Note to Reader: This report contains substantially new material. Subsequent reports will have changeshighlighted.
Reason for Report: 2Q06 earnings update Previous Ed: June 6, 2006
Overview
Milwaukee-based Harley-Davidson, Inc. (HDI) is the world’s leading designer and manufacturer of heavyweight motorcycles (engine displacement of 651+ cc) and their related products and merchandise. The company operates in two segments, Motorcycles and Related Products (Motorcycles) and Financial Services. The Motorcycles segment designs, manufactures, and sells heavyweight, touring, custom, and performance motorcycles, as well as a line of motorcycle parts, accessories, clothing, and collectibles. It also offers police, fire, and rescue motorcycles. The company has developed a strong global dealer retaildistribution network. The Financial Services segment engages in financing and servicing wholesale inventory receivables and consumer retail loans, primarily for the purchase of motorcycles in the United States, Canada, and Europe. It provides wholesale financial services to its dealers and retail financing to consumers. Management remains focused on sustaining the long-term growth and strengthening brand appeal. In addition, the company licenses the name ‘Harley-Davidson’ and other trademarks owned by it. Its website is:
The analysts have identified the following investment merits and drawbacks of HDI:
Key Positive Arguments / Key Negative ArgumentsStrong Brand Appeal - HDI enjoys little competition and strong fundamentals. It is one of the most recognized brands in the world. / Maturing Markets - Some analysts believe that HDI’s slowing unit production portends a maturing market with some uncertainty about the true size of the market for heavyweight motorcycles. Decelerating demand limits HDI’s ability to increase capacity and grow earnings.
Solid Competitive Position – HDI commands premium pricing for its products by exploiting the advantages of owning a limited production customized bike. High barriers to entry into heavyweight motorcycle manufacturing limit competitive threat. / Weakness in Retail Market – Dealers are experiencing high inventories, lower premiums over MSRP, and a soft market for used bikes.
Product Innovation, Dealer Network – HDI’s global network of dealers contributes to the company’s above-average growth rate, strong pricing power, high returns on invested capital, and growing demographic base. / Weaker Margins Ahead - The company’s plan to produce a greater number of lower-margin, entry-level bikes reflects the need to diversify its customer base. However, unless demand for these bikes is very large, a shift to low-priced models would dip margins and limit earnings growth.
Rider Edge Program – The company continues to make progress educating and bringing in new riders.
Note: Harley-Davidson’s fiscal year ends December 31; fiscal references coincide with the calendar year end.
Recent Events
On July 14, 2006, the company introduced a new engine as part of its lineup for 2007, which included four new models. Twin Cam 96, an all-new Big Twin engine, will power all models in the Harley-Davidson Dyna, Softail and Touring product families, each of which will also feature the 6-speed Cruise Drive transmission. New motorcycles for 2007 included two VRSC models, the all-new FXSTC Softail Custom, and a limited-edition model celebrating the 50th anniversary of the Sportster introduction.
On June 2, 2006, HDI announced that Donna Zarcone will be resigning from the posts ofPresident and Chief Operating Officer of Harley-Davidson Financial Services, effective August 1, 2006. Zarcone, 48, has decided to seek new entrepreneurial opportunities, the company said.
On May 24, 2006, during the final round of negotiation in bilateral WTO Market Access agreement between the U.S and Vietnam there was an agreement in principle on tradeto open the Southeast Asian country to more U.S products. HDI has not yet announced any definitive plans for selling motorcycles in Vietnam. However, the company has long been interested in expanding its presence in Asia, and considers market access of the kind provided by the trade agreement as the key to its future expansion into Vietnam.
Revenue
In 2Q06, HDI reported revenue of $1.38 billion compared with $1.33 billion in the year-ago quarter, reflecting a 3.3% increase.
Revenue from Harley-Davidson motorcycles was $1.03 billion, an increase of $21.7 million, or 2.2% over the same period last year. Shipments of Harley-Davidson motorcycles totaled 79,796 units, an increase of 2,668 units, or 3.5% over last year's second quarter.
