscal calendar for the year has one additional week of production in the first half of 2007 and one less week in the second half of 2007. This will result in one fewer week's worth of shipments in the fourth quarter of 2007 compared to 2006.

So the net result is two fewer weeks of 2008 model year shipments in the second half of this year compared to 2007 model year shipments in the second half of last year.

As I look to the third quarter of 2007, we anticipate wholesale shipments to our dealers of between 91,000 and 95,000 Harley-Davidson motorcycles. This compares to 97,046 units in the third quarter of 2006. This expected year-over-year decrease can primarily be explained by having one fewer week's worth of shipments that I just mentioned.

Now turning to the financials for the motorcycles and related product segment. Revenue from Harley-Davidson motorcycles was $1.25 billion, up 22% compared to last year's second quarter. Increased model year pricing and favorable currency, partially offset by promotional costs, helped to drive an average revenue per Harley-Davidson unit increase of $305 or 2.4% from the year-ago period.

Parts and accessories and general merchandise both delivered positive results in the second quarter. Parts and accessories revenue was $263.4 million for the quarter, which is up 4.6% over the year-ago quarter. This group continues to focus on how Harley-Davidson's customers can personalize their motorcycles to make them uniquely their own and enhance their customer experience. General merchandise revenue was also strong at $72.7 million, an increase of 8.4% or $5.6 million.

Let's take a look at margins. Gross margin in the quarter was 37.4%, virtually flat with the 37.5% in the second quarter of 2006. During the quarter, higher pricing and favorable currency were offset by promotional cost and higher material charges. Operating margin improved from 23.6% in the second quarter of 2006 to 23.8% in the second quarter of 2007, as operating expenses grew at a slower rate than revenue.

The company's second quarter effective income tax rate was 35.5%, compared to 36% in the same quarter last year. This decrease primarily reflects the reinstatement of the Federal Research and Development Tax Credit.

All in all, net income was $290.5 million in the second quarter, or up 19.3% or $47.1 million from the same period last year. Diluted earnings per share for the second quarter were $1.14, an increase of 25.3% from the year-ago period. As you know, the company's financial strength and cash flow generation are exceptional. Operating cash flow for the first six months of the year was $1.06 billion. This compares to $825.6 million in the first six months of 2006. This increase was primarily driven by securitizing $220 million more in motorcycle loans during the first six months of 2007 compared to the first six months of 2006.

For the first six months of 2007, depreciation was $106 million, and capital expenditures were $86 million. This compares to $108 million in depreciation and $89 million in capital expenditures for the same period in 2006.

For the full year of 2007, we continue to expect capital expenditures in the range of $300 million to $325 million. Expenditures related to the expansion of our Big Twin powertrain facility and the construction of the Harley-Davidson Museum are the primary drivers of this increase in capital spending, compared to the last several years.

Turning to our share repurchases for the quarter. During the quarter, the company repurchased 6.7 million shares of its common stock at a cost of $430 million. We believe share repurchases continue to be a good use of cash and an efficient way to return value to our shareholders. At our current share price, we intend to continue our share repurchase activity.

As of July 1, 2007 there were 15.2 million shares remaining on a board-approved share repurchase authorization. An additional board-approved authorization is also in place to offset option exercises. As of July 1, 2007, the company had 251.2 million shares of common stock outstanding.

Let's turn to the retail environment. On a worldwide basis, retail sales of Harley-Davidson motorcycles were down 1.2% for the quarter compared to a year ago, or about 2,500 units. In the U.S., retail sales of new Harley-Davidson motorcycles decreased 5.5% in the second quarter of 2007 compared to the same period in 2006. A decrease in sales is never desired, and we are disappointed with the retail results in the U.S.. Although we gained share in the second quarter, we would like that to happen as a result of us growing faster than the industry, not by our sales declining less than those of the industry.

On the other hand, we have many reasons to be optimistic for the future. April was the toughest month at retail during the second quarter, and we saw improvement during May and June. As Jim mentioned and we'll talk about later, we recently introduced an exciting 2008 model line up and our plans for the 105th anniversary are really coming together.

Taking a look outside of the U.S., our belief that international will grow faster than the U.S. continues to be proven out. International retail sales for the second quarter grew 13.6%. Europe was once again strong with year-over-year sales increase of 13.7%. Canada was up 9.9%, Japan was up 5.2% and the remaining 45 or so countries where our motorcycles are sold were up a collective 27.4%. This growth is evidence that our investments in international markets are continuing to pay off.

