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When Hogs Land


I received a lot of requests to analyze companies that would be beyond the scope of what I am trying to do. Amazon proves to be the best example. There are so many issues with Amazon when analyzing its prospects and stock valuation, all of which are beyond the scope of this column. While the stock is definitely richly valued, quarterly earnings are not driving the stock price. While earning a profit continues to elude the company, Amazon is doing a very good job at executing its business. There are a few issues that Amazon will face this year, namely how much as the free shipping boosted sales and will growth slow once the offer anniversaries this summer?

I was hoping I would find several egregious examples of poor earnings quality. Unfortunately, I have not been able to find any great examples to show how to detect red flags. Over the past couple years, companies have been taking a lot of charges related to various restructuring, obsolete inventory, along with various other reasons. These charges have led to current financial statements to be much more "clean." By taking charges, companies have been able to get rid of the bad stuff, either bad divisions, or poor performing assets. By taking a charge, companies have reduced the amount of assets it carries on its books. This leads to vastly improved operations measures, and unfortunately, financial statements that are almost impossible to conduct any meaningful historical analysis.

The easiest analysis used to check the quality of earnings is by reviewing a common sized income statement. Common sized financial statements are constructed by dividing each line item by the either sales (income statements) or total assets (balance sheet). By looking at each line item though the balance sheet, it is easy to determine what drove earnings growth, or lack thereof. By comparing the statements over time, it is easier to see trends in margins and when a company might start facing more difficult or easier comparisons in the future.

The best example I could find to highlight items to watch for was Harley-Davidson.

Here is Harley's earning release for those the wish to read along. A common sized income statement is included at the bottom of the page. You can open another window and scroll down if you want to be able to tab back-and-forth.

I'm not going to spend time discussing the broader macro economic factors that are obviously very important to a company like Harley-Davidson. Suffice it to say, our view of the economy does not bode well for Harley-Davidson.

Harley benefited from several items that will not provide the same boost going forward as in the fourth quarter. One of the main benefits Harley experienced was an increase in gross margins. This increase stems primarily from price increases from the 100 year anniversary bike launched last summer. The company stated that prices were 3.4% higher for the 2003 model year. Additionally, this was the highest gross margin Harley has had in over ten years, and maybe ever. The declining dollar also helped boost gross margins as Euro denominated sales were translated back into more dollars. Harley said that the Euro added $6mm to gross margins, and realistically this all flows to the bottom line, less taxes. So the weak dollar added just over a penny to EPS. ($6,000,000 * (1-34.5%) = $3,930,000/305,037,000(number of shares) = 1.29 cents per share.

Going on down the income statement, SG&A dropped as a percent of sales by 0.5%. A drop in SG&A as a percent of sales can be expected for a capital intensive business as efficiencies of scale are realized. It should be noted that these same efficiencies can backfire if production slows down. It should also be noted that the fourth quarter marked the first time in four years that Harley did not increase its production forecast by 2,000 bikes. If production levels are maintained it is likely that any efficiencies gains will be minimal if realized at all.

Also, take time to analyze sequential changes. Because of seasonality, direct comparisons are usually not valid, but by comparing how results changes quarter-to-quarter compared to how they changed previously quarter-to-quarter can provide an early warning signal.  Using Harley again, sales fell 9% sequentially. This was the largest sequential drop from the third quarter to the fourth quarter in over ten years, and was only the second time sales fell sequentially from the third quarter - sales fell 0.7% in 1996.

