A Harman Investment has Never Sounded this Good

By Tom Gibbs - July 13, 2012 | Tickers: BAMXY, DDAIF.PK, HAR, TM, VLKAY | 0 Comments

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Audio guru Harman International (NYSE: HAR), a primary competitor to privately traded Bose and Pioneer in the automotive, consumer, and professional audio technology market, has gone through an extremely shaky operating period over the past five years.  With nearly 70% of its revenues riding on the sale of automotive-geared audio products, the corporation’s revenues dropped by more than 30% in 2009 alongside the dramatic slowdown of the global automotive industry. 

Following a post-2009 rebound in revenues and margins – 2011 revenues up 32% and gross margins up 360 basis points from the trough level reached in 2009 – the corporation is still surrounded by a significant degree of pessimism in regards to the weak consumer spending outlook in the European market.  Harman stock has fallen by more than 25% over the past five months as a result, and although many are under the impression that the corporation will once again be subject to top-line swings in the near future, there are several signs that hint Harman may be a very intriguing value-focused investment.

Company Info

Harman operates under three distinct reportable divisions – Infotainment, Lifestyle, and Professional – that market the corporation’s high-quality audio technology through different channels for unique end users.  Best known for its higher-end infotainment systems and premium-branded audio system for luxury automobiles, Harman is a supplier to some of the biggest names in the auto industry, including the Volkswagen Group (NASDAQOTH: VLKAY), BMW (NASDAQOTH: BAMXY), Daimler AG (NASDAQOTH: DDAIF.PK), and ​Toyota ​(NYSE: TM).

Harman’s Infinity, JBL, and Harman/Kardon brand names are also used in the marketing of its branded Apple iPad, iPod, and iPhone docking devices, PC-related devices, headphones, and professional equipment including loudspeakers and cinema systems.   

Harman took the opportunity during the poor operating period in 2009 to lay out a rather dramatic restructuring initiative, code-named STEP Change.  With a goal of maximizing operational flexibility and increasing efficiency in manufacturing, engineering, and administration (i.e. cutting the fat), the corporation closed five underperforming plants, opened five new factories in China and India, and cut annual operating costs by more than $430 million. 

Upon the completion of STEP Change in mid-2011, Harman had shifted its manufacturing footprint from a disproportionately large penetration in higher cost nations (around 86%) to around a 50%-50% split today.  A similar transition was forced in its engineering/R&D capacity, and around 40% of such assets are now placed in so-called “best cost” nations (up from essentially 0% several years ago). 

The Progress Continues

Harman’s restructuring initiative did not only cut operating costs by optimizing its physical manufacturing, engineering, and research and development footprint around the world, but it also made the corporation a much more flexible entity.  When looking at the old Harman system for developing a new infotainment product (its largest division, 50% of annual sales), the corporation would take up to three years and nearly $50-$70 million in research and development spending to get a suitable product to market after being awarded a project by an OEM.

Harman has placed a great deal of emphasis on its newly launched scalable system, which increases the level of integration of its tooling and software with new automotive models and thus reduces research and development expenditures and a given product’s time to market.  In getting products to market much faster (now 12-18 months) and much more cheaply (now only requires $10-$20 million in R&D spending per project), the corporation can pass on a higher-quality and lower-cost product to its consumers. 

Due to such factors, as well as the fact that the new scalable system allows for the integration of such infotainment systems into mid-level autos (as opposed to strictly high-end luxury), Harman has experienced a huge surge in product demand.  The corporation’s backlog is now $14.5 billion strong and 40% of the awarded work is of the new, scalable nature.  Most importantly for investors, projects falling under the scalable system provide higher margins, and Harman expects a meaningful flow-through to its operating line over the next several years:

Because the scalable systems portion of the large backlog commands estimated EBIT margins between 8%-10%, investors will see a continual expansion of Harman’s operating margins as more of the backlog is integrated into its income statement.  A meaningful change, for example, was recently experienced in the most recent operating quarter – EBIT margins in the Infotainment division were a full 380 basis points higher (to 7.8%) than the comparable quarter in 2011. 

Luxury Auto Market

As mentioned, a large degree of the pessimism surrounding Harman’s mid-term outlook has been driven by the uncertainty of the auto market in the European market.  A meaningful portion of BMW, Mercedes, and Volkswagen Group sales are, after all, delivered in their native Germany and the neighboring nations.  Based on recent sales performance, however, it appears that the luxury market is holding up better than the overall car market.  Not only are these luxury auto manufacturers maintaining European-based sales, but Harman will benefit from the robust demand for luxury autos from key emerging markets:

Recent Sales Updates

• BMW
• Achieved record sales for first six months of 2012, with 900,539 units delivered worldwide (up 8.1% from H1 2011).
• Europe sales increased 1.5% in June to 92,686 units.  First half of 2012 sales are on par with the 2011 level (-0.1% difference).
• First half 2012 Asia sales are up 25.7% from last year, with strong double-digit growth in Indonesia (48.0%), China (30.7%), and Japan (27.4%).
• United States sales in the first half of 2012 are up 10.5% compared to the same period in 201
• Audi (Volkswagen)
• Worldwide sales in first half of 2012 are up 12.3% to 733,000 units
• European sales are up 2.8% in the first half of 2012, to 393,350 units
• China and United States sales have increased by 37.8% and 16.5%, respectively, in the first half of 2012.
• Mercedes
• The first half of 2012 had the highest volume sales for the Mercedes-Benz cars division in company history.  Worldwide sales up 6.5% from the first half of 2011.
• Germany sales up 4.5% year-to-date, and Western Europe (excludes Germany) sales are up 1.1% in the first half to 155,555 units
• China, United States, and Russia sales up 7.8%, 15.9%, and 27.6%, respectively, in the first half of 2012.

Europe is by far the weakest of the automotive markets in the current marketplace, yet discounting Harman’s upcoming growth prospects based on European weakness alone is overly pessimistic.  Whereas more mass-market automakers are simply returning to pre-recessionary sales volumes, luxury manufacturers pioneered by BMW, Mercedes, and the Volkswagen Group are continuously breaking historical company sales records.  Likewise, with Harman’s new scalable system allowing for more integration into mid-level autos, company output will continue to grow as it is entering markets in which it has never operated previously. 

Harman is leaner, more efficient, and has set itself up to become the most profitable version of itself that the public has seen in quite a long time.  With a solid balance sheet (net cash represents close to 15% of market cap), cheap valuation (nearly 50% less expensive than past five year average P/E), and an established and already proven plan to reach higher margins over the next several years, Harman needs to be on every value-focused investor’s radar screen.

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