Harley Stops Its Slide

Wide-moat

Our forecast had already factored in the persistence of competitive discounting and incremental cyclical pressures, particularly from consumers afflicted by lower employment across the oil-producing regions domestically. Our 2016 forecast incorporates shipments of 265,000 (just below the company's guidance for around 270,000 units) and pricing declines of 1% as lower-priced Street models weigh on the ability to raise average selling prices. Longer term, we see unit growth of 2%-4% and pricing growth around 2% as Harley stands to benefit from new model demand and international growth thanks to a larger dealer network.

Two of the biggest concerns we had surrounding the business were market share and potential for outreach, particularly to millennials. With regard to market share, we were mainly concerned that the slide would continue through mid-2016 when lapping the yen stabilization. However, proper marketing and advertising have repositioned the company with wider customer reach, helping drive demand. We were also glad to hear that the company is selling more bikes to young adults today than to boomers when they were young adults, because young adults are the only demographic that can truly fill the gap left by boomers exiting the market--and much has been noted about millennials preferring experiences over material things.

We do see some near-term volatility from an increasingly weak used-bike market, more-difficult credit performance (retail credit losses and reserve rates ticked up, indicating higher risk), and still-competitive pricing. However, in light of the currency headwinds and economic uncertainty, we thought full-year results were solid, despite revenue falling nearly 5% to $5.3 billion. Most of the shortfall was from motorcycles, where shipments declined 1% and average selling prices fell almost 5% as mix weighed on the metric (retail sales fell 2%). The company lowered its shipment guidance twice in 2015 to protect the brand and prevent excessive discounting. We think supporting brand positioning is paramount to maintaining our wide moat rating and allowing for price increases during better economic and competitive times, and we are confident that management has taken the appropriate steps to ensure that the heritage of the Harley brand remains intact.

Reaching Out to New Consumers Harley-Davidson is one of the most storied brands in the recreation industry. With more than 100 years of manufacturing experience, Harley's brand strength and dealer network offer the firm a wide economic moat and dominant position in the U.S. motorcycle market. However, there are no switching costs to protect Harley's brand when consumers replace their products, and the premium price Harley commands relative to its peers could prove problematic during cyclical downturns and periods of competitive pricing. Recently, we've seen foreign competitors use the exchange rate differential as an opportunity to price their bikes lower domestically, hurting Harley's market share. A concern is that competitive pricing could outweigh rising brand penetration for Harley, acting as a drag on retail sales and shipments.

Therefore, we believe producing quality, innovative products that cater to a wider audience while improving operational efficiency is imperative. To maintain the premium brand perception and boost product demand, faster product cycles are likely to ensue, and we see rising spending on product development helping to better match consumer demand with product offerings in the years ahead.

Harley is struggling to capture cost leverage as volume demand wanes, giving back some of its recent operating margin expansion. In our opinion, Harley will have to consistently fund product development to reach new consumers in order to fill the slowing demand from its core consumers. Harley has become increasingly reliant on its outreach constituents (and international); we estimate outreach constitutes nearly a third of new purchases in the United States. Additionally, new models, like the Street, will have to successfully entice a new target market of urban riders to try Harley's offerings for the first time. These newer bikes could also boost international interest as they are better tailored to the robust urban population, offering a wider global target market.

Brand Loyalty Builds Wide Moat Harley's distribution channel and brand loyalty give the firm a wide economic moat, in our view. The robust dealer network allows the company broad reach with its products; we believe the breadth of this distribution channel would be difficult and expensive to replicate quickly, particularly in North America and in certain international markets. Similarly, Harley has garnered brand loyalty from the manufacturing of quality motorcycles for more than 100 years, and its record for product innovation and reliability over a long time is difficult to copy. Harley has formidable competitors such as Honda and Ducati, and if consumer preferences shift toward smaller-displacement bikes there could be a new constraint on Harley's profitability (Harley is allaying this fear with its popular, narrower-chassis Street model). Harley's dominance in the U.S. market for heavyweight motorcycles--with about 50% share--has allowed the firm to achieve economies of scale that have so far eluded its competitors.

In the past, we were concerned that Harley would face headwinds as its core consumers (Caucasian men over 35) became a smaller proportion of the total population; we anticipated that the company could find it difficult to penetrate new markets with its traditionally large-displacement bikes. However, Harley has made significant inroads into its key outreach categories (African-Americans, Hispanics, women, and youths) over the past few years. This change, along with an increase in international penetration, offers promising opportunities in years ahead for the company. Rather than having a perpetually shrinking consumer base, we think Harley can expand its base significantly, and we model outreach/international units growing at a low-double-digit rate, with core consumer units growing at a low-single-digit rate. Although the rate of population growth for men and women is practically in line, Hispanic and African-American population segments are growing significantly faster than their peers', offering Harley promise in newly penetrated demographics.

Additionally, we still think Harley has pricing power as the company commands a premium price because of a strong brand identity. We expect that the company will be successful carrying its pricing power into outreach markets, and that it will not need to discount to entice new consumers to try the brand. This pricing power should translate into stable returns on invested capital, which have averaged 31% over the past five years, and we forecast it will increase in periods ahead as volume ticks up.

Economic Downturn, Aging Consumers Could Hurt Sales Harley faces a number of risks to its business. Motorcycles are big-ticket purchases, and a continued slowdown in the domestic economic environment could hamper the replacement and adoption rates of these products. Another downturn could also affect the financial services segment, making lending more costly and the ability to securitize receivables increasingly difficult. We believe Harley finances about half of its consumers' purchases domestically on average (and a higher percentage in recent periods), which can affect overall net income materially. The company's products have also been concentrated in the over-35 demographic, which has an increasing proportion moving into retirement age--offering slower demand growth due to a more conservative consumer. We like that Harley has embarked on an outreach to target other demographic segments and continues to innovate products to adapt to changing consumer preferences (narrower chassis, lower seat height, lower-priced options, and possibly an electric version in the future). Missteps in marketing could damage the brand, and we see the uncertainty of the business as high because of the products' discretionary nature.

Harley-Davidson carries more debt on its balance sheet than we would like, as leverage is required to finance its HDFS arm and offer loans to customers. HDFS generates increased financial risk and weak profitability when credit standards tighten or credit markets become less liquid. The firm has a defined-benefit pension program, and weak return performance of its portfolio could become a problem if it needs to make sizable contributions to it.