My Due Dilligence on Harley-Davidson (HOG)

According to Joel Greenblatt in the book ”You can be a Stock Market Genius”, there are numerous special situations in the stock market where big profits are potentially waiting for the patient and observant investor. As explained in the biggest chapter of the book, one category of special situations that can reveal an unique investment opportunity are spin-offs. I therefore explain, in the analysis below, why I believe Harley-Davidson (HOG) to be one of these spin-off special investment situations. Before proceeding, please notice at first that most spin-offs are done to create (additional) shareholder value, that is, investors find it difficult to value one share price for a company that consists of multiple companies and therefore multiple investments. Management mostly finds that the shareholders value can be increased by separating the businesses, therefore providing more clarity to the market and more value towards the shareholders (e.g. management due to their incentive schemes). The facts are overwhelming: stocks of spinoff companies, and even shares of the parent companies that do the spinning off, significantly and consistenly outperform the market averages.

.

.

1. INTRODUCTION

Harley-Davidson main business is building and selling motorcycles, as they have been doing since 1903. For further information on Harley-Davidson, I refer to their website and their Wikipedia. For brevity, I from now on assume the reader to be familiar with the main business model and general company information of Harley-Davidson. Since the purpose of this blog is related to investments, we focus on the information related to investment. At first, we notice several key points that highlight the potential value investing in Harley-Davidson (HOG) as per Yahoo Finance:

General

• With a stock price of $36.40, and given the fact that HOG has 153.569M shares outstanding, this leads towards a marketcap of $5.52B.
• The stock trades at $36.40 (at the time of writing), with a 52-week range of (32.13 – 52.06). This indicates that HOG trades towards the lower end of their 52-week range and may indicate that HOG is undervalued relatively to their own price history.
• HOG has a dividend of $0.1575 quarterly, which adds up to $0.63 yearly, or a dividend yield of 1.73%.
• Harley-Davidson is currently implementing its 2021-2025 strategic plan (The Hardwire). The company is focused on reigniting the spirit of Harley-Davidson and returning to winning, delivering the timeless pursuit of adventure and freedom for the soul for riders around the world.

Valuation

• The PE-ratio (price to earnings) ratio is currently 8.73, which means an EPS of $4.19. For comparison, the average PE-ratio of the S&P500 is 25.57. This means that relatively towards the broader market, the earnings of HOG are priced lower which may indicate that HOG is currently undervalued.
• The P/S ratio is 1.13, showing that investors are investing $1.13 for every $1 the company earns in revenue. For comparison the P/S ratio of Tesla is 15.89.
• The book value per share is $16.63, which leads to a P/B ratio of 2.20, showing that for every $1 in book value, investors are paying $2.20. For comparison the P/B ratio of Tesla is 26.47. Value investors often consider stocks with a P/B ratio under 3.0.

Cash Flow

• According to Yahoo Finance, we notice that HOG has total cash as of 31/12/21 of $1.08B, which is approximately $7.01 cash per share. This returns you 19.25% (7.01/36.40) of your investment in HOG in cash.
• For the 4 year period of 2018-2021, the company had average Free Cash Flow’s (FCF) of $894M, with the lowest year being 2018 with $686M FCF.
• With a FCF of $822 million for FY21, Harley-Davidson earned a $5.25 free cash flow per share. Eventually we notice that HOG earns more free cash flow per share than earnings, which leads to a P/FCF of 6.93 compared to a P/E of 8.73 and EPS of $4.19.

Return

• Operating margin of 15.70%, showing the operating efficiency of the company and also its ability to absorb reductions in both volume and sales price.
• Profit margin of 12.18%, with an average profit margin of the auto industry between 2015-2020 of 7.5% showing that HOG has an above industry average profit margin.
• The historical return for holding HOG stock has been -10.60% (1Yr) and -39.60% (5Yr) showing a clear downward trend. There is, however, a frequent tendency on the part of the stock market to exaggerate the significance of changes in earnings in both favorable and unfavorable direction.

Concludingly, the above analysis shows that Harley-Davidson is attractively valued based upon various statistics and valuation techniques. Furthermore, Harley-Davidson has great FCF’s, a nice dividend, above industry average margins but the stock has been in a clear downward trend in the past couple of years. In addition, there is, however, one last gem to be discovered in our investment analysis.

.

.

