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Morningstar | Shift in Timing Leads to Lower Shipment and Operating Profit Outlook at Harley; Shares Fairly Valued

Languishing domestic demand continues to weigh on wide-moat Harley’s growth, with Harley U.S. retail sales falling 8% while industry retail sales ticked down 5%, implying market share losses for the brand. While much of the share cede was attributed to the consumer’s preference for other styles, including smaller displacement bikes, we don’t see anything likely to stop overall market declines until the middle of next year, when Harley launches its first middleweight bike product. Furthermore, Harley’s ability to ship tariff-free from Thailand into the EU is not happening until 2020, a key factor in the company’s reduction in shipment guidance to 212,000-217,000 (from 217,000-222,000 prior, versus our 219,000 estimate). This delay in the ability to mitigate tariffs also hindered motorcycle operating margin expectations, excluding tariffs and restructuring, which should now be around 10% in 2019 as deleverage from volume takes hold (down from our 11% forecast prior). Harley’s profitability continues to be impacted by the ongoing trade war, which we expect will be partially mitigated in 2020 as incremental production moves overseas, boosting the gross margin temporarily before a decline as a mix shift to new model bikes ensues (which we expect to fall to below 30% over our forecast).

We don’t plan any material change to our $34 fair value estimate and view shares as fairly valued, trading at below 10 times 2019 EPS versus our 2% expected average EPS increase over the next five years. We have included Harley’s More Roads initiatives into our outlook, which forecasts unit shipments that rise 2%, average selling prices that fall more than 1%, and a gross margin of 31% on average over the next five years. While we believe Harley should gain some operating leverage from the higher volumes we anticipate, we don’t believe this will be enough to offset margin pressure from middleweight and small displacement bikes.

We outline our explicit outlook for Harley’s More Roads program in our July 2019 report, “Efforts to Rev Demand at Harley-Davidson Likely to Slow Its Roll.” Our valuation concern stemmed from fears that Harley’s strides to gain consumers abroad could lead to price taking behavior and higher marketing spend to build awareness, leading to a lower profit margin per bike. Furthermore, our updated outlook led us to re-rate Harley's moat trend to negative from stable, as shipment cadence and pricing gains have continued to struggle, leading to lower (but still healthy) ROIC performance ahead (averaging 22% over the next five years).

Overall, second-quarter sales were in line with our expectations, falling 6% to $1.4 billion, with shipments down 5%, to about 69,000 units and average selling prices falling 1%, to around $16,400. The gross margin was about 30 basis points worse than we modeled, at 31.7%, hindered by volume and mix, impacting the company’s ability to improve the motorcycle operating margin. Financial services income fell 6%, in line with shipment declines, and we forecast a mid-single-digit contraction for the HDFS business in 2019. HDFS, which has financed more than 65% of new retail motorcycle loans this year, continues to experience rising 30-plus day delinquencies and higher annualized loss experience, which the firm attributes to the rollout of its new loan management system in the first quarter. With a difficult motorcycle sales environment set to persist ahead, we expect many of the trends Harley experienced in the second quarter to continue over the back half of 2019, leaving any meaningful sales and earnings per share growth as unlikely for the full fiscal year.