To wrap up; when we look at the remainder of 2007, combined with our performance for the first six months of the year, we continue to expect that earnings per share for the full year will grow between 4% and 6%. This expectation is based on moderate revenue growth, lower operating margins and the benefits of our strong free cash flow.

As we look further out, specifically to 2008 and 2009, we believe that we will continue to grow revenue and that international Harley-Davidson motorcycle shipments will grow at a faster rate than U.S. shipments. We expect that we will continue to expand operating margin. We believe that the company will continue to deliver earnings per share growth of 11% to 17% in 2008 and 2009.

While we continue to have confidence in this guidance, based on what we know today, the bottom line is that retail sales drive wholesale motorcycle shipments. For the first six months of this year, our dealer's retail sales results have been mixed. Although international retail sales are once again up double-digits, worldwide dealer retail sales are down 1.2%, and in the U.S., retail sales are down 5.7% year-to-date.

With this context in mind, while we continue to expect worldwide retail sales to grow for 2007, we will proceed with caution. We will continue to closely monitor the retail environment and regularly assess our planned wholesale shipments throughout the remainder of the year.

With that, I'll turn it over to Larry Hund to discuss the Harley-Davidson Financial Services results for the second quarter.

Larry Hund

Thanks, Tom. Harley-Davidson Financial Services delivered second quarter operating income of $65.2 million, an increase of $9 million or 15.9% compared to last year's second quarter. This increase is primarily due to a higher securitization gain, increased wholesale and retail net interest income, and an increase in fee income from securitization servicing and credit card licensing fees.

For the first six months of 2007, HDFS originated $1.7 billion in retail motorcycle loans, an increase of 9% over the same period in the prior year.

Our retail market share in the United States related to new Harley-Davidson motorcycles, grew to approximately 53% for the first six months of 2007, compared to 48% for the first six months of 2006.

Our dealer loyalty program, called Performance Network, which rewards dealers for doing more business with HDFS in our wholesale, retail and insurance products continues to be very popular and was a significant factor in driving this market-share growth. In addition, increase promotional activity during the month of June also contributed to the higher market share.

In the second quarter of 2007, HDFS sold $950 million of retail motorcycle loans through securitization and realized a gain of $19.5 million. This gain is $8.6 million higher than the gain recorded on the securitization of $800 million of retail motorcycle loans in the second quarter of 2006. The gain as a percentage of loans sold increased to 2.05% for the second quarter 2007 securitization from 1.36% for the second quarter 2006 securitization. The higher gain percentage is due to increases in lending rates and a more favorable market interest rate environment.

Looking ahead to our third quarter securitization, we expect a lower gain as a percentage of receivables sold than we realized in our first two securitizations in 2007. Market interest rates have increased since the second quarter securitization, which will lower the net margin on our next transaction. In addition, the increased amount of promotional loans, a large percentage of which are shorter-term contracts, will also negatively impact the gain percentage.

As we discussed in previous quarters, HDFS continues to operate in a challenging consumer credit environment. Regarding past due accounts, the 30-day delinquency rate for managed retail motorcycle loans at the end of the second quarter was 4.36%, compared to 3.61% for the second quarter of 2006. Managed retail loans include both those which we keep and those which we sell through securitization.

As expected, credit losses on managed retail motorcycle loans increased in the first six months of 2007 compared to 2006. Losses totaled 1.63% on an annualized basis, compared to 1.2% for the first six months of 2006. The increased losses are due to continued pressure on recovery values for repossessed motorcycles, as well as a higher incidence of loss, primarily driven by the increase in delinquent accounts.

HDFS has taken significant actions to manage portfolio quality in this challenging credit environment. We evaluate and adjust our underwriting and pricing on an ongoing basis to make sure we are appropriately balancing risk and return in all credit tiers. We have upgraded the experience and depth of our collections management team, hired additional portfolio management staff and outsourced a portion of the early stage collection activity.

In addition, we have strengthened our capabilities in the areas of fraud management and remarketing of reposed motorcycles. While this continues to be a more difficult credit environment, we believe we are taking appropriate steps to manage through it. Overall, this was another good quarter for HDFS, as demonstrated by our growth in market share and operating income.

With that, I'll turn it over to Jim Ziemer, President and CEO of Harley-Davidson Inc.

