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Morningstar | Tariffs Crimp 2018 Operating Profit as Harley Continues to Defend the Brand, Digesting the Expense

The effects of tariffs are finally set to kick in at wide-moat Harley-Davidson, leading motorcycle operating margins to compress to 9%-10% (including restructuring costs and versus 9.5%-10.5% prior) in 2018, from 13% in 2017. Even excluding restructuring and tariffs, however, the company would anticipate flat operating margin performance in 2018--the lowest level since 2011--as the company undertook massive restructuring efforts heading out of the last recession. We expect some of the tariff burden to be transitory as Harley shifts more production for foreign unit sales abroad over time, but we don’t expect the company to fully shake off costs anytime soon, as overseas facilities will need to absorb higher capacity production.

On July 30, Harley plans to update its strategic plan surrounding its previously launched 2027 objectives to capture 2 million new domestic riders, increase its international business to 50% of unit volume, and launch 100 high-impact motorcycles. Given that many of the initiatives appear to build on existing efforts for innovative products, wider consumer reach, and a more profitable dealer base, we don’t plan to make any material adjustments to our $47 fair value estimate. Our long-term outlook already incorporates average unit and price growth of 2% each over the next decade, with 1.4 million bikes sold domestically and 1.1 million sold internationally cumulatively through 2027. We think reaching 2 million domestic riders could be challenging, given that increased marketing spending has yet to result in higher conversion of bike sales over the past 18 months and industry headwinds aren’t set to abate.

Second-quarter performance was slightly better than we had anticipated, as Harley shipped more than 72,000 units versus our approximately 70,000-unit forecast, representing an 11% decline to rightsize inventory at dealers in the United States. However, given that bike revenue fell around 5%, this implies the average price per unit rose about 7%, a solid indicator of brand equity and the consumer’s willingness to pay for new, innovative product offerings. Year-to-date industry registrations fell 8% while Harley registrations in the U.S. declined 9%, indicating that the company ceded some market share in the first half of 2018. Gross margin was about 30 basis points worse than we modeled, at 34.9%, weighed down by lower volume and manufacturing inefficiencies as Harley shutters the Kansas City plant and moves additional production to York, Pennsylvania. Incremental spending on marketing and product development pressured the selling, general, and administrative ratio, leading to a second-quarter adjusted motorcycle operating margin below 17%, from more than 20% last year.

Given that much of the quarterly performance was in line with its prior expectations, the company maintained its full-year outlook for 231,000-236,000 shipments, slightly ahead of our forecast of 230,600, with gross and operating margin flat year over year excluding the restructuring and tariff impacts. We still expect Harley can throw off more than $500 million in free cash flow annually over the next five years, supporting rising dividends and share buybacks, which should help it achieve high-single-digit earnings per share growth on average through 2022.