Harley-Davidson Already Priced For Improvement

By Stephen D. Simpson, CFA | August 01, 2012 AAA

It's worth asking how long it's going to take Harley-Davidson (NYSE:HOG) to return to former glories. Nothing has really dented the brand value or product quality of this well-loved brand, but easy credit in the early and mid-2000s spiked demand and sales for these expensive motorcycles. Although a focus on lean manufacturing ought to improve long-term margins and cash flow conversion, investors may be expecting more of this company than the numbers can deliver.

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Second Quarter Results Show Seasonal Effects
Harley-Davidson did pretty well relative to expectations this quarter, though sequential performance was definitely impacted by unusually warm weather that pulled business into the first quarter.

Revenue rose 17% this quarter, with motorcycle sales growth reaching nearly 22%. Shipment growth was robust, as the company shipped 25% more bikes in total, with domestic shipments up 33% and international up about 11%. ASPs softened slightly, down 2.6% due largely to currency. U.S. retail sales grew a much more modest 4%, though, due to that aforementioned pull-forward in the first quarter.

Margins continue to come along nicely. Gross margin improved almost a full point, with overall operating income up 30%. Looking just as the manufacturing operations, operating income jumped 41%.

SEE: Understanding The Income Statement

Will Harley See the China Effect?
Unlike other aspirational brands, including Coach (NYSE:COH) and Tiffany (NYSE:TIF), China and Asia in general (outside Japan) has not embraced Harley-Davidson. On first look, this would seem strange - many U.S. brands have been very successful in these economies, and motorcycles are hardly scarce.

Right now, though, the laws do not favor Harley-Davidson. Many Chinese cities have banned motorcycles from downtown areas and they are likewise not welcome on many inter-city highways. It's also true that many cities and administrative regions (in and outside of China) will not allow customers to register bikes above a certain engine displacement size.

As time goes on, these rules should ease. One of the reasons that motorcycles are banned from many highways is that the small bikes cannot maintain safe or efficient speeds - not an issue for Harleys. Couple this with rising affluence and rising consumer power, and it does not seem outlandish to suggest that China and other Asian countries could become bigger markets for Harley-Davidson in the future.

In the meantime, Harley-Davidson is doing alright in Asia but could be vulnerable in Europe as this malaise continues. The company's share in Europe is well behind BMW (OTC:BAMXY) and Volkswagen's (OTC:VLKPY) Ducati (as BMW and Ducati have small share in the U.S.), but the company continues to hold its own with Polaris (NYSE:PII), Yamaha (OTC:YAMCY) and Honda (NYSE:HMC) in North America.

A Leaner Base and Logical Restructuring
Plenty of companies seem to think that simply firing bunches of people and making the survivors work harder counts as "restructuring." Harley-Davidson has gone further. While the company has fired workers and closed facilities, the company has taken a more comprehensive look at its manufacturing process. The company has changed a lot, but the changes seem likely to improve the company's inherent margin power and cash flow creation potential.

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
Absent a big change in China, it looks like Wall Street expects too much out of Harley-Davidson. I don't doubt that demographics favor the company, but I do question whether the money is still there. A lot of Harley-Davidson's core target market took big hits from the housing crash and I'm not sure if we'll see a large enough return to easy credit policies to compensate for the lost buying power.

This isn't to say that Harley-Davidson is in trouble. I do believe that the company can continue to post solid mid-single-digit revenue growth and improving free cash flow margins, but I don't think that the company can post the double-digit compound free cash flow growth that the sell-side price targets implicitly assume. Consequently, Harley-Davidson looks more like a hold to me today.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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