Revenue from Parts and Accessories (P&A), which consists of Genuine Motor Parts, and Genuine Motor Accessories, totaled $251.7 million, an increase of $13.9 million, or 5.9% over the year-ago quarter. Revenue from General Merchandise, which consists of MotorClothes apparel and collectibles, totaled $67.1 million, an increase of $3.7 million, or 5.8% over the year-ago quarter.
For the long term, the company expects the growth rate for P&A revenue to be slightly higher than Harley-Davidson's motorcycle shipment growth rate, and the General Merchandise growth rate to be lower than the motorcycle shipment growth rate.
Worldwide retail sales of Harley-Davidson motorcycles increased 10.0% in 2Q06compared to the same period in 2005. In the U.S., retail sales of Harley-Davidson motorcycles increased 8.1% in the reported quarter. The heavyweight motorcycle market in the U.S. increased 9.9% for the same period.
Retail sales of Harley-Davidson motorcycles grew 17.3% in international markets in 2Q06 compared with 2Q05. Second quarter retail sales were up 15.8% in Japan, 15.6% in Europe, 13.4% in Canada and all other international markets combined were up by 33.5%.
HDI plans to ship 97,000 motorcycles in 3Q06, which includes approximately 12,500 Harley-Davidson motorcycles, an increase of 10.0% over the prior year quarter, that were produced to prepare for the new model introduction. The company reiterated its annual forecast of 348,000 to 352,000 bikes for the year, which would represent between 5% and 9% growth.
For 3Q06, analysts’ total revenue projections range from $1,527.8M (Guzman & Co.) to $1,601.3M (RBC Cap.), with an average of $1,576.5M. For FY06, the range is $5,615.0M (Raymond James) to $5,702.2M (RBC Cap.), with an average of $5,668.4M (compared to the previous estimate of $5,623.0M). For FY07, the range is $5,793.0M (Raymond James) to $6,086.4M (Goldman), with an average of $5992.2M (compared to previous estimate of $6055.7M).
One analyst (Raymond James) expects an increase in retail sales activity in 3Q06 with the introduction of the new models. Another analyst (Lehman) expects the growth rate for P&A revenue to be slightly higher than its motorcycle unit growth rate and the growth rate for general merchandise to be lower than the motorcycle unit growth rate in the long term. One analyst (J.P. Morgan) forecastsa production growth of 10.7%, P&A growth of 8%, and a general merchandise increase of 5% for 3Q06, resulting in total revenue growth of 10% as compared to 3Q05.
Revenue ($M)FY ends December / 2004A / 2005A / 1Q06A / 2Q06A / 3Q06E / 4Q06E / 2006E / 2007E
Harley Motorcycles / $3,928.2 / $4,183.5 / $1,008.5 / $1,027.8 / $1,261.0 / $1,171.5 / $4,450.3 / $4,707.6
Buel Motorcycles / $79.0 / $93.1 / $24.1 / $29.3 / $28.1 / $24.3 / $104.3 / $110.3
Parts & Accessories / $781.6 / $815.7 / $182.9 / $251.7 / $245.0 / $180.1 / $858.3 / $909.9
General Merchandise / $223.7 / $247.9 / $68.6 / $67.1 / $67.1 / $62.9 / $264.7 / $274.0
Other / $2.6 / $2.1 / $1.0 / $1.1 / $1.0 / $1.0 / $2.2 / $4.0
Total Revenue / $5,015.2 / $5,342.2 / $1,285.1 / $1,377.0 / $1,576.5 ↑ / $1,436.4 ↑ / $5,668.4 ↑ / $5,992.2↓
Digest High / $5,015.2 / $5,342.2 / $1,285.1 / $1,377.0 / $1,601.3 / $1,438.8 / $5,702.2 / $6,086.4
Digest Low / $5,015.2 / $5,342.2 / $1,285.1 / $1,377.0 / $1,527.8 / $1,434.3 / $5,615.0 / $5,793.0
YOY Growth / 6.5% / 4.0% / 3.3% / 10.2% / 7.0% / 6.1% / 5.7%
Sequential Growth / -4.3% / 7.2% / 14.5% / -8.9%
Margins
In 2Q06, gross margin was 37.5% of revenue, equal to the margin for the same period in 2005. Operating margin was27.3% in 2Q06, equal to the margin for the same period in 2005.