Jim Ziemer

Thanks, Larry. No one argues that these are challenges times in consumer lending and for the U.S. economy in general. I appreciate the great results that HDFS has delivered for the company this quarter.

Over the years, Harley-Davidson has distinguished itself as a premium brand, the ultimate choice in motorcycling; the only choice that includes a complete lifestyle experience. The Harley-Davidson brand is admired the world over. It's a very strong position to be in. This morning I would like to talk with you about three things that underpin the strength of our brand and why they are so important.

First, balancing supply and demand; which includes having the right product in the right place at the right time.

Second, achieving retail excellence, which is the entire experience our dealers offer.

Third, ensuring that our motorcycles lead and define the heavyweight motorcycle industry. All of these dynamics contribute to our strong brand position.

First regarding worldwide supply and demand, I have made a commitment to our worldwide dealer network related to the motorcycle shipments we make to them. I have assured our dealer network that we will not ship more Harley-Davidson motorcycles than we expect that we will sell this year. I believe this to be critical in helping them better manage the business, maintain industry-leading profitability and create strong demand for our products.

We are also taking steps to improve our ability to get our motorcycles into the right places at the right time. Market demand for Harley-Davidson motorcycles has always fluctuated around the globe at any given time, region by region and also within region, and from market to market. Those differences have been amplified this year, as many of our U.S. dealers face a tough economic environment. We found ourselves with dealers who had way too many motorcycles, while other dealers were sold out well before the model year came to a close.

At the same time, most of Harley-Davidson's international markets continued their rapid growth. The appetite for our product has been almost insatiable in some of the international markets.

Today's environment requires a dealer allocation process that is more flexible and better able to distribute motorcycles based on demand in individual dealer markets. During the second quarter, we announced a new U.S. motorcycle allocation system to our dealers. Previous systems served us well for many years, but those were different times with different market conditions.

The new system is more market-driven, and includes assessing a wealth of relevant data. It is much more forward-looking than the previous process. With this data, our dealers, along with the help of the company, will develop an individualized annual sales plan and those plans will be updated several times during the year.

In the dealer meeting last week, dealers seemed to feel the new allocation process is going to work well, because it's much more customized to their markets.

The second factor that we believe has growing significance for our brand is retail excellence. Retail is where rubber meets the road for our business. We must provide a premium purchase and ownership experience at the retail level. While ultimately the dealers are independent and in control of their own businesses, it is our role to give them the tools to stand apart as the very best. There is an expression that the sale begins after the sale. At Harley-Davidson, a large part of striving for retailing excellence is helping our dealers develop strong bonds with the customers well after they've sold them a motorcycle.

One way we help is by giving them a continuous stream of fresh ideas for events. The goal is to build those connections with customers while creating life-long memories for them. You already know that Harley-Davidson excels in this arena and this year we are once again taking our customer relationship-building to a higher level.

One of the things we're doing is to help dealers track different types of customers like women, young adults, and minorities by assembling all of the best practices we've learned from marketing pilots. Innovative concepts like urban street parties for young adults and garage parties for women are among the ideas included.

Of course, next year marks another anniversary milestone for Harley-Davidson enthusiasts. In Nashville, we gave the dealers an exciting preview of our plans for the 105th celebration. The anniversary cross-country ride and the party will take place in the days and weeks leading up to Labor Day weekend next year. It will include large numbers of dealerships that are on or near the 105 different ride routes leading to Milwaukee. Once again, no one does it like Harley-Davidson.

Speaking of creating memories for customers; construction of the Harley-Davidson Museum is well underway. There will be another significant opportunities for dealers, whether it's organizing an annual ride to Milwaukee with the customers or hosting their own customer events on the grounds. Excitement is building for the grand opening next summer. When it comes to great motorcycling experiences, Harley-Davidson is unrivaled.

To help our dealers achieve a new standard in retailing excellence, there are also important infrastructure changes being made. Late last year our North American sales organization began to undertake a comprehensive assessment of the capabilities. One of the major outcomes of that study has been to develop a sophisticated set of business performance tools to help dealers evaluate the business metrics.

Another was a restructuring of the sales organization. In summary, the entire internal sales organization and the field sales force are now galvanized around supporting dealers' retail needs. That is the primary reason for being and some 40 new positions have been added to our domestic sales organization to allow us to do a better job of driving retailing excellence at the dealer level.

