Harley's HOGgish Market Valuation

By Tom Gibbs - February 5, 2012 | Tickers: AMZN, GM, HOG, HMC, TM | 0 Comments

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Harley-Davidson (NYSE: HOG) is one of the most exciting stocks of 2012 thus far – the company recently smashed earnings estimates, its sales are rebounding from recessionary troughs, and Jim Cramer (per usual) is singing to the masses about the future potential of the stock.  

Cramer could not be more right with his take on the company’s brand, as he reiterates a quote from the corporation’s CFO, “It is much more than a motorcycle: it’s about a lifestyle, it’s about freedom, independence, irreverence, and most of all, rebellion.” 

There is no doubt that HOG is the epitome of a value-adding, brand-building entity.  Its commanding market share in the United States (near 50%) is attributable to several key factors that other corporations have not come close to replicating.  More specifically, the huge protective moat constructed around its operations is further widened with scale economies and a deep captive customer base. 

Its highly-sellable brand image not only commands continuously strong margins, but it also creates a “lifestyle” meaning around the product.  Unlike any other brand in the world, Harley connects deeply with its consumers – Harley owners sport logo-laden apparel, they tattoo the brand’s image on their bodies, and they celebrate the corporation’s legacy year after year.  (I have seen Disney and Apple T-shirts, but have yet to see many Disney or Apple tattoos).

The company’s historical performance translates this powerful brand image into economic terms.

*Return on net operating assets (RNOA), four quarter runs, from Q1 2003 to Q4 2007.  See footnote for methodology

Between Q1 2003 and Q4 2007, the corporation continuously generated excess returns on its core operating assets.  This trend was in existence long before the time period illustrated, and will no doubt continue well into the future as sales and margins normalize to pre-recessionary levels. 

Even for automakers with prestigious brand images (BMW and Mercedes, for example), returns on core assets have been in the single digits for decades as intense competition from GM’s (NYSE: GM) Cadillac, Toyota’s (NYSE: TM) Lexus, and Honda’s (NYSE: HMC) Acura premium brands erased all excess profits.  Unlike the motorcycle manufacturing industry, the automaker sector is characterized by such intense competition and extremely diverse consumer wants/needs that it is an extremely difficult proposition for one single automaker to gain a significant captive customer base.  Although BMW and Mercedes may have a more prestigious brand image than large parent companies like GM, Toyota, and Honda, competition has always eroded excess profits to zero in any new market that is penetrated.  Harley's ability to sustain above-average returns and build an ever-expanding captive customer base over its 110 year life illustrates the truly unique nature of its brand value. 

Good Company = Good Stock?

The value of Harley’s brand cannot be denied, but there is a huge difference between a great stock and a great investment.  Cramer no doubt puts on a great act (he looks great in leather) but is his excitement about HOG warranted? 

There is no question that the company will continue to perform well over the next several quarters, as the willingness, and ability, of consumers to spend on discretionary items will increase.  Similarly, Harley’s restructuring charges taken in 2009 will, as Cramer anticipates, make the corporation a much stronger and efficient operator as volume increases.

As depicted, sales and operating income have begun to improve from their recessionary troughs.

However, with the stock up more than 18% since the first trading day of 2012, and with HOG within points of its 52-week high, is the stock past value investing territory?

Historical Pricing

One of the primary faults with a Cramer-like analysis is that the success of its “buy high, sell higher” mantra relies on a greater fool that will purchase the stock in the future.  At a recent price around $45.60/share, Harley is selling at one of its most HOGgish prices of the past decade. 

Four quarter EBITDA and EPS runs were generated to date since Q4 2002, paired with median market prices for each corresponding quarter.  Median enterprise multiples and P/E ratios were selected from the data.

The market is no doubt anticipating large growth from the corporation over the mid-term, as its earnings are priced at a premium over their historical median valuations. 

Following and pricing the corporation’s excess income generating abilities also yields an overweight rating for the stock at its current market price.  An unlevered balance sheet analysis looks at Harley’s core operations – net operating assets defined as (total assets – financial assets) – (total liabilities – financial liabilities).  The last twelve month period is highlighted below:

*See footnote for methodology

With $0.35 per share in residual operating income generated over the past four quarters, the market is pricing HOG’s excess earnings ability with a multiple of 132.  In calculating the same residual earnings since Q1 2003, the median residual operating earnings-to-price multiple is 20.60. 

