Harley Davidson: Too Cost-Heavy For Comfort

The two most important factors that go into buying companies are moat and margin of safety. You could, and likely will, be wrong on your future owner earning projections. You may be overly optimistic or overly cautious and end up buying too soon or passing on a great opportunity.

Your moat helps promote consistency. Your margin of safety helps minimize losses. Still, there's a business in there and we need to look at and understand it as well. Such is the case with Harley Davidson.

I don't know how popular Harley Davidson (HOG) is outside the U.S. (I never saw any in Europe when I visited), but it is a staple of our society in the U.S. Nothing says 4th of July like 500 hogs piercing our ears as they cruise down the street.

Justin had put this comment out there:

I've been using your spreadsheet with a few companies to try and get a feel for how it works. For HOG, for instance, I get a per share value of $91.28. The median growth in FCF, however, was a hefty 16.1%.

While continued growth for the next ten years at that rate is possible, of course, in my judgment (best guesstimate based on my research, really, I'm no pro) it seems likely that the growth of HOG may be slowing.

I'm sure there is no pat answer for my question, but I'm interested to hear your thoughts. I would like to lower my estimation of the growth of FCF for HOG over the next 10 years, to build in a more comfortable margin of safety, but I don't know what factors to consider to come to an appropriate estimation. I've plugged in various percentages to see how that affects the per share value, but I don't know how to evaluate which one I should use.

First...The Numbers

HOG has grown considerably over the years. Owner earnings have been through the roof and shareholder equity has chugged along more than 22% a year for 15 years. CROIC has been on the rise too, tripling to a healthy high teens and better. It's no wonder that HOG has been growing.

Next...The Chart

If you look at the below chart, you'll see the stock price (market cap) of Harley Davidson vs. its intrinsic value (using a 15% discount rate). The intrinsic value uses the actual results of operations for the past years, and assumes 13% growth for years 1-10 and 3% growth for years 11-20. (Here's the PDF of the chart.)

It looks as though, using the above assumptions, Harley Davidson is fairly priced right now. To generate a high return on HOG, you'd have to be spot on in your assumptions and Harley would have to meet or outperform your expectations.

Finally...The Business

Is Harley Davidson a wonderful business? I think so. Still, I see a problem: Capital Expenditures eat up about 40% of owner earnings. That has been lower in recent years; but, back in the late nineties, CapEx was eating up as much as 80% of owner earnings.

Here's the potential problem: If Harley Davidson goes through a few lean years (as most businesses do in their natural cycle), their capital expenditures will still be relatively large. If that proves to be the case, owner earnings will suffer.

The Result

Harley Davidson is a wonderful, growing company. That will probably continue to be true. Still, there is no margin of safety and we don't know how CapEx will eat into owner earnings in the future. High CapEx businesses are generally bad investments (think auto manufacturers and airlines) because they have massive costs and little moat. Harley has high costs but a very nice moat.

In my opinion, Harley Davidson is a cost-heavy business and I wouldn't buy. There are plenty of other companies out there that have similar financials, but lower CapEx. When times turn rough, those low-cost businesses will tend to weather the storm a little more easily and will generally begin growing sooner than their high-cost counterparts.

Changing The Assumptions

If we were to change our assumptions, we'd end up with a different picture. For example, if we slap a 9% discount on our valuation, HOG appears to be at a 30% margin of safety. Then again, with a 9% discount rate, we need a 50% MOS.

This game of "fudging the numbers" can be played to justify the unjustifiable. That is precisely why we need to look into the business as well. No matter how much you play with the data, you need to have the reasoning as well. When tough times come for Harley Davidson again, as they tend to come for all businesses from time to time, it will still have to shell out money for its CapEx.

Don't go with your gut—go with your data and reasoning.