As I often say, we have the best dealer network in the motorcycle industry by far; but to continue to be the best, we're taking another giant step forward with this change.

Another significant piece of news is that we have selected Marc-Hans Richer as Chief Marketing Officer for our organization. Marc-Hans is a Harley rider and was most recently at General Motors, where he was responsible for the marketing of all Pontiac products. He is well-known in the marketing circles for innovative and non-traditional marketing strategies. He will be on the ground in Milwaukee at the end of this month.

Now I would like to spend a few minutes on our exciting new 2008 model year products that we just launched at the summer dealer meeting last week. We all know that new products help drive retail sales and the dealers literally roared their approval last week when we unveiled the 2008 models.

Let me start with our exciting 105th anniversary models, which are decked out in a unique, instantly recognizable paint scheme. Anniversary models have always created a lot of customer interest and floor traffic. This time around, the number of anniversary models will only represent about 10% of our total production, so they will be scarce and in high demand. Our plans call for all anniversary models to be shipped to dealers before the 2007 year end.

Taking Harley-Davidson's custom leadership to a new level, the 2008 model line includes three new models, each with a unique profile and distinct look. The all new Dyna Fat Bob takes advantage of the nimble, lightweight Dyna chassis, which has always provided great riding. But the Fat Bob takes Dina styling in a totally new direction. It screams “cool custom”.

Two all-new models, the Rocker and the Rocker C , will also stand out in the crowd because they are so different from anything available in the motorcycle industry today. The most unique feature of the motorcycle is a rear fender that moves with the wheel, creating a slammed lower look. Our engineering and styling groups created a great look for the Rockers by working together to incorporate a new rear suspension called the Rocker Tail. Between the two models, Rocker and the Rocker C, we expect to attract two different types of buyers.

We have big news in the touring end of our product line, too; it is a huge leap forward in technology. Our product development goal was to give our customers more reasons to stay in the saddle longer. Since touring is all about being on the open road and enjoying the ride, we have added a whole slew of significant enhancements to the top end of our product line.

Some of the more high-profile features are a larger capacity, six-gallon fuel tank, cable-less throttle, and an optional anti-lock braking system. These are features that serious touring riders will really appreciate.

There's also exciting news for the V-Rod family. For 2008, the whole family is fitted with a 1250cc Revolution engine. Originally designed for the CVO Screamin' Eagle V-Rod, this engine is tuned to produce up to 125 horsepower. All of the 2008 V-Rod models have a new clutch design that reduces clutch effort by more than 20%. Since performance is such an important factor for the typical V-Rod buyer, they will love all of this.

There's also big news on the XL platform, especially on the international front. The XL 1200 Nightster, which we launched in the U.S. this spring, will now be available on international markets.

The European dealer network was thrilled to hear that the new high-performance XR 1200 that we prototyped and unveiled at the major motorcycle shows there last fall will go into production sometime next year.

All of these new products and technology are coming to market worldwide and only at a 1.5% average price increase. Remember, these enhancements are in addition to the twin cam 96 engine and the six-speed transmission introduced last year on all of our Big Twin models.

So you see, we'll continue to lead and define the heavyweight market, our product plan looks well into the next decade, and the roll-out is timed to create excitement at every turn.

The big product news isn't limited to Harley-Davidson. Buell Motor Company celebrated its 25th anniversary last week by introducing its first liquid-cooled motorcycle, the 1125R. The new engine is the most powerful engine ever offered by Buell, putting out 146 horsepower.

Since a picture is worth 1,000 words, I encourage you to stop by our dealership to attend one of the numerous events that our demo fleet is supporting this summer, or just check out our websites. You really need to see them for yourself.

So as I think about the initiatives I have described to you today, I believe we continue to be headed in the right direction when it comes to balancing supply and demand, which includes having the right product in the right place at the right time; achieving retail excellence, which is the entire experience that dealers offer; and ensuring that our motorcycles lead and define the heavyweight motorcycle industry.

Bottom line, I am very enthusiastic about our future. It's true, there are some lingering questions about the economy and consumer confidence here in the U.S., but I believe there is plenty of room to significantly grow demand in all of our markets throughout the world for years to come.

With the most passionate employees, customers and dealers in the world, our great brand with global appeal, motorcycles that are sought after around the world, and incredible opportunities for future growth I'm excited and optimistic about our long-term success.

Operator, I will now open it up for questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Hakan Ipekci - Merrill Lynch.