It is also important to analyze the balance sheet. Two of the most important items to look at is accounts receivable and inventories. In Harley's case, finance receivables must be included. Harley helps it dealers by financing bikes in dealer show rooms (short-term receivables) along with providing consumer financing (long-term receivables). Both items grew significantly faster than sales growth of 13.3%. Short-term receivables grew 32%, while long-term receivables grew over 55%. This is a situation that has been happening for quite some time now, and should be a cause of concern. If financing to dealers is growth faster than bikes shipped, it is likely that there will be excess inventory. This will have to be worked off and with a product as brand conscious as Harley-Davidson, losing its scarcity status coupled with a price drop could rub off some of the allure of owning a hog. With long-term receivables increasing, Harley is financing more of the bike purchases itself and is holding a larger portion of the receivable instead of securitizing it, although they are increasing the amount of securitizations it does. By holding more consumer receivables, Harley is increasing its exposure to credit concerns. With credit quality generally declining, this will be an area to watch. Looking at inventory, we see for the first time in over five years, inventory days of sales increased on a year-over-year basis, rising from 27.8 days to 28.6. While not enough of an increase to throw up a red flag on its own, it is worth noting that the trend has changed.

Harley also provides detail data on its motorcycle sales. This data also throws up a few "red flags." Total shipments increased 3.8% in the fourth quarter compare to last year. For the whole year, shipments rose 12.5%, so it is easy to see the run rate is declining. Additionally, most of the growth came from the V-Rod bike, which by some accounts is not living up to its expectations. Plus, Sportster shipments fell 8%. The Sportster is Harley's lowest priced bike and some view it as the future pipeline for the bigger bikes. This sales data, seems to confirm that Harley benefited earlier in the year from its 100 Anniversary edition, and now is seeing sales slow. At the same time, our macro economic outlook casts a dim light on Harley being able to revive its 25% growth rates of just a few years ago.

Also know what companies have said in the past and noticing any departures can be very telling. Harley-Davidson for the first time in four years failed to increase production, which also confirms that the anniversary edition might have pulled forward some sales. Every quarter going back four years, Harley increased its planned production by 2,000, just like clockwork. Wall Street did not like this fact and was the most discussed topic accounting for the drop in stock price after earnings were reported.

Along the same line, watch for changes in how companies report numbers. For the first time, Best Buy included online sales in its same store sales calculation. Best Buy defended the procedure as, "…the way we engineered on line sales you can now do a lot of online ordering in our stores. We think the dot.com numbers are benefiting from the fact that we are becoming better and more competent in terms of building sales in store through the online channel." If this is the case and online sales are driving same store sales growth, then show the numbers. Why are they hiding the traditional measure of same store sales growth if they are "becoming better and more competent" driving sales in the store?

While in may seem that investors are losing out with the recent announcements from companies like Coca-Cola that are doing away with issuing quarterly guidance. It should actually get easier for those than can perform analysis. This might actually help Wall Street analysis as well. Before, analysts were hesitant to utter anything negative, fearing they would be locked out by the company. If companies start the practice of not issuing guidance, more Wall Street analysts will not be as conflicted, plus now investment banking is not exactly on fire. Maybe its just wishful thinking.

Harley-Davidson income statements.

  Year-over-Year Sequential
  Dec02 Dec01 Dec02 Sep02
  $mm % sales $mm % sales    
Sales 1,080.5   955.0   1,080.5 1,191.2
  Cost of Goods Sold 684.5 63.4% 625.1 65.5% 684.5 764.6
  -------   -------   ------- -------
Gross Profit 396.0 36.6% 329.9 34.5% 396.0 426.5
SG&A  Expense 160.8 14.9% 147.4 15.4% 160.8 177.1
Oper. Income Bef Deprec. 279.30 25.8% 222.78 23.3% 279.30 293.63
Deprec, Depletion, & Amtz 44.11 4.1% 40.32 4.2% 44.11 44.15
  -------   -------   ------- -------
Operating Profit 235.2 21.8% 182.5 19.1% 235.2 249.5
Non-Oper. Income/Exp. -4.9 -0.5% 0.6 0.1% -4.9 2.5
  -------   -------   ------- -------
Pretax Income 230.3 21.3% 182.1 19.1% 230.3 251.9
Total Income Taxes 79.5 7.4% 63.7 6.7% 79.5 86.9
TAX RATE 34.5% 0.0% 35.0% 0.0% 34.5% 34.5%
  -------   -------   ------ -------
Net Income 150.86 14.0% 118.35 12.4% 150.86 165.02
EPS (Primary) 0.49   0.39   0.49 0.54

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