2. THE LIVEWIRE SPIN-OFF

Harley-Davidson has a electric motorcycle business unit (Livewire) that is planned to go public in a recent SPAC deal. This means that Livewire is the first publicly traded EV motorcycle company in the US. The combined company is expected to have an enterprise value of approximately $1.77 billion and post-money equity value (= marketcap) of approximately $2.31 billion at closing. Investors are able to then buy shares in the newly formed company, while Harley-Davidson still remains in control of 74% of Livewire stock. Fun fact: even Dr. Michael Burry recently has taken up a position in the SPAC, so we examine this deal a little further. According to their own figures, Livewire has an 2021 annual revenue of $33M and a valuation of roughly $2.31B. When comparing Livewire’s numbers to those of various other EV companies, we note the following:

1) Compared to other US EV companies such as Rivian and Lucid Group, Livewire has a higher revenue for their valuation, or put differently, Livewire has a lower valuation for their revenue. If the valuation of Livewire would be similar to that of other EV companies, the valuation of Livewire would be multiples higher than the $2B stated in the recent SPAC accouncement. Compared to Tesla, the valuation for Livewire is significantly higher.

2) According to the Livewire investor presentation, the company projects $1B revenue between 2025 and 2026. Although investors should be critical on internal future revenue and earnings projections, a higher revenue could eventually lead to a higher valuation.

3) The $2.3B recent valuation of Livewire, and the 74% stake of HOG in Livewire leads to a potential ownership of (74% x 2.3B =) $1.7B for Harley-Davidson. For conservative purposes, we round this number to $1.5B. The total number of shares outstanding for Harley-Davidson is 153.569M, which means that the 74% ownership of Livewire constitutes to around $9.7 per share of Harley-Davidson.

• So when you are buying Harley-Davidson stock for $36.40, you are indirectly buying into a 74% investment into Livewire, which leads to $9.7 per share. This $9.7 per share could even be higher if the valution for Livewire increases.

.

.

3. THE INSIDERS

We now come to the most important part of our investment analysis: the insiders. In ”You can be a Stock Market Genius”, Joel Greenblatt further explains:

”Insider participation is one of the key areas to look for when picking and choosing between spinoffs. Are the managers of the new spinoff incentivized along the same lines as shareholders? Will they receive a large part of their potential compensation in stock?”

Simply put, when insiders benefits to the same extent as you the shareholder, their incentives are in line with yours (e.g. they too want a higher share price). So we basically want to check whether incentives of management are aligned with the incentives of shareholders. Due to our research, we notice the following:

• From the Livewire investor presentation, we notice that Jochen Zeitz (CEO of Harley-Davidson) and Gina Goetter (CFO of Harley-Davidson) will become the CEO and CFO of Livewire, respectively. We notice from the 74% ownership that a higher share price of Livewire would eventually lead to a higher share price of Harley-Davidson, and therefore the management incentives of management of both companies are aligned.
• According to their latest SEC filing on April 1st, we notice several executive compensation plans. We highlight several significant developments:
• Proposal 4: ”We are seeking shareholder approval for an amendment (the “Plan Amendment”) to the Harley-Davidson, Inc. 2020 Incentive Stock Plan (the “2020 Plan”) to increase the authorized number of shares of our common stock by 3.3 million, bringing the total number of shares authorized under the 2020 Plan since its adoption to 8.7 million.”
• Proposal 5: ”We are seeking shareholder approval for an Aspirational Incentive Plan (the “AIP”) authorizing the grant to our President and Chief Executive Officer and a small group of other executive leaders of up to 3.0 million aspirational performance shares or performance share units (“Performance Shares”) relating to our common stock, contingent upon achievement of specific stock price thresholds.”
• 
• The CEO has given up $600.000 in base salary in order to receive stock options with strike prices between $45 and $65. In addition, ”the letter agreement provides that Mr. Zeitz will be eligible to participate in our long-term incentive plan and will receive an equity award consisting of RSUs with a target value of $6.0 million as of the grant date of February 9, 2022 and an award of options to purchase 500,000 shares of our common stock, which we have called the WIN stock options. The Board elected to grant the WIN stock options rather than performance share units as the long-term performance component of Mr. Zeitz’s new compensation terms to provide a focused incentive to increase shareholder value.”
• We furthermore notice that for the past 6 months, as shown in the image below, insiders have purchased 213.779 shares and have only sold 8.614 shares of HOG. This indicates that management (and insiders) think that the stock is undervalued, and have high conviction that the share price will rise. Insider buying mostly indicates that the insiders expect to stock price to rise in the following period.