Hakan Ipekci - Merrill Lynch

With respect to your second half guidance, do you need to see improvements in the market relative to the first half to be able to achieve it, or is status quo sufficient? Can you give us an update on your negotiations at the Kansas City union? Thank you.

Jim Ziemer

In terms of the second half of the year, there's no doubt that we are looking for improved retail sales in the U.S. market. As I just went over, all of the things that we have introduced, coupled with the 105th anniversary, the events, the excitement around the events that dealers can start planning for the 105th. I think with the retail experience and the products, we have great confidence that retail activity will pick up. But, again, we will focus on the reality of the current market, and continue to reevaluate what is going on.

As for the question on negotiations in Kansas City, our Kansas City contract expires August 1st, next month. We are in negotiations and can't comment on those negotiations, but we look forward that they continue to go to a good outcome and not have an interruption in any production.


Our next question comes from Craig Kennison - Robert W. Baird.

Craig Kennison - Robert W. Baird

Dealers are telling us that some bikes are beginning to sell below MSRP as their inventory builds. What does your internal data show?

Jim Ziemer

As I mentioned in my part of the conference call, there's no doubt that with the changing market, that some areas of the market have more inventory and other areas have none, or virtually none. There is an imbalance market to market, dealer to dealer and with this new allocation system, we hope to go after that.

With imbalances, there will be different selling practices from dealers. But as we monitor this, on average, our motorcycles are selling at MSRP which means if there are any bikes selling below, there are some bikes selling above. Obviously, that's mathematical.

So again, there are some imbalances at the dealer, and we hope to work our way out of that with the new allocation system. That will take some time.

Craig Kennison - Robert W. Baird

With respect to your retail demand; can you attribute the weakness to anything in particular? In particular, is there any more pronounced weakness with less affluent customers or customers with weaker credit?

Jim Ziemer

As we look at retail demand, I mean, there's no doubt we started the year out soft in the first quarter, and we attribute some of that to weather. We're not going to do that for the second quarter. As we look at it, there's no doubt that we look at things that drive the economy, whether they be gas prices or interest rates or consumer confidence. Those certainly have had some implications on the market and we'll continue to watch those things. Those are things, obviously, out of our control. We'll monitor those things. Again, as for information consumer by consumer, we don't have that at the moment but we do measure that, and we'll measure it as we go along.


Our next question comes from Tim Conder - A.G. Edwards.

Tim Conder - AG Edwards

Tom, if you could just give us a little bit of color, you said foreign currency benefited the quarter; whether you want to give that on a sales, EBIT basis, or whatever, just a little bit of color there. Also as it relates to any material surcharge on a year-over-year basis in the quarter?

Jim, you alluded to it and we have heard from dealers coming out of Nashville that in your presentations to them you mentioned two things: that you are going to help them enhance the scarcity factor, and I think you alluded that's going to be new products. And then also you said that the promotions, you will not go towards the automotive model, and that those are going to end. Just a little bit of added color on that, if you would.

Tom Bergmann

On the currency impact during the quarter, if you look at the currency impact on motorcycle revenue, it's about $18 million on the revenue line and on the EBIT line, it's probably about $12 million or so. Raw material surcharges in the second quarter were just over $7 million compared to a year ago.

Jim Ziemer

As to some of the other questions you directed to me. On the topic of scarcity, another way to look at it number one, I did talk about it in the preamble here; the 105th anniversary editions of our motorcycles. In 100th anniversary, virtually most if not all of our bikes were anniversary editions; we have chosen to take a different approach whereas approximately 10% of our models will be anniversary editions. We hope to get those all out before the end of the year so that this drives traffic.

Undoubtedly, going from all anniversaries to 10%, these will be in great demand, and dealers will be able to generate great excitement and create open houses and events to bring customers in to see the new anniversary models as they come in.

Also when we look at the new Rocker models -- the Rocker, Rocker C -- we'll start shipping those out sometime in September. So we're not sending all of our new models out all at one time. We're trying to stagger those. We're sending them out during times of the year when they are more seasonally impacted and the floor traffic goes down, helping them to drive some floor traffic, create some scarcity, spread the models out.

Also, with some of the ideas we have generated about rides for the 105th and how they can do different events scheduled around getting people in to join lotteries or whatever, stuff like that, so a lot of things on when we introduce product, how we introduce it, how much of a product and the programs that support that.

