For Investors, Is HOG a Pig, or Ready for a Nice Ride?

By Jason Hall - January 29, 2013 | Tickers: BAMXF, HOG, HMC, PII | 0 Comments

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If you've never been on the back of a motorcycle, there's little that I can tell you to explain the feeling.  We can talk about the wind, the way it pushes against you, grabbing you in a way you never experienced on that 10-speed bike as a kid.  I could describe the noise of the engine, the feel of the bike and motor, and the road beneath it.  It's a visceral, gripping feel that leaves you numb when you get off, and pretty sore after a few hours, but always wanting more.  In a word, it's freedom. 

It's a tired, old cliche, I know.  But it's the best word in our language that describes the experience, much in the same way that a single word has come to represent the epitome of the lifestyle: Harley.

Harley-Davidson (NYSE: HOG) has been a symbol of the American biker ideal for half a century, and the freedom that comes along with that ideal.  But increased competition, both domestically and internationally, as well as a reliance on outdated manufacturing & design processes and major inefficiencies all through its business, came to a head during the Great Recession.  The chart below gives us a good picture:

HOG Revenue TTM data by YCharts

This 10-year shapshot paints a good picture of what both the business and the share price have done. The first thing that's easy to spot is that the share price, both in actual performance and against the S&P 500 index, has not rewarded shareholders very well at all -- that is, shareholders that have held for a full decade. But the key takeaways for this chart are the recent data points, especially taken with proper context.

From the FY11 Annual Report:

"We expect the changes underway in our approach to product development, manufacturing and the retail experience will enable Harley-Davidson to be world-class and customer-led in everything we do, and we are pursuing this work with a relentless drive."

The best summary that I can give is that, as the chart above shows clearly, Harley's expenses were crushing it, as revenues were driven down during the recession, sending earnings down at an even faster rate.  Management recognized these concerns, and in 2010 implemented the first steps to address these problems, and reorganize the company in a manner that would help it be more nimble, shorten the product development cycle, and increase production capabilities while simultaneously reducing overhead.  That's a pretty tall order, and FY2011 would be the proving ground. 

A couple more key takeaways from the FY11 Annual Report:

"When it comes to creating remarkable motorcycles, we have re-engineered our entire product development approach with a focus on three key elements:  1) a laser focus on the best product opportunities;  2) reduced time-to-market; and  3) increased product development capacity through efficiencies."

Continued:

"Beginning in early 2013, we expect to have surge capability at York, enabling us to more closely match production to changes in seasonal demand. We also expect to have significantly greater flexibility to adjust product mix based on retail demand."

While the latter will be proven (or otherwise) in Spring of 2013, the necessary actions to get there included the implementation of a new ERP (enterprise resource planning) system last fall that had a measurable impact on sales results, driving sales down by over 6% for the year-before quarter.  But this critical step to refining the manufacturing process is absolutely necessary if Harley intends to make the strides forward to meet its "surge" capability, and to drive costs down in production. Which leads us to the just-announced Q4 results.

FY12 Q4 Results

A couple of takeaways:

Net income for FY12 is up, as is total revenue.  However, both of the past 2 quarters are down compared to the same periods in FY11, and this is worth noting.  The real question is whether or not all of the investments in improved capacity, streamlined development, and reduced cost structure will lead to more sales and profits.  Honestly, those questions won't be answered for another quarter or two, but year-over-year, Harley's results are improved. 

There is competition, but a Harley's a Harley

There are dozens of companies that make motorcycles, from Honda (NYSE: HMC), Kawasaki Heavy Industries' (NASDAQOTH: KWHIY), Yamaha Motors (NASDAQOTH: YAMHF) Star motorcycle brand, Suzuki Motors (NASDAQOTH:SZKMF), and BMW (NASDAQOTH:BAMXF).  I have lumped all of these companies together for three reasons:

1. They all are part of large organizations, of which motorcycles range from being a relatively important part of (such as Yamaha, Suzuki and Honda) to massive conglomerates like Kawasaki, where it's a very small piece (around 18% of sales) of the overall company.
2. Their motorcycle lines include sport bikes as well, which Harley does not produce, nor compete directly with. 
3. They are all non-American companies, which can make a difference to someone who's looking to buy the ideal of American Freedom in a motorcycle.

The larger competitive challenge is from American brands such as Indian and Victory, both owned by Polaris Industries (NYSE: PII). And similar to the companies above, these two brands are part of a larger company, with a much smaller piece of its business being generated from motorcycle sales. However, especially for Indian, having the backing of a larger business was a key to why Polaris was able to acquire the company in 2011.  From the website:

"Indian will operate as an autonomous business unit, building upon the potent combination of Polaris’ engineering acumen and innovative technology with Indian’s premium brand, iconic design and rich American heritage."

Having a significant financial backing from the $2+ billion Polaris Industries, and the autonomy to operate the business, could lead to stiff competition for Harley.  But in many ways, the future of Polaris' motorcycle businesses -- especially Indian -- is less a product of Harley's failure to execute and more a product of both its ability to establish Indian as a viable competitive product on a large scale, and the overall economy supporting the motorcycle market.  But at more than 55% of the heavyweight (651cc+ engine size) market in the U.S., Harley is by far the behemoth. 

As important as this dominant position in the domestic market is, Harley's biggest opportunity for growth is likely to be overseas.  And while the Harley brand and legacy is still a linchpin to overseas sales, it doesn't put the non-American companies at as much of a branding disadvantage as it does in the U.S. of A.  International sales are a growing part of the company's results, and are expected to have increased from around 25% of total sales in 2007, to nearly 40% for FY2012, and the trend is expected to continue, which bodes well. 

Frankly, motorcycle owners have been described as being in two groups: 

• Those that ride a Harley
• Those that want a Harley. 

Maybe that isn't much of an analytical statement, but the point is that Harley Davidson carries a cache, (though I doubt you'd hear it described that way by a Harley owner) that sets them apart from their import competitors, and it's worth noting, because it is as powerful of a competitive advantage as you will find.

I'd love a Harley, but is HOG a Buy?

Let's take a look at some valuation metrics, and see how, on a historical basis, the stock is priced:

HOG PE Ratio TTM data by YCharts

The market actually seems to be pricing Harley in line with its historical valuation, which leads me to believe that if the past two quarters are just a blip on the radar, and that the investments the company has been making into improved operations are taking hold, this could be a good time to buy. 

Foolish Bottom Line

Harley Davidson's success over the next few years depends on more than it's just being a better-run organization.  Buying a Harley requires disposable income, which requires an income to begin with.  And while there have been a number of positive signs that the job market is improving, there needs to be a sustainable source for job growth.  That could come from the the housing market, which is also turning a corner. 

From a recent article from The Motley Fool's Morgan Housel:

"But we're still far below average. And just returning to that average would be a huge tailwind to the economy, adding roughly $300 billion to economic output over 2012."

And this "tailwind to the economy" is a major factor in the long-term success of a in investment in Harley Davidson.  If the economy, spurred by housing, continues to grow, then this could be a nice investment.  Personally, I'll wait until the end of Q1 before I make that decision.  I'd love to believe management when it tells us that tomorrow will be better because of today's sacrifices, but I'll pretend I'm from Missouri on this one: 

Show me.

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