Harley-Davidson: Easy Riding on Less Bad Results

“Bucking the trend, Harley-Davidson, which uses that great ticker symbol, HOG, with a solid 8% gain thanks to a return to profitability in the finance arm.” – Fox Business Network 7/20/2010

Thanks to improving sales trends and a profitable quarter from Harley-Davidson (HOG) Financial Services, the iconic motorcycle maker surprised Wall Street to the upside in their second quarter earnings report.  Harley shares have jumped more than 13% in morning trading after the company announced net income from continuing operations was $139.3 million, or 59 cents per share; analysts had estimated profits to come in around 41 cents per share.  The obvious star of the quarter was strength out of the HDFS unit which had been a major drag on results as the recession deepened.  In the second quarter, HDFS posted a profit of $60.8 million compared to a loss of $90.5 million last year.

As for the top line, revenue was slightly better than expected with sales of $1.135 billion versus estimates of $1.128 billion.  Overall sales did decline by about 1% with the worst of the declines coming from the key US market, and excluding parts, actual bike sales dropped 5.5% worldwide and 8.4% in the US.  Despite the declines, Harley management is heartened by the moderating pace of declines, yet they are not sugar coating the reality of the situation.  Chief Executive Keith Wandell said, “We continue to believe conditions will remain challenging this year for new motorcycle purchases and we will manage the business based on that expectation, with a continued strong focus on managing supply in line with demand.”

Clearly, Harley’s reorganization has allowed them to squeeze more profits from each dollar of sales, as gross margin expanded to 35% from 34% a year ago.  In addition, management did slightly raise their guidance for gross profit for the full year to 32.5% to 34% of sales from 32% to 33.5%.  Restructuring efforts over the last year have seen entire lines shut down such as Buell and MV Agusta, as well as labor renegotiations and factory realignment.  Drastic actions were necessary in order to confront slumping sales, and management hopes to find more ways to cost cuts as they are currently in talks with labor at two key plants in its home state of Wisconsin.

At Ockham, we would not recommend buying Harley’s stock following today’s earnings report because “less bad” just is not good enough.  Harley-Davidson is struggling to reinvigorate sales; in fact, bike shipments are expected to be down 5% to 10% from even last year’ anemic sales.  The financial services piece of the business has gone from being a weakness to a strength in the last year, which is encouraging but leaves us unimpressed with their core business activity of producing and selling motorcycles.  For instance, if you compare this quarter to a year ago without the wild card of financial services, it is not a pretty sight.  In second quarter 2009, the company reported net income from continuing ops of $33.4 million but that was hindered by $90.5 million loss from HDFS.  Excluding HDFS, the company would have earned around $123.9 million.  This quarter Harley earned $139.3 million from continuing ops after getting a boost of nearly $61 million from HDFS.  So, when you remove that financial services segment from earnings its core business dropped to $78.5 million; a decline of 36%.

Obviously, we have serious questions over the shrinking domestic market for relatively expensive motorcycles.  Cost cutting and financial services have kept HOG’s head above water for now, but at some point they need to start showing growth again before the stock starts to look more attractive to us.  They have stated grand ideas about expanding their presence abroad to up to 40% of sales, and there is real potential for growth overseas.  However, we have not seen enough at this point and we are reiterating our Overvalued stance on HOG after today’s run.

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