Posted on Thursday, October 30, 2008 - 08:19 pm:

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I continue working through the BC Portfolio – difficult enough between the number of stocks (about 35) and the number of sacred cows that are apparently forbidden from being sold, but further complicated by the selloff that’s made so many stocks look so cheap. It’s a constant process to remember that stocks are owned for where they are going, not for where they’ve come from, and that there are opportunity costs to any position – namely, the returns that could have been realized elsewhere with that capital.

When I look at the portfolio, I begin with the lens that each stock was added for a reason. This can be difficult, because in most cases the stock’s existence in the portfolio predated my tenure in the club, but I think it’s necessary because not adopting this process can allow stocks to linger indefinitely. Circumstances change, and sometimes the environment a company finds itself in is radically different than what was expected… especially in times like this. This is the position I found myself in last Monday, when I presented an update on fund holding Harley-Davidson (HOG) to the club.

In doing this re-assessment of Harley, I felt that stock was likely added to the portfolio because of the strong growth the company showed in the first half of the decade, which was assisted by the use of Harley’s finance arm (HDFS). In hindsight, it’s clear that many of those new customers were riding a wave of unsustainable home price appreciation and easy credit to dreams of riding a Fat Boy. From this perspective, it’s clear that HOG is not being held for the right reasons – volumes are down double-digits in the North American market, dealer inventories remain elevated, and HDFS has drawn scrutiny for poor lending practices.

Considering the techniques used by HDFS – zero down, 100%+ LTVs, and teaser rates – it’s not too much of a stretch to compare them to an out-of-business subprime lender. The growth of HDFS has expanded finance receivables as a percentage of total assets from 35% in 2003 to 56% currently, with the result that Harley’s balance sheet makes it look more like a lender than a manufacturer. Because of how closely HDFS is tied to Harley’s core business of selling motorcycles, being able to offer continuous funding is crucial, and HDFS has $400 million in financing due by year-end whose ability to be renewed at reasonable rates is not assured.
Even those concerns about credit issues in the lending portfolio exist, the secured nature of these transactions (collateralized by the motorcycle, with high re-sale values) has minimized credit losses to less than 2%, on 6% delinquencies.

This information, and the ugly outlook for spending on big-ticket discretionary items, bodes poorly for Harley. But with how much time has passed and how circumstances have changed – especially regarding Harley’s share price, down more than 65% since the peak – the question changes to: “knowing what we know now, would we buy this stock at this price?” It’s obvious that Harley committed a number of sins during the good times, but they have been punished, and then some. So where is the good here, and is it enough to save Harley from being sold?

If Harley has one strength, it is that they are highly profitable, and that forgives many sins. Their ten-year average return on equity is 29%, although it is apparent how the company added leverage to achieve a higher ROE from 2005-2007. Nonetheless, such a high ROE is nothing to dismiss as a simple byproduct of leverage, which averaged just 1.83x over that decade (relative to 2.68x now). As volumes decline, Harley will suffer reduced profits, but the consistent 20%+ operating margins should cushion the blow to some degree, as will the extremely depressed valuation multiples. The stock trades for under 2x book, and 0.75x sales, and looking at a ten-year average of net income ($643 million), the stock trades for under 7x long-run earnings. For a stock that has historically traded around 6x book and 3x sales, those multiples are exceptionally low.

So value, or value trap? Under $20/share I find the prospects truly compelling between the earnings power and minimal implied value given to Harley’s brand name, which is not carried on the balance sheet. While there are no guarantees HOG does not go lower in a bad market, I believe this company – present bad headlines and all – is worth adding to on a long-term time frame.

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