Concludingly, we noticed that the incentives of management (insiders) of Livewire are in line with the incentives of management (insiders) of Harley-Davidson. In addition, we notice a significant increase in various performance shares, restricted shares, short-term incentive plans, stock options and long term incentive plans for the insiders of the company. We furthermore notice that insiders have been buying HOG shares significantly more than they sold the stock. Various incentive plans have a strike price above $45 and even above $70, as well as stock options that allow management to buy additional shares. Lastly, we conclude that the incentives of insiders in both the spinoff as the parent that spinsoff the company are highly aligned towards increased shareholder value, even more so compared to other periods.

.

.

4. CONCLUSION AND THE STORY

Combining our due dilligence above, we arrive at the following outtakes:

• Harley- Davidson currently has a stock price of $36.40 – $7.01 in cash per share = $29.39 (i.e. investors only pay $29 dollars for the entire business of Harley-Davidson)
• Harley-Davidson has a business division that is likely to spinoff in Q2 2022 in which it will hold a 74% stake, currently valued at $9.7 per share. The spinoff company is undervalued relatively to its peers. This means that investors are currently able to buy the entire business of Harley-Davidson for ($36.40 – $7.01 – $9.7 = ) $19.69 per share, or a P/E ratio of 4.69.
• If the spinoff company is to be valued compared to its peers, this would value the spinoff company even more than the entire business of Harley-Davidson (i.e. investors could buy Harley-Davidson shares for the spinoff company and receive the entire Harley-Davidson company for free). At a $10B valuation ($20B), this would mean a value of $48.5 ($97) of Livewire per share of Harley-Davidson.
• Management has strong incentives to increase shareholder value for both Livewire and Harley Davidson. Incentives are structured above the $45 – $70 per share region.
• Revenues and therefore valuation of the spinoff company is expected to increase exponentially as Livewire is the first publicly traded EV motorcycle company

Considering the 74% stake of HOG in Livewire, we notice in Table 2 below what different Livewire valuations would mean for the HOG share price. We notice that at a valuation of $6B for Livewire, investors basically receive the entire business of Harley-Davidson for free when buying the stock at $36.40. Eventually, at a valuation above $6B, we notice a significant arbitrage opportunity.

Initially, it is highly unlikely that Livewire receives a valuation above $2B but we notice that the company plans on generating nearly $1B in revenues in 2026 which could justify valuations shown in the Table above. Since the valuation is most likely to be around $2B, this means that investors only pay $19.76 per share for the entire business of Harley-Davidson including their 100+ years experience. If the valuation would be below $2B, investors only have to wait patiently untill the sales and therefore valuation of Livewire increases, all while owning part of the Harley-Davidson company as well.

Ever since I read the book ‘One up on Wallstreet‘ by legendary investor Peter Lynch, I have taken the Lynch approach in investing which basically comes down to the following: for every investment that you make, you should be able to clearly specify the investment analysis in 10-15 sentences (the story) to yourself or another individual. So, here is our story for Harley-Davidson:

Harley-Davidson is undervalued and remains a value buy based upon its own principals. Harley-Davidson has a electric motorcycle business unit (Livewire) that is planned to go public in a recent SPAC deal. This means that Livewire is the first publicly traded EV motorcycle company in the US. Investors are able to then buy shares in the newly formed company, while Harley-Davidson still remains in control of 74% of Livewire stock. So when you are buying Harley-Davidson stock for $36.40, you are indirectly buying into a 74% investment into Livewire, which leads to $9.7 per share. This $9.7 per share could even be higher if the valution for Livewire increases. We furthermore notice that the incentives of management (insiders) of Livewire are in line with the incentives of management (insiders) of Harley-Davidson. In addition, we notice a significant increase in various performance shares, restricted shares, short-term incentive plans, stock options and long term incentive plans for the insiders of the company. We furthermore notice that insiders have been buying HOG shares significantly more than they sold the stock. Even when all of the above would seem trivial, Harley-Davidson is undervalued and remains a value buy based upon its own principals. You would even reap some nice dividends rewards of 1.73%. Simple math and logic, combined with the skill to think indepently and think correctly are the only skills an investor needs. At the current price and situation, this seems to be the perfect specific situation that Joel Greenblatt describes in his book

DISCLAIMER

Eurykleia Investments is not a registered investment, legal or tax advisor or a broker/dealer. All investment/ financial opinions expressed by Eurykleia Investments are from the personal research and experience of the owner of the site and are intended as educational material. Although best efforts are made to ensure that the all information is accurate and up to date, occassionally unintended error and misprints may occur.