Harley Davidson's latest quarter reflected its usual strong sales and earnings growth. A close look at the company's 10-Q filing, however, stirred up some questions about its inventory buildup. A 54% jump in finished goods -- compared with a 1% slide in raw materials -- would seem to suggest slowing end-user demand, contrary to what we've come to expect from Harley.

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By Mike Trigg (TMF Tonto)
August 15, 2001

Harley-Davidson (NYSE: HDI) has grown from a single motorcycle manufacturing facility in the Davidsons' backyard into one of the country's most recognized brands. That's historically left the company with a pleasant quandary: it can't make enough bikes to satisfy demand. While this has led to notoriously long waiting lists for Harley bikes, a look at the company's latest 10-Q filing raises interesting questions about the company's working capital management, particularly its finished goods inventory.

Harley's second-quarter earnings jumped 28% over the year-ago period to $0.38 per share, beating Wall Street's estimate by three cents on revenues that increased 13% to $850.9 million. (No surprise: another quarter of solid sales and earnings growth.) That's business as usual for the company.

Unfortunately, Harley's Foolish Flow Ratio -- a measure of working capital management -- increased from 1.83 in the year-ago period to 1.93. That suggests worrisome trends among the company's current assets and liabilities.

When working capital problems arise, I first look at accounts receivable and inventory. In Harley's most recent quarter, sales increased 13% but accounts receivable (a measure of creditor debts) and inventory increased 20% and 13%, respectively. It's never a good sign when inventory or receivables increase faster than sales because it means the company isn't bringing in cash as fast as it should be. Increasing receivables suggest that sales haven't been paid for, while rising inventories may indicate that products are sitting on shelves rather than being sold.

The company gave this explanation for the receivables/revenues discrepancy in its 10-Q: "The second-quarter 2001 increase in accounts receivable of $38.5 million was driven primarily by the second quarter increase in European unit shipments which were up approximately 21.7% over the same quarter last year. Accounts receivable collection terms for sales in Europe are generally much longer than those for domestic sales, and as a result the quarterly increase in shipments had a direct impact on quarter ending accounts receivable balances." That satisfies me, but investors should nevertheless consider tracking this number as the company continues working to expand its European sales base.

After combing the company's 10-Q footnotes further, I stumbled upon its inventory composition and discovered a big jump in finished goods inventory. Harley has three types of inventory: finished goods (product ready to ship), work in process (partially assembled product), and raw materials (unassembled components). Here's the growth breakdown of Harley's inventory components over the past year: (Dollar figures in millions.)

                         6/00    6/01  Change
Raw materials           $66.6    65.9   -1.1%
Finished goods           27.8    42.9   54.4%
Parts & accessories      83.9    88.2    5.1%

Investors can gain insights by looking at the dynamics of inventory components. An increasing amount of finished goods inventory, for example, could signal a slowing of end-user demand. Clearly, this would go against conventional Harley wisdom, considering the company's well-publicized waiting lists. An increase in raw materials inventory, on the other hand, might signal increasing demand, as a company gears up for production. This would seem more logical for Harley.

With no explanation in Harley's 10-Q as to why finished goods have increased significantly beyond that of raw materials, there are still some questions left unanswered. (We weren't able to obtain an explanation from the company in time for publication.) One simple explanation is that the company has notched up production in an attempt to meet more of its demand, which would be reflected in improved sales down the road.

Lehman Brothers released a research note today that said following conversations with 20 dealers across the country, those selling at sticker price continue to have waiting lists of about one year on most models, while dealers selling at a premium to sticker had inventory on the floor. Perhaps aggressive pricing by some dealers could at least in part explain the increase in finished goods. Harley is a company that seems almost impervious to economic ills, but perhaps this is a sign of chinks in the company's armor.

Mike Trigg is scared of motorcycles following a moped crash some years ago. To see his holdings, view his profile. The Motley Fool is investors writing for investors.

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