Description

I think Harley Davidson is a compelling long opportunity and should trade at $35 in the next 12 months and potentially $50 longer-term, as the short term pain from prior management’s missteps and the new CEO’s move to streamline costs and rationalize the dealer base (lower shipment volumes) should pave the way for a turnaround heading into 2021/2022. To be clear, this is not a business benefitting from the surge in outdoor sports.  This is a complete reset and it will take multiple quarters to truly measure the impact of the new turnaround strategy. In fact, their business is currently really ugly, with retail volumes down 27% in the second quarter, while peers such as Polaris saw a 20% increase.  But this is not a fair representation of the franchise as some of the pressure was self-inflicted while some was Covid related.  Despite secular pressure from lower motorcycle ownership, Harley is still an iconic American brand that has been mismanaged and has lost share to smaller, upstart brands. However, the new German-born CEO, who was hired in February and had previously resurrected the Puma brand from the ashes, is reversing the prior CEOs strategy, with a new focus on streamlining the business and more importantly creating scarcity value around the brand.  He also believes the secular decline thesis is overstated, and while current riders continue to age, a new generation of riders will “age into” to core riding demographic.  Also, a broader population shift from cities to more rural communities should support riding trends on the margin.  The previous failed strategy was purely volume focused, which in the face of competition and secular pressure, hurt resale pricing, the brand and ultimately retail sales.  Lastly, bike sales previously peaked in 2006 so a large percentage of the installed base is reaching scrappage age, which should further support used pricing and new retail sales. 

This crux of an investment in HOG is 2-fold.  First, you must believe in the value of the Harley Davidson brand as an American iconic status symbol.  Second, you need to believe that the new CEO has the chops to execute a turnaround in the face of ongoing secular headwinds.  Management is rationalizing the business to refocus on its strengths, which I believe makes sense.  On the most recent earnings call, Management laid out their plan to fix prior issues (lower costs, reduce inventory, maintain supply/demand balance) and stem the losses.  Later this year, the Company will announce its 5-year plan, which will present their plan to grow the business. 

While there is some complexity around valuation (Financial Services segment “HDFS”), the core motorcycle manufacturing bike business “HDMC” is trading at an attractive implied valuation.  Assuming the Financial Services segment can be valued at 10x normalized earnings, the core Bike franchise is trading at sub-7x 2021 EBITDA and 5.5x 2022 EBITDA.  This assumes that Management is able to improve margins to 2019 levels, however, sales remain well below.  Given the magnitude of the cost cutting targets, the margins improvement appears reasonable.  A $35 stock price would value the core bike business at 8x EBITDA.  Assuming the company restores the dividend to prior levels (something free cash flow should support) would result in a 5+% dividend yield.  Should Management be successful in their turnaround efforts, I believe this forecast could ultimately prove conservative and you could see further upside in the stock. 

From an investment perspective, I don’t think it will take much for the market to price in a turnaround.  Management has guided to further weakness from a sales perspective, but margins and pricing should respond to the current aggressive actions being taken.   If the Company can put up a decent quarter showing any real progress/traction, the stock is likely to price in the turnaround.  There is also an activist poking around that I believe could accelerate changes, and at a minimum, give a boost to the stock. 

What is the long-term upside to Harley if turnaround is successful?

I think under reasonable assumptions, mostly driven by cost discipline, the Company can earn somewhere around $2.40 per share for next year.  If they are successful on the demand side – driving mid-single digit volume growth, than the business can earn upwards of $4 over the next 4-5 years.   For much of the last decade, HOG generated mid-teen operating margins on its bike business.  This dropped to 6.3% in 2019, with tariffs and manufacturing inefficiencies adding to their problems.   Assuming the Company can get back to a 10% operating margin by 2023 (driven by modest volume growth from depressed 2020 levels and cost savings and still well below their avg over the last decade), HOG could earn around $3.25 in 2023.  At a 15x multiple, the stock would trade at roughly $50.  

The following summarizes the key drivers of the Harley Davidson turnaround opportunity:

-          Leadership change with fresh vision and proven record (new CEO who turned around Puma)

-          Plan to drive scarcity value back into iconic motorcycle brand – slashing inventory, reducing number of models, exiting underperforming markets and rationalizing dealers

-          Expectations for better used bike values; boosting rider currency for trade-ins – used prices already up this year and prior peak sales (2006) now entering scrappage phase

-          Easy 2021 wholesale growth after aggressive 2020 inventory reduction, covid drop and six straight years of declines

-          Formal acknowledgement of the need for “more credible expectations” – management has lowered the bar.  Cost cuts alone should drive meaningful margin expansion.

-          Potential for ESG investors to embrace CEO and his sustainability vision

The new strategy is focused on:

-          Reducing cost structure and operational complexity - 700 jobs eliminated;

-          Cutting dealer inventory and bike lineup - 30% sku reduction;

-          Focusing on higher margin aftermarket, accessories and general merchandise;

-          Exiting low-ROI international markets - focus on 50 key markets in North America, Europe and parts of APAC;

-          Shrinking dealer footprint ~50 dealers worldwide could be shut down; and

-          Focusing on supporting strong brand and driving scarcity value via reduced supply

Early Signs of Success:

-          2020 new bikes are selling at MSRP on average

-          Used bike prices up 6% in Q2

-          Dealer inventory levels down 32%

-          250mm in cash savings from SG&A and capex reductions for 2020

Are there any examples of successful turn-arounds that involve reducing volume and increasing prices?

Hard to find great examples that compare.  Ferrari is probably the strategy most comparable, where the company has limited supply to create scarcity value.  Harley is obviously at a much lower price point.  We’ve seen a number of turnarounds in retail/apparel.  Lacoste, Converse, Puma were all next to dead before using a more premium strategy to elevate the brands.  I would argue that Harley is more of an operational turnaround than a brand turnaround. The Harley Davidson brand is still very strong but has been mismanaged.  It is an iconic brand in the motorcycle space and I don’t think much has changed around that.  The prior management team chose to push volumes at the expense of profitability, which has had longer term impact thru used bike prices.  This created somewhat of a downward spiral (dog chasing tail) and requires some pain to fix.  2020 appears to be that pain point where management is slashing inventories, cutting underperforming dealers and getting out of certain international markets. Prior management also misread the market, choosing to maintain their focus on the large, heavy duty bikes and not putting out smaller models.  While the Company is going to reduce overall models, they will broaden their portfolio to cover more of the market. 

I think the best way to judge the progress is thru pricing – both new bike sales compared to MSRP and used bike sales compared to prior years.  On their Q2 call, Management noted inventories were down 32%, new bikes were selling at MSRP and used bike prices were up 6%yoy.

With easy comps for 2021 and a significant right-sizing of the cost structure, Management should be able to exceed what are now lowered expectations.  The potential for a more meaningful turnaround provides a call option for far more upside over the long term. 

Key risk: The biggest risk remains demand and competition.

Catalyst

- Unveiling the new 5-year plan in Q4 2020. 

- Margin improvements over the next quarters.