In 2Q06, Harley-Davidson Financial Services (HDFS) reported operating income of $56.3 million, an increase of $5.3 million, or 10.3%, compared to the year-ago quarter. This increase was primarily due to higher net interest income and insurance revenues.
For the long term, the company expects the HDFS operating income growth rate to be slightly higher than the growth rate of Harley-Davidson motorcycle shipments.
One analyst (J.P. Morgan) forecasts HDFS operating income to grow by 5% in 3Q06 and also expects a gross margin of 38.8% as compared to 3Q05. Another analyst (Lehman) expects HDFS operating income to grow at a rate slightly higher than its motorcycle shipment rate in the long term.
Margins / 2004A / 2005A / 1Q06A / 2Q06A / 3Q06E / 4Q06E / 2006E / 2007EGross / 37.9% / 38.2% / 38.4% / 37.5% / 39.3% / 38.4% / 39.2% / 39.7%
Operating / 27.1% / 27.5% / 28.0% / 27.3% / 28.3% / 26.0% / 27.6% / 28.3%
Pre-Tax / 27.5% / 27.8% / 28.5% / 27.6% / 28.7% / 26.4% / 28.1% / 28.9%
Net / 17.7% / 18.0% / 18.3% / 17.7% / 18.5% / 17.1% / 18.0% / 18.5%
Earnings per Share
HDI reported 2Q06 diluted earnings per share of $0.91, an 8.3%increase compared with $0.84 reported in 2Q05. Net income in the reported quarter was $243.4 million compared to $237.4 million, an increase of 2.5% over the second quarter of 2005.
Management expects annual EPS growth rate of 11-17%.
For 3Q06, analysts’ EPS forecasts range from $1.04 per share (Guzman & Co.) to $1.17 per share (AG Edwards), with an average of $1.10 (compared to previous estimate of $1.08). For FY06, analysts’ forecasts range from $3.70 per share (Guzman & Co.) to $3.91 per share (AG Edwards), with an average of $3.79(compared to previous estimate of $3.76). For FY07, analysts’ forecasts range from $4.00 per share (Lehman) to $4.41 per share (Guzman & Co.),with an average of $4.19 per share (compared to previous estimate of $4.11).
EPSFY ends December / 2004A / 2005A / 1Q06A / 2Q06A / 3Q06E / 4Q06E / 2006E / 2007E
Digest High / $3.00 / $3.41 / $0.86 / $0.91 / $1.17 / $0.98 / $3.91 / $4.41
Digest Low / $3.00 / $3.41 / $0.86 / $0.91 / $1.04 / $0.88 / $3.70 / $4.00
Digest Avg. / $3.00 / $3.41 / $0.86 / $0.91 / $1.10 ↑ / $0.92 ↑ / $3.79 ↑ / $4.19 ↑
YoY growth / 13.7% / 11.7% / 8.3% / 15.0% / 9.9% / 11.3% / 10.3%
Sequential Growth / 2.4% / 5.8% / 21.3% / -16.4%
Zacks Consensus / $1.09 / $0.91 / $3.77 / $4.12
Management Guidance
Target Price/Valuation
Of the fifteen analysts covering Harley-Davidson, twogavepositive ratings,elevengaveneutral ratings, and two gave negativeratings on the stock.
Analysts’ price targets range from $54.00 per share (Lehman) to $66.00 per share (R W. Baird), with the average price target at $59.44 (↑ from the previous report). Most of the analysts are using P/E multiples to compute their target prices.
