Harley Davidson should be one of those companies that delivers solid, steady investment returns. It has the premier brand name in the manufacture and sale of motorcycles, and earns 23% operating margins in an industry where 14% operating margins are the norm. Heck, can you even name its competitors? I could name Yamaha, Kawasaki, and Polaris, and that was it.
Despite these superior operating results, Harley Davidson stock has barely appreciated in price over the past twenty years. It traded at $29 per share in 1999. It trades in the $30s now.
Why aren’t the shareholders of the most dominant motorcycle franchise on the continent getting any richer?
The answer is because Harley Davidson’s management team is not satisfied with modest single digit (think 4-6%) sales growth, similar earnings per share growth, and the return of cash to shareholders in the form of dividends and share repurchases.
Instead, it wants to deliver double-digit growth to shareholders, and in the pursuit of it, has decided that it wants to extend loans to individuals who otherwise wouldn’t qualify for loans through a traditional bank so they can get their hands on a Harley motorcycle.
The company makes half-a-billion dollars in profit. The risk factor? Almost half of those profits come from Harley’s financial division which provides secured loans to riders.
For the typical car purchaser across the United States, the default rate on vehicles is 1.2%. For Harley’s motorcycle borrowers, the average default rate is 3.5%. That is almost triple the risk rate of the typical U.S. borrower. Now, some might say that heightened borrower risk can be offset by higher borrowing costs by charging the lender a higher interest rate. The problem is, higher interest rates charged to borrowers only result in additional wealth to the extent that they are actually repaid.
During the last recession, Harley Davidson saw its motorcycle default rate rise to 7% as its profits of $683 million fell to $14 million. You read that correctly. Harley saw its profits fall 98% between 2008 and 2009, and even here in 2019, profits are 21% lower than they were 11 years ago. This illustrates a longstanding problem that has faced Harley, namely that the cost of repossessing a motorcycle and trying to sue the borrower for a deficiency balance doesn’t actually result in Harley getting its money back when times get tough.
It should be noted that Harley has done a commendable job of repurchasing its own stock, as the share count has declined from 232 million to 160 million over the past 11 years, so earnings per share have actually climbed from $2.79 per share in 2008 to $3.35 per share in 2019.
I call Harley the “Anti-GEICO Business Model.” For those of you who are familiar with Warren Buffett’s investment and takeover of GEICO, you know that GEICO originally stood for “Government Employees Insurance Company” and it was a specialty insurer that provided automobile insurance for postal workers and other U.S. government employee’s.
Buffett’s reasoning for the GEICO investment was that government employees paid the same insurance premiums as everyone else, but the type of person who sought government work was a more cautious person in general and would generally be a more cautious driver that would be involved in fewer car accidents. Since this proved to be the case, GEICO shareholders did very well because the claims payouts were dramatically lower than the premiums brought in.
Harley Davidson is doing the opposite of this. It is bringing in borrowers that pay more or less the same interest rates as other subprime borrowers, but in fact, its riders are twice or maybe even three times as likely to default as the typical subprime automobile buyer.
The management team says that it has algorithms to track high-risk borrowers and that “this time is different”, but I’m not taking those statements at face value. Harley’s default rate of 3.5% is currently higher than its default rate of 3.1% (prior to the last recession), and its borrowers are currently paying a slightly lower interest rate on average than its 2007 borrowers did. If another recession were to strike, it would have to go through the same process of hiring an attorney and towing company to effect the repossession in compliance with state law, actually succeed in locating and repossessing the moveable collateral that is motorcycles, and then try and sue the individual for a deficiency judgment. That costs a lot of money for each motorcycle borrower in default, and that explains how a business can go from $600+ million to breaking even in less than a year.
To make an investment, you must be able to figure out (even approximately) where profits for a business will be 5-15 years from now. Otherwise, how do you know whether the price you are paying is appropriate or not? Under a best case scenario, Harley Davidson could see its profits soar to $8 per share on the heels of buybacks and motorcycle sales growth and lowered default rates. With a P/E ratio of 15, it could be a $120 stock sometime between 2025 and 2030. On the other hand, if there is another 2009, the stock could be worth somewhere in the single digits, especially considering the $7 billion in debt on the company’s balance sheet (with $5 billion due before 2024).
There is a rational basis for why you could see 20% compounding from this stock over the next five years, but there is a rational basis for why you could lose 70% of your money. I suppose there are worse ways to speculate, but I don’t like it. The company should spin off its lending division to shareholders, and those who want 500% returns or bankruptcy tradeoffs can have them, leaving behind the core manufacturing motorcycle business to deliver 6-9% long-term returns to investors.
For what it’s worth, I would not buy Harley-Davidson unless the country were in a deep recession and the stock was trading at liquidation value but appeared likely to survive and deliver 5x returns once the path to survival were widely accepted by the investor community. It’s a decent business with a junk loan portfolio attached, and investors will get all the risks and rewards that come with it. Personally, I prefer assets that move from strength to strength no matter the economic conditions.