There’s an old adage in Detroit. You make money selling cars, but you also make money helping consumers finance those purchases. And there’s never been a better time to be a lender. Big firms can borrow money at super-low interest rates, but consumers still need to pay 6%, 7% or even 8% to finance their purchases. The profit spreads have rarely been so juicy.
That’s all you need to know about this morning’s quarterly results from Harley-Davidson (NYSE: HOG). Profits are up sharply, thanks to a big boost in financial services revenue, pushing shares up more than +10% in Tuesday trading.
From Red to Black
Of course, to make money when lending, you hope that your customers will repay their loans. A year ago, Harley-Davidson had to set aside reserves to account for many delinquent customers. That led to a $90 million quarterly loss for its financing arm in the second quarter of 2009. But with a more stable economy, that unit has swung from red to black, posting a $61 million gross profit this time around. That $151 million swing accounts for all of Harley’s eye-poppingly strong quarterly performance.
|Harley Davidson: A Sharp Profit Spike|
|($ mill)||Q2 - 2010||Q2 - 2009||YoY Change|
|Gross Profit (Vehicles)||$397.0||$387.2||+2.5%|
|Fin. Svcs. Revenue||$173.7||$124.0||+40.1%|
|Fin. Svcs. Gross Profit||$60.8||$(90.5)||N/A|
Need to Move the Metal
But investors are looking past some more sobering news. Consumers are buying fewer new motorcycles these days. International sales at dealerships for Harley were flat in the second quarter, as a weak European economy offset the positive impact of a push into emerging markets. That global expansion is nearly complete, which may make further emerging market gains harder to come by. Sales at dealerships in North America fell -8% from a year ago. And management expects total sales to stay in a funk for the remainder of the year.
So in the absence of organic growth, the company has been paring expenses. Management has already shed nearly $150 million from annual overhead, and is seeking further gains from its workforce in terms of flexibility (which basically means that unionized employees will agree to a reduction in hours if sales are weak).
So you can look at this two ways. On the one hand, motorcycle sales may not return to their previous highs any time soon. Harley’s sales peaked in 2005 through 2008 at around $6 billion per annum, leading many to conclude that those glory days were tied up in a broader spending bubble that also impacted home sales and other high-ticket items. These days, annual sales are stuck close to the $4 billion mark, and some think they may stay there for awhile. If so, cost cuts can only support a stock for so long, as investors look out a year or two to flattening profit growth.
But perhaps sales will rebound as the global economy picks up, in which case those cost cuts could turn this into a powerful profit growth story. Sales forecasts appear reasonable. Analysts think sales will remain under $4.5 billion in 2011. That’s roughly 25% below the boom years. If the company can move up above $5 billion in sales by 2012, earnings per share (EPS) could approach $3. (Per-share profits peaked at $3.93 in 2006).
Action to Take --> From 1996 to 2007, Harley-Davidson traded for about 25 times next year’s earnings. But sales and profits are on a lower growth path these days, and a high-teens multiple is likely more justifiable. That multiple is at a premium to the broader market, which is justified in light of the company’s very strong brand name recognition. If shares trade up to 18 times projected 2011 profits, then they’d rise to $36, or more than 30% above current levels. Consider this: If EPS can approach $2.50 in 2012 (a reasonably conservative assumption), then shares would be worth $45, more than +80% above current levels. Even with today’s sharp gain, the reward looks better than the risk for Harley-Davidson.
-- David Sterman