Time to Crack Piggy Bank for HOG?

Among the many icons of the consumer boom born in the 90’s, a Harley Davidson certainly ranked high on the list. Wannabe outlaw CPAs, lawyers, surgeons, and bankers rediscovering their youth became so common; it spurred the movie Wild Hogs, a testament to the Harley moniker and ticker. Wall Street certainly bought into the “Hog Hype”, as from 12/89 to 12/06, HOG’s stock price increased from $1.08 to $69, adjusted for splits. Not only was a HOG in the garage a status symbol, but also very profitable in a portfolio. Since January of 2007, however, Harley Davidson has had a tough go of it, as its recent price of $37.96 is close to a 5 year low, and the company has been one of the market’s worst performers over the last year. The question facing investors today is whether HOG is an attractive value stock, or simply another value trap.

For its fiscal year 2007, Harley showed 3 quarters of comparable sales declines, the worst being in its recently released 4th quarter results, where motorcycle revenue declined 8.6%. In addition, gross margins also declined in the quarter, to 35.7% from 38% from the 4th quarter a year ago. Actual motorcycle shipments in the US declined approximately 20% from a year ago. Offsetting this gloomy US performance, the company appears to be making significant inroads into the international market. Relative to a year ago, international HOG shipments increased 20%. So what does this all mean?

The Applied Finance Group pioneered the use of a process we call Value Expectations to help us understand what is priced into a stock price. Essentially, this process allows us to determine the sales and margin levels a company must generate to justify its current stock price. For example, prior to the technology bubble, in 1994, the market price implied that Cisco Systems would generate 0% sales growth over the next five years. Those lucky enough to buy the stock, benefited from Cisco outperforming the S&P 500 index by approximately 65% a year. Conversely, during the height of the technology bubble, in July 2000, the market priced Cisco Systems to grow at 65% a year, 50% above its average performance relative to its past three years. Its not surprising that as Cisco failed to deliver on that performance; its stock significantly underperformed the S&P 500. As this Cisco example demonstrates, by understanding the performance expectations embedded in a company’s stock price, investors are in a much stronger position to understand the risk/return investment decision behind an investment at a point in time. With that in mind, let us evaluate Harley Davidson at the start of 2007, and today.

Entering 2007, Harley’s previous 3-year median sales growth was approximately 8.5%. With its 2006-year end price of $70.47, the market priced Harley to grow at 7% a year over the next 5 years. While certainly not outrageous given the company’s recent track record, the market certainly expected the future 5 years to mirror the past 3. Given that the consumer was starting to tire, and oil prices and interest rates were on the rise, such expectations in hindsight appear to be a bit rich. Clearly as Harley under-delivered relative to those expectations in 2007, it’s not surprising that its stock price tumbled. Interestingly now, with the stock trading near 5 year lows, the market has taken a very bearish stance on the company. Friday’s closing price implies that the market expects Harley’s sales to decline 9% a year over the next 5 years. While anything can happen over the course of 5 years, it seems that such expectations are severely harsh for a number of reasons. First, management currently is guiding for low single digit sales growth in 2008. That seems plausible, and should they have flat to negative growth, then a sub $40 price provides a reasonable cushion for error. Second, for investors with a long-term investment horizon, Harley’s international trends are very promising. For 2007, international units accounted for 27% of all shipments, compared to 21% in 2006. Given the low expectations embedded in the current price, investors may very well be rewarded for such growth. Lastly, because the company tends to ship fewer units than consumer’s demand, the pent up demand should lead to greater sales as the economy improves and consumers become more confident. All told, these factors indicate that at current price levels HOG is likely to deliver patient investors superior long-term returns.

As every little piggy knows, sometimes you need to get in the slop to make some bacon.