Rating DistributionPositive / 13%
Neutral / 73%
Negative / 13%
Digest High / $66.00
Digest Low / $54.00
Digest Average / $59.44 ↑
No. of Analysts with Target Price/Total / 9/15
Capital Structure/Solvency/Cash Flow/Governance/Other
HDI isexpanding its ongoing efforts to attract new riders. The company’s motorcycle training course, Rider’s Edge is held in conjunction with the dealer base, and has been successful in attracting a different demographic mix than the core HDI rider. The program, which has expanded from just fewer than 1,000 participants in 2000 to an estimated 32,000 riders per year in 2006, is attended more heavily by women and younger riders. The program is currently offered at approximately 120 dealers, growing by about 20-25 dealers per year. In addition, the company is also expanding its rental program, which allows current customers to try new models, as well as provide an additional profit source for the dealer network. Finally, Harley-Davidson continues to improve its dealer network through the addition of service personnel focused on customization, as well as increasing the skills of its sales force, which will become more of a determinate in the success of both HDI and the individual dealer going forward.
Cash and marketable securities totaled $1.00 billion as of June 25, 2006, adecrease of $41.7 million during the second quarter. Cash flow from operations was $828.8 million and capital expenditurewas $89.1 million during the second quarter. The Company repurchased 7.8 million shares of its common stock at a cost of $392.5 million during 2Q06. These shares were repurchased under an authorization from the Company's Board of Directors to buy back 20 million shares. A total of 10 million shares remain under this authorization.
Potentially Severe Problems
There are none other than those discussed in other sections of this report.
Long-Term Growth
Long-term (3-5 years) earnings growth projections for HDI vary from 9% (Raymond James) to 15% (FTN Midwest Res., Merrill).
The long-term growth outlook for Harley-Davidson rests on HDI’s ability to retain its rare but positive imbalance in supply and demand, as well as its ability to manage production and stimulate growth. It is expected that the company will continue to command premium prices and comparatively high margins as the purveyor of a highly-rated luxury good. HDI is ramping up plans for capacity expansion, and has announced three new motorcycles to round out its designs for 2005 and 2006. Management expects long-term production growth of 5% to 9%.
However,most of the analysts, particularly those with a neutral view on the stock, believe the imbalance in supply and demand will be hard to sustain in the long term. Analysts view that longer-term demand continues to decelerate and growth expectations remain too high. Many analysts are also concerned about the maturing market and are worried how long the company will keep enjoying its pricing edge.
One analyst (FTN Midwest Res.) believes that the sustainable growth rate for registrations is in the 5-7% range based on twomajor factors. First, the expansionof the Rider’s Edge program across the dealer base will help to attract new riders to the HDI product line, which is expected to contribute 1-2% to registration growth. Second, growth in the company’s core demographic, including new purchases by existing riders, will support 3% growth in registrations.
One analyst (Piper Jaffray) expects growth to continue for the next three-year period,and is more comfortable at lowsingle-digit levels. Further, declinein the prices of used bikesis a major deterrent to new bike purchases over the longterm.
Another analyst (R W. Baird) believes that several factors should support the company’s long-term growth like capacity expansion at York, new engines and models, the growing rider base, worldwide dealer market development, ongoing investment in entry level bikes, and a stable number of customers.
New product development is a key to the company’s growth strategy, though HDI remained secretive about its plans for 2007 models. Management emphasized that product development is entrenched in the company’s culture. Bill Davidson, director of the motorcycle development department, stated that customers are satisfied with HDI’s revamped Dyna line with 6-speed transmission and advanced audio system on the touring bikes.
Upcoming Events
October 11, 2006: 3Q06 earnings releaseexpected.
Individual Analyst Opinions
POSITIVE RATINGS
AG Edwards – Buy ($62 – target price): 07/18/06
R W. Baird–Outperform ($66– target price): 07/17/06–The firm maintains the rating due to HDI’s attractive valuation based on its longer-term earnings growth potential, a market leading position as a well-recognized brand, a disciplined management, and balance sheet strength. INVESTMENT SUMMARY: Astrong balance sheet and cash flow to support dividend increases and stock repurchases in FY06. The firm recommends the purchase of shares based on valuation and fundamentals.