What are the market’s assumptions at these high valuations?

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Market Price Per Share = Net Operating Assets Per Share – Net Financial Obligations Per Share  + [(Residual Earnings Per Share) / ((1 + Cost of Capital) * (Cost of Capital - Growth))]

$45.60 = $19.65 - $8.62 + [($0.35) / ((1.10)*(0.10 – G))]

G = 9.08%

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At the current per share price, the market is implying a long term 9.08% growth rate in the corporation’s residual income.  Surely this is not difficult when considering the corporation’s ability to capture customers and maintain impressive margins.  Likewise, HOG’s most recent quarter sales were more than 13% higher than the corresponding quarter in 2010. 

The growth in residual earnings requires more than a simple growth in sales, however. 

Growth in excess earnings above and beyond cost of capital requirements requires a firm to have firm control on all facts of its business – because net assets (generally) increase as the firm expands its operations, sales growth, maintaining margins (or growing margins), and improving turnover levels are all required.  Likewise, core asset efficiency can be maximized through operating leverage – special firms like Amazon (NASDAQ: AMZN), which have huge interest free short term loans in the way of accounts payable, essentially push inventory and sometimes even accounts receivable balances onto suppliers.  This allows for the investment of shareholder funds into higher yielding projects, and for higher subsequent returns on core operating assets. 

Harley’s recent restructuring charges may help to boost the efficiency of its core assets, but maintaining a long term residual earnings growth rate of 9.08% would be accomplishing a task it never has over the past decade: between 2003 and 2009 residual earnings fell, on average, 19.7% per year, and between 2003 and 2011 they fell more than 33% per year. 

Purchasing HOG at $45.60, its bulkiest per share price over the past decade when compared to its enterprise value, its earnings per share, and its residual earnings per share, would be giving in to the market’s implications about the future.  Despite generally impressive performance throughout the 2000s, the corporation still experienced declining excess earnings over the long-term horizon – the market’s implication at this market price allows for no tolerance of such underperformance, and it therefore contains no margin of safety. 

A Value Investment?

Using the same methodology as above, did the market ever present a value-focused investment opportunity on HOG shares?

Soon after the release of the corporation’s 2008 annual report, the market priced Harley shares around $10.32 (median market price from February 2, 2009 to March 16, 2009).  When comparing the corporation’s past four quarter performance at that time, the market’s assumptions about HOG’s future were quite pessimistic:

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Market Price Per Share = Net Operating Assets Per Share – Net Financial Obligations Per Share  + [(Residual Earnings Per Share) / ((1 + Cost of Capital) * (Cost of Capital - Growth))]

$10.32 = $23.33 - $14.25 + [($0.81) / ((1.10 * (0.1 – G))]

G = -49.3%

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The market’s assumptions of a prolonged annual decrease in residual operating income of more than 49% was a stark contrast with the corporation’s performance up to that point, and an investment made and held in the corporation at this point would have yielded a 64% annual return to date. 

There were other signs present between early February 2009 and mid-March 2009 that would have indicated a large relative mispricing of the stock: The trailing twelve month enterprise value (EV/EBITDA) multiple of 4.43, the Price/Book ratio of 1.14, and the Price Per Share/Residual Earnings Per Share multiple of 12.74 compared nicely with the median corresponding values – 8.37, 4.61, and 20.58, respectively – over the previous six years. 

Harley-Davidson remains one of the world’s strongest brands, it has control millions of loyal customers, and it is undoubtedly going to continue its improved performance as the retail sector continues to strengthen.  However, despite it being a good company, at current market valuations HOG contains no margin of safety and is not a good stock. 

*Methodology

• Operating Assets = (Total Assets – Financial Assets).  Financial Assets are all cash/equivalents in excess of 5% of the corporation’s sales for the period.  5% is assumed to be needed for day-to-day operations
• Operating Liabilities = (Total Liabilities – Financial Liabilities).  Financial Liabilities are current and long term notes/debt outstanding
• Net Operating Assets = (Operating Assets – Operating Liabilities)
• Net Financial Obligations = (Financial Liabilities – Financial Assets)
• Common Shareholders’ Equity = (Net Operating Assets – Net Financial Obligations)
• Return on Operating Assets = (Post Tax Operating Income) / (Average Net Operating Assets)
• Residual Operating Income = (Return on Operating Assets – Cost of Capital Requirements) * Average Net Operating Assets.  10% Cost of Capital requirements assumed

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