Your question on promotions; there's no doubt that we had a midsummer promotion in June and July. As we looked at it as Tom pointed out, retail activity was slow starting out the second quarter. We did not want to have a build-up of '07 model year product standing in front of the '08 introduction so we wanted to address that particular issue, reducing the number of '07 product out there. So it was directed at an issue.

That is certainly not a change in the way we're going to go to the market and we intend to go to the market. This again is a premium product and we want to continue to promote it that way. So this was not a change in our philosophy, but just addressed at one particular issue.

Tim Conder - AG Edwards

One other question relating to HDFS; do you see the sub-prime mix as a percent of the overall portfolio going up in the third quarter? It ticked up quite noticeably in the second quarter, securitization, 35%. How do you see that going forward?

Larry, you had alluded to even in the third quarter of last year that you would see the credit losses go up in '07 versus '06. Where do you see that year-over-year leveling off?

Larry Hund

As we talked about on the first quarter call, we had seen I would say roughly up to a 5% shift between the A and B credit tier versus the C and D in the early part of the year. Now with some of the promotional activity that Jim just talked about, that actually is driving a lot of high quality credit borrowers into the dealerships. So the third quarter, I would actually see maybe a slight shift towards little bit higher credit quality overall than maybe what we saw on this most recent securitization. But we'll see how that promotion plays out.

Tim Conder - AG Edwards

You said that we should see the mix of the customers in sub-prime go up or down in the third quarter?

Larry Hund

We should actually see the mix of sub-prime probably go down a little bit in the third quarter because the promotional activity is really driven towards the prime-based customer.

Regarding credit losses, we have told you in advance that we expected losses to go up this year, and that's playing out pretty much like we expected. That increase in losses is really driven by lower recovery values and also some of the pressure on the consumer we have seen. But as far as giving a specific range or target, we're really not prepared to do that.


Our next question comes from Felicia Hendrix - Lehman Brothers.

Felicia Hendrix - Lehman Brothers

I wanted to see if you could elaborate a little bit more on your new allocation program? We also talked to some dealers after the show and they were very excited about this, actually. They felt really empowered.

Jim, I was wondering if you could give some more color than you already provided us to that, maybe some specifics? What in your experience would be a realistic expectation of the time it would take for this new program to have a noticeable effect on the dealer network?

Finally, my second question is on gross margins. With the promotions pulling back, can we expect to see perhaps a gross margin increase year-over-year in the second half of the year?

Tom Bergmann

On the allocation system, as Jim mentioned, we're very excited about it, and the dealers have given us very good feedback when we rolled it out here in Nashville last week. So really what the allocation system is focused on is providing us more flexibility and helping us make sure we get the right motorcycles in the market at the right time and in the right places, and give us more flexibility.

Inventory allocation, as we have balanced supply and demand, is becoming more and more important to us so we really think is a big step forward. Our team internally here has done a lot of work on it, and has done a very nice job rolling it out to our dealer network.

Really what it will do is give us that flexibility. It is probably more forward -looking than our prior allocation system and it will be more customized, as well, for each of the markets, as we can take local market conditions and changes in demographics and changes in industry conditions in each of those markets. So we're pretty excited about it.

With any allocation system, it will take time. I think we'll see some short-term immediate impacts, but as we roll it out throughout the dealer network this year, we'll implement it and we'll learn from it and we'll continue to refine it as we go forward. So we think it is a good step forward.

Felicia Hendrix - Lehman Brothers

It's been my understanding with this new program too you are also just looking at each dealer on an individual basis, and if they have an ability to service their market or not, you look at their technical abilities, and that sort of thing. Is that the case, indeed?

Tom Bergmann

Yes, our allocation is always done on a dealer-by-dealer basis. This new allocation program will continue to work on a dealer-by-dealer basis. Our field sales force will work very closely with our dealers, and in the prior system and this system, we always take the customer experience into account and how that impacts allocation going forward, to make sure the dealer is providing that premium customer experience. So we have built in some of those types of metrics as well to make sure the brand maintains its integrity through the allocation system and we have the right customer experience.

Your second question was on gross margin, and the impact on promotions. I think you know we stopped giving guidance specifically on separate gross margin versus operating margin lines a few quarters ago. All we have said for the year, really, is that we expect operating margins for the full year to be down for 2007.


Our next question comes from Robin Farley - UBS.