NEUTRAL RATINGS
KeyBanc – Hold 3: 07/18/06–The firm has maintained a Hold rating and has opted to wait forthe near-term trends to become more favorable. INVESTMENT SUMMARY: HDI’s future growth is believed to be balanced as the company brings in supply of bikes in line with demand, unlikethe past decade.
Raymond James –Market perform: 07/17/06–The firmmaintains a Market Perform rating on the shares given the high level of inventory in the dealer channels.
FTN Midwest Res. – Neutral:07/17/06–The firm maintains a Neutral rating on the stock. INVESTMENT SUMMARY: Harley’s prospects for growth are strong versus its other leisure segments (boats, ATV’s, snowmobiles). Relatively wealthy consumers and a fuel efficient product are expected to shield this segment from the factors afflicting the overall consumer space.
Goldman – Neutral ($58 – target price):07/17/06 –The firm is maintaining a target price of $58, with a Neutral rating. INVESTMENT SUMMARY: HDI has a strong positive outlook due to solid longer-term value play, and thus, investors should continue to benefit from increasing dividend and share repurchase program. However, due to retail sales slowdown, the company is expected to cut production levels.
J.P. Morgan – Neutral: 07/17/06 – The firmmaintains a Neutral rating. INVESTMENT SUMMARY: The firm believes the stock may be range bound due to retail demand and the company’s long term production guidance. The company is expected to grow its penetration rate among its target market and expand its market share.
Merrill–Neutral:07/17/06–Although margins slightly proved positive for Harley, the firm’s rating is based on the specter of a slowing consumer and poor domestic sales.
Piper Jaffray –Market perform ($59 – target price): 07/17/06–The firm maintains a Market perform rating as market conditions remain highly volatile and risk to consumer discretionary sector is high. INVESTMENT SUMMARY: Dependence on key management, HDFS credit quality, pricing of new & used motorcycles, cultural changes and economic risks, can pose risks to the achievement of target price.
RBC Cap.–Sector perform ($57 – target price): 07/17/06–The firm has maintained a Sector perform rating due to lingering concerns over the company’s longer-term growth, but also believes HDI could prove to be a relatively safe haven in the near term. The firm has increased its target price from $53 to $57 to account for slightly higher production outlook as well as continued share buyback. INVESTMENT SUMMARY: Positive retail momentum can continue in the near term due to the potential demand for the new engine. However, these are balanced against some potential headwinds including an increasingly uncertain consumer environment and high level of inventory concerns due to tough retail comparisons and strong shipment targets.
SmithBarney –Hold ($58 – target price): 07/17/06 – The firm has increased its target price from $55 to $58 based on HDI’s superior brand, dominant market share and significantly large market capitalization. INVESTMENT SUMMARY: HDI is well positioned to capitalize on the favorable industry trends given its strong brand recognition and a loyal customer base within the industry.
UnionBankSwitz. – Neutral (2) ($58 – target price): 07/17/06 – The firm expects management to continue to increasethe company’s dividend and share buyback activities. INVESTMENT SUMMARY: The firmholds a positive view about the stock given its low valuation level, strong brand and cash flow.
William Blair – Market perform: 07/19/06 – The firm has maintained a Market perform rating. INVESTMENT SUMMARY: The firm believes HDI’s dominant position and a great brand name buffers the stock against a sharp and sustained decline in the share price, especially relative to the market.
NEGATIVE RATINGS
Guzman & Co. – Under perform ($63 – target price): 07/17/06–The firm believes HDI to be relatively unattractive and rates the stock Under perform as the given modified fed model indicates the market to be approximately 26% undervalued. INVESTMENT SUMMARY: Though international opportunities and the strength of HDI’s brand are well recognized, the firm believes the home market is getting highly saturated, making it difficult to address the business expectations.