Margin of Safety Saves the Day in a DCF Valuation of Harley-Davidson

I recently stumbled across an old discounted cash flow model from mid-2006 that I built for Harley-Davidson Inc. (NYSE:HOG) as I was weighing whether to invest. I thought it would be fun to assess my process from the vantage point of 2019.

In June 2006, Harley-Davidson's stock chart looked like this compared to the S&P 500 (SPY) over the previous five years:

Source: Yahoo Finance

It was up almost 13% versus the index, but in the year prior it had had a pretty big tumble, from $62 to $45, reaching around $54 by the end of June 2006. This brought it to a relative value that made it worth taking a look at.

The main reason Harley-Davidson had come across my radar, however, was its dividend. It had steadily grown its dividend to the point where its dividend yield (as of mid-June 2006) was about 1.28%. My minimum screener threshold is usually around 1%. Here's the company's recent dividend history at the time:

2001

2002

2003

2004

2005

Dividends paid per common share

.115

.135

.195

.405

.625

% Growth

17%

44%

108%

54%

• Warning! GuruFocus has detected 4 Warning Signs with HOG. Click here to check it out.
• HOG 30-Year Financial Data
• The intrinsic value of HOG
• Peter Lynch Chart of HOG

That's a strong, consistent dividend growth rate.

With a company like Harley-Davidson, I already knew quite a bit about their products, so less digging was necessary. Here are some highlights from my research (mostly quantitative, since anything qualitative is gone):

• Overall sales growth had been solid, especially during the economic weakness from 2001-03, but it had slowed of late -- which was concerning given the strength of the worldwide economy by that point.

  	2001	2002	2003	2004	2005
  Net revenue	3,407	4,091	4,624	5,015	5,342
  % Growth		20.1%	13.0%	8.5%	6.5%

• U.S. sales were up slightly, while international sales were more robust but were still only 20% of the total. It seemed like there was room to run internationally, but the U.S. and European heavyweight motorcycle markets would probably not grow much, so the main opportunity in the two largest markets was to take share (a difficult proposition).

  		2005		2004		%Change
  United States		253.4		243.2		4.2	%
  Europe (b)		29.5		24.6		19.9
  Japan		11.4		10.3		11.1
  Canada		11.7		11.2		4.1
  All other markets		11.2		9.3		19.4
  Total Harley-Davidson retail sales		317.2		298.6		6.2	%

• Harley's financing division was also growing, and at a slightly faster rate than sales. This was under 6% of sales, though, so I didn't consider it hugely material.
• Enterprise value to earnings before interest, taxes, depreciation and amortization was around 8.2, so it didn't look expensive.
• Free cash flow to sales was around 12%, so it's obviously not a massive free cash flow generator, but it was OK. The dividends were decent and growing. The actual dividend payout was around $174 million, so it was covered by free cash flow of 3.5 times. The dividend seemed pretty safe.
• As brands and products go, I rated Harley-Davidson as very strongly differentiated.

Valuation

My preferred valuation method is a DCF analysis. Here's how I did it:

Net revenue

5,342

EBIT

960

EBIT margin

18%

Tax rate

37%

NOPAT

605

Depreciation

207

CapEx

-198

Chg. in Working Capital

-5

Unlevered Free Cash Flow (UFCF)

609

From here, sometimes I forecast out each of these line items separately, and sometimes I forecast out just the unlevered free cash flow. In 2006, I did the former, but since then, I have begun to do the latter as I've come to realize it's a lot of extra work for a false feeling of precision. You most often get a very similar result anyway.

Discount rate

For the discount rate, I calculated Harley-Davidson's weighted average cost of capital. I've since changed my perspective on how to discount future cash flows. I'll write about this soon, but, to put it simply, investors should discount relative to their own hurdle rate or opportunity cost, factoring in their assessment of the riskiness of an investment. This rate is probably not the same as the company's cost of capital.

Anyway, here's how I did it back then:

The DCF

I assumed a 6% unlevered free cash flow growth rate, with a 3% terminal rate (back when inflation was close to that). That yields:

This ended up not being all that close. Harley-Davidson looked close to being fairly valued, with no margin of safety. With slowing sales growth and a growing but low dividend yield, it wasn't compelling. Did I think the company would be around in 10 or 20 years? For sure. But for a stable company in a stable, mature market, there didn't seem like enough opportunity given the price at the time.

