Harley-Davidson (NYSE:HOG) is scheduled to report its earnings for the third quarter of 2012 on October 23. The motorcycle manufacturer reported solid figures in Q2 with strong growth in worldwide retail sales as well as market share on a y-o-y basis. This translated to a 15% growth in revenue and 40% growth in operating income for the motorcycles segment.
The company is nearing the end of a comprehensive five year long restructuring process and will hope to see substantial cost savings from its efforts going forward. Further, as was the case during the first half of this year, we believe that a reduction in restructuring spending as compared to last year will have a favorable effect on margins. We also think that the company’s altered strategy with a focus on attracting a larger number of customers in non-core segments, along with a larger on emphasis on emerging markets such as India and Brazil, will have a positive effect on retail sales. However, we are also wary of the threats faced from the increased competition in the U.S. heavy-duty motorcycle space, and the effects of the deteriorating condition in Europe on the company’s operations there.
Favorable Impact of Restructuring
The restructuring process, which began in 2009, is expected to reduce manufacturing costs, increase efficiency, facilitate far more flexibility in labor requirements, and will also help reduce product development time by 30% that will enable the company to launch new models faster. The ERP database management system, which was implemented at the York plant last quarter will further support the company’s cost-saving and efficiency efforts.
Harley expects to spend a total of around $40-50 million on restructuring this year, which is $10 million less than its original projections at the start of the year. It has already spent around $18 million during the first half, which means that it will be spending between $22-32 million for the rest of the year. This compares to $31.4 million spent during the second half of 2011.
Its restructuring savings last year amounted to $217 million or around $54 million on average per quarter. This year it expects to save between $275-295 million or $69-74 million per quarter on average.
Overall, this translates to net restructuring savings of between $53-63 million during this quarter, assuming the restructuring for the remaining portion of the year is split evenly between Q3 and Q4 and gross savings are split evenly across the four quarters of the year. During the third quarter of 2011, net savings amounted to $41.6 million. Clearly, this will have a favorable impact on the quarter’s gross margins relative to the prior year.
The company’s management expects full year gross margins to be in the range of 34.75-35.75%. Gross margins in the first half of 2012 were 35.9%, around 1.8% higher than the first half last year. We expect annual gross margins for the motorcycle segment to reach 36.3% by the end of our forecast period.
Expansion of Customer Base
Another important trend in Harley-Davidson’s business is the shift in the company’s target customer base. Historically, the company’s primary customer base consisted of American males aged between 40 and 50. However, due to a shift in American demographics, the size of this segment is facing a steep decline going forward.
As a result, the company has now begun to focus on a number of new segments, including young adults, minorities and females. It is also targeting large scale expansion in emerging markets such as Brazil and India. In the past few years it has set up assembly plants in both these countries, its first ever such ventures outside of the United States. Its motorcycles segment has performed exceptionally well in Latin America and Asia in the last few years. These two regions constituted 10.1% of worldwide retail sales last quarter, compared to 9% in the same quarter last year.
Risks Faced From Increased Competition and Slowdown in Europe
A number of competitors are emerging in the heavy-duty Motorcycle segment in the United States. Harley-Davidson is probably the most vulnerable because of its 56% market share. Polaris, a company which is known for its snowmobiles, jet skis and all-terrain vehicles, is aggressively expanding into the heavy-duty motorcycle space, and is now holds the second largest market share in the segment after Harley. Last year, the company acquired Indian, a historically well known motorcycle brand which lost its footing after going bankrupt and has ambitious plans to bring it back to the forefront. 
Europe, which currently makes up around 17% of the company’s sales, is another major concern. A protracted slowdown there, while leaving market share intact, could lead to a reduction in sales due to a decline in the overall market size for heavy duty motorcycles. The company’s management expressed its concerns regarding this during last quarter’s earnings release, and that may have played a part in the following decline in the company’s stock price.
We currently have a Trefis price estimate of $56 for Harley-Davidson, which is about 35% above the market price.Notes: