Wednesday, February 7, 2007

Don't Reach For The Bacon Just Yet...

Harley Davidson (HOG) (get it bacon.....hog?) shares have come under pressure recently and you may be tempted to buy some. Let's step back, take a deep breath and take a closer look.

The case for Harley Davidson:

When you think of motorcycles what comes to mind? Yeah, me too, a Harley. They may have one of the most enduring durable competitive advantages out there today. Can anyone legitimately imagine any motorcycle maker ever becoming a serious threat to Harley? What does this advantage do for them and us as potential investors? It allows us with a higher degree of confidence to estimate future earnings for them as there are far fewer competitive challenges to their products than say Suzuki or Honda face. The fewer variables we have to put into any equation the more certain we may be in the results we arrive at. It also gives them a pricing advantage. Since the average Harley user is college educated and earns $83,000 a year, they are far less price sensitive than the high school kid buying his first Suzuki. Pricing power also enables us more of comfort level when it comes to future earnings. These factors immediately vault Harley to the top of our investment possibilities.

Harley is doing a couple very important shareholder friendly things. Raising the dividend, which puts more money in your pocket and buying back shares. Let me explain why buying back shares helps shareholders. When you buy a stock, if you think of it correctly you are buying a piece of a business. A piece of a whole pie if you will. Let's say there are 100 shares outstanding of a company (again for easy math) and you buy 2 (two pieces of the whole pie). Now, you own 2% of the business. The company then decides to buy back 5% (or 5) of the shares. After the buyback there are now only 95 shares out there. This increases your ownership to 2.1%. Big deal right? Let's go a little further. We need to talk about earnings. The company makes $100 a year the year we buy the stock (or $1 for each share we own). The next year after the buyback earnings only grow 5% to $105 dollars, but on a per share basis because the are less shares outstanding they grow from $1 to $1.10 or 10% ($105 / 95 shares). In this case the buyback grew earnings per share from what would have been only 5% to 10%. What does this do to the price of the stock? If it trades at a pe of 15, then at $1.05 per share earnings it would be priced at $15.75, at $1.10 in earnings that gives us a price of $16.50. Now, you could also argue that a stock growing earnings per share at 10% would trade at a higher pe (therefore price) than a stock growing at only 5% (and probably be correct) but I am just trying to keep the comparison easy.

How do buybacks effect the dividend? Our hypothetical stock here also pays us a $1 annual dividend. The cost of that dividend to the company is $100 ($1 X 100 shares). After the buyback if the company still commits to spend $100 on dividends then that per share dividend is raised 5% to $1.05 a share ($100 / 95 shares) with no additional funds being expended by the company. A win / win. Harley has bought back almost 40 million shares since 2004 and raised it's dividend from 20 cents a share to over 80 cents (over 300%).

So, why not buy it now? You ask..

It will get cheaper, that is why. Here are a couple reason that are setting us up for a Value Play..

Insider Selling: The price of HOG rose about 50% during the last six month of 2006 and have remained more or less at that level. After the rise insiders sold 1.5 million shares. Now 966,000 were from a retired CEO that had to either sell them or lose them so we must eliminate them from our thinking. But, for those who do not do their homework, they only see the whole number and think "there must be a problem". The reality is that you had people taking advantage of a huge run in the stock. They also recognized that for the stock to jump 50% when earnings only grew12% (and are not projected to grow much more than that in the future) that there was a disconnect and the price should fall in the future. Fund managers also realize this and will dump shares as their price growth this quarter may lag the market thus affecting the returns they can advertise. The result? They dump the shares and move on to another stock. Since these guys are all lemmings it will happen en-mass causing the price to fall.

A Strike: For the first time in history Harley has a strike at its production facility in York, PA. This plant makes Harley's most profitable bikes. Now even though Harley says there should be no long term effect, there will be an effect now and this year (the longer the strike, the larger the effect). This will cause earnings to be negatively effected and that will spill over into the stock. Bank of America analyst Michael Savner said a strike could cost the company almost 1 cent per share of earnings per day. So a 50 day strike could cost the company the 50 cents a share they grew earnings in 2006 over 2005. That would cause the stock to drop.

Credit: Harley has been selling more and more self financed motorcycles recently through Harley Davidson Finance (this is no different that any other retailer offering you "a credit card" at the checkout). The number of bikes sold this way has gone from 21% to about 48% in the past 6 years. There is concern that more of these loans may be of questionable credit. This could cause losses or decreased earnings at this division which would negatively effect earnings as a whole. True or not it is irrelevant (I believe the fears are overblown) but the hint of yet another possible problem adds more fear to the stock and fear usually equals a stock price decline.

All three of these negative catalysts are temporary in nature and have no real long term negative effect on the company. They should have a negative effect in the short term though. Let's just sit back and wait for the price drop. I need to add a disclaimer here. Everything I say only applies to the information were have today. What? If the strike is settled tomorrow and Mastercard buys the credit division we have immediately eliminated two factors weighing on the stock. That may cause the stock top turn around and go up. So we may miss an opportunity to buy the stock at an ok price today. That's fine because we want to buy it at a great price. If you are a batter in baseball, you are more likely to succeed letting the ok pitches go by and wait for the perfect pitch to hit. Why take a chance and swing at an ok pitch only to pop out when you can wait for a great pitch and hit a home run? Unlike baseball, in investing you can stand at the plate as long as you want and wait for the perfect pitch.

So, what price to look for?

HOG rose over 50% the second half of 2006 and hit $75 a share (38% for the whole year Jan 1 to Dec. 31). Earning will grow 12% in 2006 and probably the same in 2007 (strike dependent) we need to give most of that back in order to consider shares of HOG. Look for a price of $60 or under as an entry point. At a $60 price it will trade at a pe of 15 times 2006 earnings. This matters because if the strike does last, 2007 earnings may match 2006 (at this price, there would not be much more downside). If HOG trades at 17 times the projected 2007 earnings (usual multiple) of around $4.51, then you get a price of $76. The potential problem in paying a high price for "next years" earnings is if they do not materialize, you are left holding the short straw. It is all about the earnings. If you buy it now your upside is maybe $5 or $6 or 7% (if everything goes right) with a lot of near term uncertainty (risk) that could blossom into more depressing the shares. If you wait to see how these events shake out, your risk is minimized and your upside is much greater (14% or more).

I will add it to the portfolio under a "watch list" category and track it's progress to our buy point, if it ever gets there. Remember, if it doesn't, no big deal. We'll just wait for the next pitch.

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