In terms of my process, looking back, it seems pretty solid. A good company came across my radar and I had the discipline to not buy it, even after a lot of research, given the lack of a margin of safety. And thank goodness for that!

Outcomes

So, what happened? The stock pretty quickly hit a high of $75 in November 2006. It reported solid earnings at the end of September, but I'm not quite sure what propelled it to those highs in the two months following that. In any case, that's the highest it ever got.

Soon after that high, things started going wrong. There was a strike at one of its factories in early 2007, shutting down production for a month. This hurt the stock in the short term, but then things went from bad to worse with the Great Recession. Not only did its motorcycle sales plummet worldwide, but its financing division had a some write-offs of bad debt.

Source: Yahoo Finance

It's down 37% since then to around $36, while the S&P 500 is up 100%. Sure, it's had dividends along the way and, as the price dropped, the yield increased, but that doesn't make it attractive.

The dividends per share dropped for years before they got back to the levels they were in 2006. The dividends help make the capital loss a little less, but not by much.

The thing that strikes me is the revenue:

When I first did this, I simply took the 2005 revenue and trended it out at 6% a year. That looks insane now: 2017 revenue was almost identical to 2005 revenue. Dig a little deeper and you can see the company changed the way it states things. Before, financial services was not included in net revenue. Now, having doubled in size, it's included. The real comparable number versus what I used on 2005 is $4.9 billion, which is lower than the $5.3 billion in 2005. Even worse!

Obviously, I was not predicting the downturn of 2008. There's no way I could have factored that into my DCF valuation, but it really highlights the need for the margin of safety. If I could have gotten Harley-Davidson for a 25% discount to its fair value, or around $38, I might've done it. That might have helped me preserve my capital better, though it's impossible to know. (Maybe the stock would be at $20 today if it had been at $38 then.)

The company is still around after 13 years, so that assumption of my thesis held true. Its current price is right about that level I would've bought in 2006, and its current dividend yield is above 4%.

Still, the company has recorded declining sales since 2014. Now, with the international economy in trouble and the U.S. in a late cycle, we know vehicle sales are going nowhere but down. This is not a good trend.

Current valuation

But for giggles, let's take a quick look at how things stand today. At $35.71 and with largely similar metrics as when I looked in 2006, maybe now is a good time to buy?

• The price-earnings ratio is at 11, at the low end of its range. Many of the price metrics are at the low end of the range.
• EV/EBITDA and EV/EBIT are in the middle of the range, however.
  
  
  Source: Old School Value
• This is explained by EBITDA profit margins that have been shrinking, driven by increases in cost of goods sold.
• Earnings per share have been pretty steady, driven by share buybacks.
• The company has taken on a lot of debt. In 2006, net debt was around 1% of enterprise value, now it's about 40%. (Market cap is about $8.5 billion, net debt is roughly $6.3 billion, enterprise value stands at $14.8 billion and debt as a percentage is 43%.) This makes me nervous, though it's hard to predict interest rates. Its quick ratio has dropped under 1 in the trailing 12 months. Solvency is not a no-brainer. You can see this in its Altman Z-Score:
  
• Trade wars with China, on top of the declining market for motorcycles and the current stage of the economic cycle.
• A new electric bike is going to be coming to market, the LiveWire, but I don't expect this to materially affect results. It's $30,000 for goodness' sake!

A quick, back-of-the-envelop calculation puts its unlevered free cash flow at a similar level as 2005, around $673 million. (That puts its dividend coverage at approximately 2.7, which isn't worrisome territory -- yet.)

To do a quick DCF, you can use Old School Value's valuation tool. I put in $673 million as the start value with a 2% growth rate and terminal rate. I used an 8% discount rate. Even though the risk-free rate and the equity risk premium are lower than in 2006, Harley-Davidson's solvency issues seem like a fairly decent risk for me to take on as an investor, and there a good alternatives for my cash at that level and above. I used 8%, but I could be convinced to make it even higher. When you do that, you end up with this:

Again, it's almost exactly at fair value. I see greater downside risks for the company right now, some of which are baked into my DCF.

Maybe if it drops another 25% from where it is, and I can get my margin of safety, I would think about it. At that level, the dividend yield would be even more attractive, too. I'd have to look a lot more at its debt, though.

Disclosure: No position.

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