Robin Farley - UBS

I wonder if you could help us manage our expectations about your concerns about retail sales and what it may mean for production? In terms of do you need see growth in third quarter retail sales in the U.S.? Or in other words, it is not going to decline for the third quarter or would it be just a lower growth rate?

Also, would any change in production mean a change in your earnings guidance? Since you give us full-year earnings guidance, not full-year production guidance, but in terms of what your internal expectations are. If those change, does that impact your full year EPS guidance?

Jim Ziemer

There's no doubt , on the first part of the question on retail sales growth, we're looking for a year-over-year improvement in the second half of the year on retail sales in the U.S. With everything we're coming out with, at this point in time we are highly confident in the models we put out there, the timing, the programs, the allocation system. I think we have got everything in place to give us great comfort on the guidance we're currently giving.

We're not going to speculate if there is a change. We have had great confidence in our guidance, but we need to be realistic in what is going on in the first six months, and we were disappointed in retail sales in the U.S. in the first six months.

Balancing those two things out, we have given the guidance, we have given the reasons why and also said that we will continue to monitor the market, because we didn't meet our expectations in the first six months. So we're being cautiously optimistic and letting everybody know that we will monitor the situation, and that's the basis from where we're going. We would not do a “what if” forecast on if something happens. Right now from what we see, what we have, the dealer feedback we've got, we are confident in the current guidance.

Robin Farley - UBS

Would you say there are several different ways for you to get to the EPS guidance that you have given for the year?

Jim Ziemer

In running any business, there's always many different ways to get to the bottom line. We'll run this business for the long term, and our biggest guiding light is running it for the long term.


Our next question comes from Ed Aaron - RBC Capital Markets.

Ed Aaron - RBC Capital Markets

I would like to actually get your thoughts on your business cycle from a little bit of a longer-term perspective. It seems likely that heavy weight sales in the U.S. will probably be down this year, I guess for the first time since the '90/'91 recession. It seems like it is hard to have confidence there would be one down year after a 16 or 17-year growth cycle. Curious to get your thoughts on that long-term outlook for your cycle.

Jim Ziemer

I'll go back to my previous answer to the last question from Robin Farley. I mean, we're expecting retail sales for Harley-Davidson to be up for the year. I can't comment on the industry, but what we have and the dealer network programs, support and everything else, we're expecting an up year. I'm not going to comment on the industry, but I think what we have in place, we're going to do quite well.

Tom Bergmann

Ed, I would just add to Jim's comments. From a long-term perspective and health of the overall industry; we think there's a lot of potential left in the sport of motorcycling and in the heavyweight industry. So we look at it long term and do all of our strategic analysis and work, and look at the number of people, the youth still coming into dirt biking and performance biking and the migrations they'll actually make over time into the heavyweight industry. All of those trends still remain very positive.

If you look at it overall, the enrollments in safety courses and so forth, those continue to trend positively. If you look at some of the early feeders into the sport of motorcycling and how those ultimately convert over into the heavyweight industry, we're still bullish that long term, this is still a very healthy industry and a good place to be.

Ed Aaron - RBC Capital Markets

Also, your commitment to shipping less than you are retailing this year; is that a worldwide commitment, a U.S. commitment, or does that go all the way down to the regional level?

Jim Ziemer

That's a worldwide commitment.

Ed Aaron - RBC Capital Markets

Last question, could you give us an idea of the number of bikes that you would have produced but not necessarily shipped in the second quarter versus last year? I just remember a year ago, you made a number of bikes in the second quarter what were then the model year '07s, that you didn't ship until Q3. I'm wondering how that might have fed into the quarter at all, on a comparison basis?

Tom Bergmann

Ed, we really don't break down the difference between productions and shipments. We had a little bit of a one-week timing difference this year in production schedule versus last year model year and this year, but I don't think we're going to give a specific number.

Jim Ziemer

If your question was on last year, we certainly can get back on it, we don't have that in front of us. But there was a difference as Tom said in his part of the conference call, there was a difference this year versus last year when we cut off the model year production and started shipping model year. So if you need more clarity, we can probably get back on last year, yes.


Our next question comes from Bob Simonson - William Blair.

Bob Simonson - William Blair

Larry, a couple of questions on Harley Finance, if you can. On the third quarter, I think you said you have an estimated gain. Can you share a number on that? Or at least remind us what it was last year?

Larry Hund

I don't have that number in front of me. But the gain in the third quarter I think was about 125, 130, somewhere in there. We can get back to you with a specific number.

