Identifying an undervalued business franchise

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Sep 19, 2007
“The difficulty lies not so much in developing new ideas as in escaping from old ones.” -- John Maynard Keynes. Scott F. Yarnell shares his thoughts with Harley-Davidson (HOG, Financial).

Tightening credit, declining consumer confidence and talk of recession as investors nervously await the results of the next scheduled meeting of the Federal Open Market Committee (FOMC) would not seem to present the best climate for investing in equities. Investing in companies that sell high priced recreational products might seem particularly counterintuitive at this time. Of course, the market does not offer up great companies at attractive prices when things are looking rosy. Fear by speculators creates opportunity for investors. For the patient investor who enjoys accumulating, at reasonable prices, those rare privileged companies with a durable business franchise, current market conditions offer such an opportunity with Harley-Davidson (HOG).

The purchase of strong business franchises at attractive prices offers the greatest opportunity for superior long-term investment returns with minimal risk of permanent loss of capital. Unlike most companies whose products or services are mere commodities, a few rare privileged companies occupy competitively advantaged positions in industries with growing demand. By virtue of their privileged positions, these companies earn high returns on equity and grow their earnings power over time with reasonable predictability, persistently creating value for their owners that will eventually be reflected in their stock prices. Given that stock prices fluctuate around a company’s intrinsic value over time, when such companies are purchased at a reasonable discount to that intrinsic value, an investor reaps the combined benefit of growth in the business’s value and the reappraisal of its market price while enjoying protection against loss (i.e., the margin of safety). The challenge lies both in recognizing such valuable business franchises and finding ones offered at an attractive price.

Warren Buffet has explained that the test for a business franchise is how much harm a competitor can do to the company if the competitor did not behave rationally with regard to its own performance. In the case of Harley, the well established mystic of owning a Harley among its devoted customers appears impossible for others to imitate. Harley customers pay a premium for both the image and quality of a Harley motorcycle. The company has managed to create an entire culture. Although I have seen many willing to adorn their bodies with the Harley name, I have yet to see anyone with a Honda motorcycle tattoo (and not for lack of looking). For most of its customers, a Harley is the only motorcycle they will purchase. This strong brand loyalty among its customers seems to cement Harley’s status as a durable business franchise. Harley has over 49% of the market for heavyweight motorcycles in the U.S. while its closest competitor has only 15%.

Harley’s financial characteristics certainly bear the hallmarks of the strong business franchise with a sound balance sheet, healthy profit margins and consistently high returns on equity of well over 20% (and not just reported return on equity but return on equity calculated using owner earnings, i.e., net earnings plus depreciation and amortization minus capital expenditures).

The durability of Harley’s franchise is evident. A Harley motorcycle is often described as a midlife crisis product. According to the company’s data, the average U.S. purchaser is a married male in his mid-forties. The company even seems to exploit this perception in its marketing efforts. Unless one believes that the midlife crisis is a thing of the past, Harley should have a bright future. And regardless of the motivation for purchasing its products, Harley has a long demonstrated track record of sales growth. Harley and Davidson made their first motorcycles in 1903. In 1907, 150 Harley-Davidson motorcycles were reportedly manufactured. By 1991, the company was selling 68,626 motorcycles a year. Last year, the company sold 349,196 Harley-Davidson motorcycles (as well as 12,460 Buell motorcycles). Although the meteoric growth of the last few years is unlikely to be repeated, Harley will remain a steady growing company for the long haul as it continues to successfully extend its franchise to other countries and build its franchise in the U.S. including by increasing its appeal with non-traditional purchasers such as women. Harley’s seasoned management team has proven adept at operating the business to expand the franchise while making wise capital allocation decisions, including opportunistically repurchasing shares.

Unlike, for example, the commodity business with earnings too cyclical or the high technology company with earnings too unpredictable to determine their intrinsic value, the strong and durable business franchise has enough earnings predictability to allow for a reasonable estimate of intrinsic value. Given Harley’s status as a strong and durable business franchise, not only can it be reasonably expected to create value over time for its owners, but it also has an intrinsic value that is knowable (for comparison to its market price). Therein lies the two-fold advantage of identifying the business franchise, one can identify both the best businesses to own for consistent predictable investment return over time and can determine when such business are available at an attractive price relative to their value, reducing risk of permanent capital loss and increasing investment return.

Even the best companies will occasionally stumble. Harley is currently out of favor with the market because it hit a bump in the road in August. Indeed, the road may be rocky for quite some time to come, but at Harley’s current market price investors should be well compensated for the wait.

From 2004-2006, the company generated owner earnings of about $650 million per year on average. From 1997-1999, the company generated owner earnings averaging about $130 million per year. Based on those figures, owner earnings have grown about 23% compounded annually over about the last decade, a level of growth that is unlikely to be achieved in the future. If one estimates a 10% earnings growth rate for the next ten years leveling off to 5% growth after that, using the $650 million average of the last three years, and choosing a conservative 9% discount rate (well above the current yield on the 30-year Treasury bond), one arrives at a discounted present value of over $20 billion for Harley-Davidson. The current market value of the company is about $11.7 billion, presenting a desirable business franchise at an attractive price.

The author owns shares of the company mentioned in this article.


Scott F. Yarnell, Esq. is a partner in the litigation and intellectual property practice of Hunton & Williams LLP, a major international law firm. He primarily represents pharmaceutical, biotechnology and consumer products companies in patent and other intellectual property matters. He graduated from Drexel University in 1994 and received his law degree from George Washington University Law School in 1997.