RealMoney Silver - I'm Not High on the HOG

I'm Not High on the HOG
By Bill Trent
RealMoney.com Contributor
3/28/2008 1:26 PM EDT

Harley-Davidson (HOG) has been trading lately at levels not seen since 2000. Although it appears cheap on a P/E basis and generates strong and consistent cash flow, I'd need a much cheaper price to make me want to hop on.

As Scott Rothbort predicted in January, consensus earnings estimates for Harley have been falling fast. Ninety days ago, analysts figured the company would earn $3.94 a share this year and $4.19 next year. Now, the $3.94 in earnings has been deferred to 2009, while 2008 estimates are just $3.65. As a result of the persistent cuts, Harley's Zacks Rank has fallen to 5, which puts Harley among the worst 5% of all companies in terms of earnings momentum.

According to the 10-K, Harley "believes that low consumer confidence and persistent housing and credit issues have resulted in a weak retail sales environment in the U.S. for major discretionary purchases, including Harley-Davidson motorcycles." Tell me about it. And while motorcycle fuel efficiency rivals that of hybrid cars, the practical limitations (roof, anyone?) suggest to me that higher gas prices won't fuel demand.

Still, at roughly 10 times earnings, doesn't the current price reflect the cuts? I don't think so. With a 33% payout ratio, a P/E of 10 times is justified only if the difference between investors' required return and Harley-Davidson's growth rate is at least 300 basis points.

It would be one thing if earnings were growing 12% per year, as they have for the last five years. In that case, investors could expect 15% annual returns. But I don't think the growth will be even close to that rate, or to the 11% consensus growth estimate.

If the company does manage to earn $3.94 in 2009, it will have finally regained the levels it earned in 2006, and would then have a five-year earnings compound annual growth rate (CAGR) of 5.5%. I think that is a more reasonable growth estimate to use, and plugging that in implies a decent but not great expected return of 8.5%. If I hope to earn double-digit returns, I'd expect a share price no higher than $29 per share next year, or about $26 a share today.

Taking a free cash flow approach to valuation, Harley generated $556 million in free cash flow in 2007, for a 6.2% yield against the current market cap. That's a nice yield, but I've seen quite a few names with similar or higher yields and more attractive growth prospects. In order to generate a double-digit free cash flow yield, the price would have to drop to $23 a share.

One problem is that the market is shifting away from the heavy motorcycles that are Harley's bread and butter. Although total shipments were down 5.5% in 2007, the declines for touring and custom bikes were 7.6% and 10.4%, respectively. Smaller Sportster unit sales grew 11.6%.

Based on surveys indicating that three-quarters of Sportster buyers either have previously owned competitive-brand motorcycles or are completely new to the sport of motorcycling, Harley expects Sportster sales will lead to future sales of its higher-priced models. However, one might just as easily imagine that these new buyers will get their fill of motorcycling and their first bike will be their last.

I'm also concerned about Harley's growing exposure to financing, particularly given today's credit environment. In 2005, the company collected more from securitizing financial receivables than it expended by originating loans. In both 2006 and 2007, originations exceeded securitization proceeds by nearly $450 million. As a result, cash flow from operations went from being $3 million higher than net income in 2005 to being $282 million lower in 2006 and $135 million lower in 2007.

All that exposure to financial receivables seems dicey to me. What's more, if the company is unable to continue absorbing financing it could see an even more significant sales drop.

If we get a share price in the $20s, Harley would once again start looking like an easy rider. Until then, I'd sell the name and keep my motor running -- in the form of cash idling on the sidelines.