We aren't giving out a specific number here for the third quarter this year, other than to tell you that directionally there are a couple of factors that are going to impact that gain based on the gains we realized in the first quarter and the second quarter of this year.

Bob Simonson - William Blair

Am I to take that it's going to be lower?

Larry Hund

Yes. I mean, if you think about it, since we did the second quarter transaction, market interest rates have moved up 25 to 30 basis points from the benchmarks that we use. In addition with the recent promotional activity, it's driving a lot of activity on shorter-term contracts. Those, if you think about it over the life of the contract, just generate less interest income. Also, a lot of those are to very attractive borrowers that are at more attractive financing rates.

Bob Simonson - William Blair

Second question, same area though. There's a lot of moving parts with what you are doing with your dealer system. How critical is it to you to improve the delinquencies and the credit losses, those ratios? If they don't, because of the economy, let's say don’t get better, would you give up market share to not have those ratios go any higher or conversely to improve them?

Larry Hund

I think what I would say, Bob, is we have a very attractive business model at HDFS. We always evaluate risk and return across all credit tiers. As you can see in the first half in the second quarter, that while we have had some increase in our delinquencies and in our credit losses, we have delivered, I think, very attractive financial results. So I think our business model is very sustainable and certainly has been able to sustain that level of increase in delinquencies and credit losses that we saw here in the first half of this year.

Bob Simonson - William Blair

Assuming they don't deteriorate because of the economy, let's say; you would not pull back on your efforts to promote and sustain and improve your market share?

Larry Hund

What I would say is, we continually evaluate market situations and we evaluate our pricing and underwriting criteria and our risk/reward and that's all done, really, on a very dynamic, ongoing basis. We'll make adjustments that we think are appropriate as we see changes in market conditions going forward.

Bob Simonson - William Blair

Jim, you have said in the past, I think that you said that Harley Finance should now grow about in line with your growth in domestic shipments. Other than changes in securitization, et cetera, or interest rates that are more cyclical in nature; is that still a good benchmark or not?

Jim Ziemer

I think you are going a little back in history, but at the same time we had reached I think a high 40s market share and Harley-Davidson Finance has gone from 2% or zero of our range up to 10%, 12%, 13%. We aren't expecting that kind of growth any more, and that it would be closer to the growth of the motorcycle business. We would not see it continue to grow at the rate it had grown before.

Tom Bergmann

About a year ago, I think last year's third quarter, we discontinued giving any specific guidance around HDFS.


Our final question comes from Tony Gikas - Piper Jaffray.

Tony Gikas - Piper Jaffray

You have made a handful of cautious comments today, and for the first time in years, I think you have had some cautious comments in the press release talking about sales didn't meet expectations and you are monitoring retail and you are going to assess shipments going forward. Could you just tell us what were your expectations for the quarter? Were you expecting growth at retail?

Trying to figure out where you would make a change. Last year in the September quarter, retail sales were up 7% on what was, in my view, a more significant change to the product line than we saw this year. So does it take one quarter of continued declines or is this something that probably takes a little bit longer to assess? Can you just shift more of the business to international, where you are really seeing some terrific growth there?

Jim Ziemer

In response to your first statement, really not a question; but this is really not the first time that we've brought some reality to what we're doing versus what is going on. I think if I reflect back in the last couple of years, there have been times when we were cautiously optimistic or whatever. I think we try to, over many years, to put some realism into every one of our conference calls.

We don't do a forecast on expectations or even on backward forecasts on what our expectations were. As we pointed out, we were disappointed. I can guarantee you we are not looking for a negative comparison on retail sales. Our expectations were certainly not in the negative territory for the second quarter.

Going forward, we will always monitor everything of what is going on. There's a lot of dynamics, but again I'll stick to the commitment that at the end of the day retail sales need to exceed our wholesale shipments for this year on a worldwide basis.

Thanks, Tony.

With that, I want to thank everybody for your time this morning. I appreciate your interest and your investment in Harley-Davidson. Now I would like to turn it back over to Mark for some final logistics.

Mark Van Genderen

Thanks, Jim. Remember that a taped replay of this conference call can be heard by calling 973-341-3080 and entering PIN number 8942410 followed by the pound sign, until July 26 or by accessing it on the Harley-Davidson website. If you have any questions, please contact me at Harley-Davidson's Office of Investor Relations at 414-343-8002. Thanks and have a great day.

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