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RIDING THE HOG

Riding the Hog

Harley-Davidson has been one of my favorite companies for several years now. A very “Buffett-esque” company, if you will, Harley-Davidson (HOG) earns consistently high returns on equity, sports very strong margins, reinvests a chunk of earnings profitably to drive growth, boasts a management that has achieved remarkable success over the past few decades, and, of course, enjoys a brand name and competitive position impossible to rival.

When evaluating a company, I always find it good practice to poke holes in its operations, prospects, management, etc. and give as much credence as possible to its competitors. It allows you to avoid getting too giddy about any company, and keeps expectations and risk factors in line with reality. In Harley’s case, this was a very difficult exercise. There’s simply not much to poke. And with around 49% of the heavyweight bike market, there’s no competitor nearly as dominant.

Some have expressed concern that Harley will suffer from shrinking profits as the baby boomer generation retires and stops buying Hogs en masse. That demographic has fueled growth for years, and it may be true that with its maturation comes Harley’s maturation. Indeed, 80% or so of the company’s revenues are still in the US, and the aging baby-boomer generation won’t drive profits domestically in the same way we’ve seen the past decades.

Nonetheless, the company is expanding successfully into new markets, and is seeing fast growth in Europe while also entering into China in the past few years, opening its first dealership in Beijing earlier in 2006. While a relatively small portion of Chinese middle-aged men (middle-aged men being the company’s most important demographic) have the discretionary income to go out an buy a Harley, the number is steadily growing, and if Harleys are successfully marketed to a burgeoning middle and upper class of Chinese, shareholders could see respectable growth for years to come.

Yet, what most people don’t know is that China’s motorcycle industry is already quite competitive, and the country is starting to see some of its own icons emerge. Harley has recognized the growing biker culture in China, and is flexing its muscle to capitalize on it. But call me pessimistic, this is going to be a tough sell. With the top 20% of Chinese only earning around $3700 annually, and given that the cheapest Harley will likely cost almost twice that in China (since the company is not manufacturing there), Harley’s share of any Chinese market is likely to be small (especially at first). But I believe their long-term strategy (which is not capital intensive and will focus on steady and sustainable growth) is sound and can yield dividends in the long-run.

So does that make the company a buy? Well, I virtually salivated over the share price when it hit around $45 about a year and a half ago. I felt, at that time, that the shares were worth at least $65-70. So I bought some near $50 and held for a while, only to sell out this year (stupidly, you might say) around $63. Why I did that is anybody’s guess.

What about the here and now? With shares trading around $70, is it still a bargain? Well that depends how you look at it. Even at $70, you’re getting a great company at a decent price. While it’ll be hard to trounce the market at these levels, steady growth prospects along with the plethora of aforementioned selling points should make for a comfortable and likely market-beating return over the long-run.

That said, I’d estimate the shares to be a bit more fairly valued on a DCF basis today than they were around 18 months ago. I estimate the shares are worth somewhere between $65 and $85, so those seeking huge bargains won’t find it here, but anyone looking for a first-class operation with a wide (and widening) moat should keep riding the HOG.

Citigroup, Lampert et al.

I just scooped up some Citigroup shares. I’ll be honest: I didn’t dig ultra deep into any filings yet, as I figured the thesis may no longer be applicable by the time I finished reading the massive tome that is a Citigroup annual report. My reasoning was simple — the sprawling firm has some premier properties, trades at what I consider unjustifiably low valuations, sports a strong dividend yield to provide downside risk protection, and has garnered the sponsorship of a few well-respected value guys, namely someone I consider a Graham and Doddsville superinvestor, Eddie Lampert.

Given that I don’t have many extraordinarily knockout ideas right and had some cash that could have been put to work, I felt this was a safe place to park some dough with the added benefit that a catalyst (breakup, anyone?) could send the shares significantly higher. My back of the envelope calculations put a break-up value at somewhere between current prices and a whole lot more. This highly scientific reasoning is coupled with the fact that Citigroup sports solid returns on equity, respectable — albeit modest — growth for a behemoth its size.

Bottom line: potential for outsized upside, downside protection with dividend yield around 80% of Treasury yields, and lots of smart money showing interest in catalyzing an opportunity.