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Morningstar | Restructuring Costs and Tariffs Pressure Harley’s Operating Profit; Shares Undervalued

Like other manufacturing companies, wide-moat Harley-Davidson is facing external headwinds stemming from both domestically implemented and retaliatory tariffs, which is largely out of the company’s control. However, we think Harley also faces internally inflicted profitability headwinds from its More Roads initiative, which is expected to lead to $1 billion-$1.15 billion in additional revenue and $200 million-$250 million in higher operating income by 2022, above our internal forecast of $800 million in sales and $150 million in gains. The mix of the revenue stream driving these incremental gains surrounds our concern, with operating margin of new bikes launched unlikely to be as lucrative as existing heavyweight models, and also set to drive lower average selling prices over the introduction period, as smaller-displacement bikes should price at materially lower points. Given the languishing demand of the core domestic customer, this pivot was imperative for the brand to remain relevant (supporting our wide moat rating) and prevent share losses by participating in markets to where demand is shifting.

In this vein, we plan to lower our $48 fair value by about $3 to account for lower shipments in 2019 and lower average selling prices over the duration of our forecast as new products ramp up adoption. This should leave our average shipment growth around 2% beyond 2019 as international market demand gains traction, with ASPs rising closer to 1%, rather than the 2% we previously forecast. Furthermore, establishing a presence in these emerging markets (relative to the established domestic market) will be an investment, constraining motorcycle operating margin gains, which we project could be stuck below 12% over the next few years. All in, shares appear undervalued, trading at about a 20% discount to our estimated new fair value and at below 10 times our 2019 estimate.

Third-quarter revenue was better than we anticipated, as both shipments and average selling prices handily outpaced our forecasts. Shipments rose 17% versus our 8% outlook, and ASPs increased 8% relative to our 2% forecast (as a function of mix, with more touring bikes sold in the period). However, both parts and accessories and general merchandise sales declined 8% and 20%, respectively, neutralizing the aforementioned gains. Domestically, Harley ceded 220 basis points of share, to 50.9%, as retail sales declined more than 13% and industry sales contracted about 10%. Internationally, Harley gained 80 basis points of share, to more than 10%, helped by healthy demand in Western Europe and Latin America. Gross margin rose more than 200 basis points to 30.9%, helped by volume, pricing, and mix, as touring represented 46% of shipments in the period, versus 35% last year.

Given company guidance across multiple categories, the final quarter is set to experience some pressure, with potentially flat shipments and a motorcycle operating margin that should contract more than 300 basis points as tariffs and restructuring costs surface. We expect Harley will pull out all stops to defend its margin, and had modeled a motorcycle operating margin above the 9%-10% outlook, as we anticipate efforts to mitigate the total will be at least partially successful. Despite the multitude of headwinds Harley faces, it still delivers healthy ROICs (20%-plus) well above our 7% weighted average cost of capital and has plenty of cash to support its dividend and to repurchase shares, supporting our Standard stewardship rating.