After Harley-Davidson (NYSE:HOG) shares spiked 20% on rumors there may be a private equity buyout of the company in the works, the irrational exuberance brought on by the unsubstantiated speculation wore off, and shares cooled. The motorcycle maker's stock is now trading just 7% above where it was before the rumor spread, and it's likely it will fall further, simply because Harley's business remains as soft as ever.
The suggestion making the rounds was that private equity firm KKR (NYSE:KKR) was sniffing around the big bike maker. While both Harley-Davidson and KKR refused to comment, there could be some sense in KKR or some other hedge fund making a play for the business.
Still the king of the road
Harley-Davidson, of course, is the unchallenged king of big bore motorcycles. It controls half the market for motorcycles with engine displacements of 601 cubic centimeters and larger, while its next closest competitor, Polaris Industries (NYSE:PII), which owns both the Victory and Indian marques, has a market share of 5% to 10%, depending upon who is counting.
Yet despite the yawning chasm between No. 1 and No. 2, it's clear that Harley's business is struggling, particularly in the U.S., which is a problem because the domestic market accounts for 61% of its sales.
Harley-Davidson's global motorcycle shipments peaked at almost 350,000 bikes in 2006, but during the depths of the recession following the financial crisis, they plunged to just 210,000 bikes. Since then, it's worked hard to rebuild sales, and last year they hit 266,000, but that was still down from 2014, and below the management's original estimates for the year.
In the first quarter, U.S. sales fell once again. Although the decline was just 0.5%, which was a better result than what Wall Street had expected, it indicates that Polaris Industries, which enjoyed an 18% increase in motorcycle sales in the period, is continuing to steal market share.
Even so, Harley-Davidson is not a broken business. It possesses a strong balance sheet, an iconic and resilient brand, and it continues to generate significant cash flow. So here are some places to consider that might be most attractive to a hedge fund buying Harley-Davidson.
Motorcycles naturally comprise the bulk of Harley-Davidson's $6 billion in annual revenues, with the U.S. market the crown jewel of its portfolio. But its Asia Pacific market is its third-largest, and has been enjoying sustained growth, up 6.6% in the first quarter and up over 7% in 2015. In fact, it was the only market that saw growth for the company last year.
The Asia Pacific region has also seen sales grow at a 9% compounded rate annually since 2010, whereas U.S. sales are up just 3% since then. While Latin America sales have grown by over 12% annually, last year, they fell 4%, and the region is rife with political unrest and turmoil that may make it difficult for sales to get back on track any time soon.
A spinoff of the Asia Pacific division under which Harley retains an ownership stake could be one way private equity could try to carve out additional value.
We've seen just this sort of thing occurring in the restaurant industry, where both McDonald's and Yum! Brands began strategizing about how best to separate the risks from the region with its obvious growth potential.
Many people might not realize Harley-Davidson has a large and profitable financing division that helps riders buy their motorcycles. HDFS generated over $686 million in revenues for the motorcycle maker last year, up 4% from 2014, with both short- and long-term receivables totaling $7.4 billion.
The risk here is that the credit profile of Harley's customers is starting to deteriorate. Subprime loans account for fully one-fifth of HDFS's loan originations, and the division's operating profits decreased by nearly 13% in the first quarter due in part to it increasing by $13 million the provision for loan losses as it suffered higher retail credit losses.
Because Harley-Davidson has largely avoided participating in the discounting going on in the industry to sell bikes and maintain market share, it's had to take on riskier customers. But the motorcycle company isn't perturbed by this, since subprime lending remains profitable and it has been operating above historical norms for several years. It views the current weakness as just a reversion to the mean.
However, consider that retailers such as Target and Nordstrom used to own banks to operate their credit card business, but eventually sold them to third parties. In the same vein, a PE firm might find it advantageous and profitable to buy Harley-Davidson's financing business.
Worth more together than apart?
In the end the rumors may not be anything more than that, and speculating on rumor is no way to invest. Still, Harley-Davidson's strong balance sheet would allow a hedge fund to leverage it with a significant amount of debt.
Whatever happens, it still has to contend with a strong U.S. dollar, increasing competition from domestic and foreign manufacturers, declining domestic sales, layoffs, and more. However, operating away from the short-term pressures of the public market could let it focus once more on building great bikes.
Although its stock is trading 15% below its 52-week high and a third below the all-time high it hit in 2014, like its bikes, Harley-Davidson doesn't really sell at a discount, and that might be the biggest hurdle of all for any potential buyer to get over.