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I own some HDI, that way it doesn't hurt so bad every time I spend money at the dealer.

JMS

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Morningstar Quicktake® Report |Analyst Report Morningstar Rating 09-13-02
Harley-Davidson HDI

Analyst Report | 09-13-2002
by T.K. MacKay

Thesis
Harley-Davidson is a well-oiled machine worth buying in the low $30s.

We're big believers in strong consumer brands, and find Harley-Davidson to be one of the most robust of them all. Harley-Davidson easily meets one of Warren Buffett's foremost criteria for a sound investment: long-term competitive advantage. In 2003, the company will be 100 years old, having dominated the American motorcycle industry the whole way. Harleys sell at or near their manufacturer's suggested retail price, and the company makes just enough bikes each year to retain this pricing power. By the end of 2002, Harley-Davidson will have produced 261,000 motorcycles for the year, and every single one will be sold.

Ensuring that demand constantly outweighs supply is the key to Harley's fat profits; it relieves the company from much of the high costs of marketing that other manufacturers put into selling their bikes. For example, Harley's selling, general, and administrative expenses are 8 percentage points lower than those of venerable Italian motorcycle manufacturer Ducati DMH, at 17% of sales. Such cost savings afford Harley the highest operating margins in the industry. This superior profitability combined with a strong increase in demand has resulted in annual free cash flow growth of 33% over the past decade. Harley also carries more cash than debt on its balance sheet.

Harley puts part of its cash hoard to work each year by expanding its manufacturing capacity, the most recent project being a $145 million, 350,000-square-foot expansion at its York, Pennsylvania, plant that will come online in 2003. Capital projects like these paid off in spades during the 1990s as the country enjoyed one of its greatest periods of economic expansion. Harley was able to increase prices at the same time it increased output because demand always outweighed supply. This led to high-double-digit sales increases year after year. In less affluent times, however, increased supply could produce a lower return on investment than Harley hopes. We fear that aggressive capacity expansion in a slow-growing economy could lead to an imbalance of supply and demand, resulting in pricing pressure. This would jeopardize Harley's gross margins, which have historically topped 33%.

The prospect of lower returns makes it hard for us to put a premium valuation on Harley stock. We believe the company's wide economic moat makes Harley an attractive investment, but only at the right price.

Valuation
We have revisited our model, and now believe that Harley's operating margins will decline slightly over the next several years from their current level around 21%. We expect the company will continue to expand sales in the midteens. We estimate Harley's fair value to be $38 per share, and would consider the stock if it fell into the low $30s.

Risk
The greatest risk an investor in Harley-Davidson faces is valuation. Harley's franchise may not be able to handle fast growth at the same level of profitability it has in the past, making the stock's lofty price (in relation to cash flows) hard to justify.

Close Competitors TTM Sales ($Mil) Market Cap ($Mil)
Honda Motor ADR 58,319 39,600
Ducati Motor Holding SpA ADR 268 223
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 09-13-02


Strategy
Harley-Davidson's brand name ensures rabid demand for its products and makes it difficult for competitors to crack the firm's market share for recreational and custom heavyweight motorcycles. Harley's near-term goal is for modest production increases. It also wants to build up its line of Buell performance motorcycles to bring younger and entry-level riders into the Harley-Davidson fold.

Management
Jeff Bleustein has been with Harley-Davidson for more than two decades, first as an engineer and then as part of the management group that led the buyout of the firm from AMF. He has been CEO since late 1998.

Profile
Harley-Davidson manufactures motorcycles and related parts and accessories. Its products include motorcycles with V-twin engines ranging from 883 to 1,450 cubic centimeters of displacement. The company markets its motorcycles under names like Softail, Sportster, Fat Boy, Low Rider, Road King, and Wide Glide, as well as the Buell brand. It also sells accessories for its motorcycles and clothing bearing the Harley-Davidson name. The Harley-Davidson Financial Services subsidiary offers financing for the company's customers.

Growth
Increasing unit sales have fueled double-digit revenue growth, though Harley-Davidson's market share has remained steady. Modest price increases for anniversary editions and continued capacity expansion should keep sales growth steady.

Profitability
As befits its strong brand name, Harley earns outstanding profit margins, especially on its top-of-the-line custom bikes. A relatively debt-free balance sheet and efficient production process also help.

Financial Health
Harley-Davidson is in great shape. It carries virtually no debt, aside from funding for its finance division, and generates loads of free cash flow. That means it can internally finance growth.


Morningstar Risk
Low

Economic Moat
Wide

As of 09-13-2002
Stock Price

$48.30

Morningstar Fair Value

$38.00


Bulls Say
Harley-Davidson's brand cachet is second to none. This allows the company to earn much better margins on its motorcycles than competitors.
Harley-Davidson holds a large and steady share of the domestic and worldwide market for heavyweight motorcycles.
All of Harley-Davidson's lines--including parts, accessories, and licensed products--have posted double-digit unit and revenue growth in recent years.


Bears Say
Big increases in supply could drive down prices, putting Harley's rich margins in jeopardy.
Buell, the company's entry-level and performance motorcycle division, has yet to turn a profit. It has also made a few product recalls.
A consumer-led recession could put the brakes on Harley's strong sales growth and fat margins.
About 15% of Harley's operating profit comes from its financing business. Should interest rates rise, profits in this business could decline, despite the company's hedging efforts.

T.K. MacKay is an analyst with Morningstar. He can be reached at [email protected]. As of the date of this report, Analyst T.K. MacKay does not have a position in this stock.Find out about Morningstar's editorial policies related to stock ownership here.
 
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