Undervalued Dividend Growth Stock of the Week: Harley-Davidson Inc. (HOG)

You are what you eat.

That’s true to a degree: what you eat will have some kind of impact on how you look and feel, as well as your overall health.

But if that’s true, you’re also what you save and invest.

Your financial self will be almost wholly shaped by what you save and invest.

If putting your best face forward is a good idea, then putting your best financial self (via good savings and investing habits) forward is a fantastic idea.

I aimed to put my best financial self forward every single day for years – and I continue to do it on a regular basis.

The result?

Financial independence in my early 30s, paid for by the five-figure passive dividend income my real-money dividend growth stock portfolio generates for me.

This financial independence is possible because I truly believed that my financial self is what I save and invest.

And like a physical self that eats healthy and gets lots of exercise (something I also do), my financial self is looking great these days.

But that excellent condition involved a lot of hard work, plenty of saving, and intelligent investing.

That last point is what we’re going to talk about today.

I have yet to come across a more robust long-term investment strategy (especially if your aim is to create enough growing passive income to become financially independent at a decent age) than dividend growth investing.

Best of all, the strategy isn’t that difficult to understand or implement.

It simply involves buying shares in high-quality businesses that have lengthy and sustainable track records of paying their shareholders growing dividends. One buys these shares at appealing valuations. And they hold for the long haul, reinvesting that growing dividend income upon such time the income is needed to cover bills.

You can find more than 800 US-listed dividend growth stocks by checking out David Fish’s Dividend Champions, Contenders, and Challengers list – an invaluable resource that has compiled information on US stocks that have paid their shareholders increasing dividends for at least the last five consecutive years.

So right there, a lot of homework has been done for you.

It’s never been easier to be a dividend growth investor.

In addition, I’m going to highlight a high-quality dividend growth stock that appears to be undervalued.

That’s a compelling long-term investment idea that you can think on and research more, making the strategy even easier.

The reason why I’m going to highlight an undervalued dividend growth stock is because undervaluation confers a number of huge benefits to the long-term investor.

While price is what something costs, value is what something is actually worth.

And when the latter is higher than the former, an item could be describe as undervalued.

It should be obvious as to why you’d want to pay less than something is worth. And it should be intuitive as to why you wouldn’t want to knowingly pay more than something is worth

But when it comes to high-quality dividend growth stocks, undervaluation can be absolutely critical to a long-term dividend growth investor’s success.

That’s because an undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

This is all relative to what the same stock might offer if it were fairly valued or overvalued.

The higher yield comes about because price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield not only potentially positively impacts current and long-term income, but it also has a way of positively impacting total return.

That’s because total return is comprised of income (via dividends/distributions) and capital gain.

The former is boosted by that higher yield.

And the latter is possibly boosted by the “upside” that exists between the lower price paid and the intrinsic (higher) value of the stock.

While price and value can diverge quite a bit over the short term, they tend to more or less converge over longer periods of time.

And that convergence can result in capital gain when the price paid is well below fair value. That’s before even factoring in whatever organic upside is available as a business becomes more profitable, increasing its value.

These dynamics have a way of also reducing risk, as one builds in a margin of safety, or a “buffer”, when the price paid is well below intrinsic value.

The further below fair value you pay, the more buffer you have. That means a lot could go wrong (and things sometimes go wrong) before your investment would be worth less than you paid.

Perhaps counterintuitively, upside is maximized precisely when downside is minimized.

As you can probably see by now, an undervalued high-quality dividend growth stock can be very appealing.

Yet the interesting thing is that it’s not actually all that difficult to estimate the fair value of just about any dividend growth stock out there.

Fellow contributor Dave Van Knapp’s valuation lesson makes quick work of this process, and it’s a great resource for any dividend growth investors out there who are maybe a little unsure of how to go about valuing dividend growth stocks.

With all of this in mind, I’m going to reveal and discuss a dividend growth stock that, based on a vigorous quantitative fundamental analysis, appears to be undervalued right now…

Harley-Davidson Inc. (HOG) is the world’s largest manufacturer of heavyweight motorcycles, and also a major supplier of motorcycle parts and accessories.

With corporate roots dating back to 1903, Harley-Davidson has exhibited the staying power and ability to dominate (with a US market share of approximately 50%) like pretty much no other company in its industry.

Harley-Davidson is now known to manufacture a high-quality, premium product that deserves a premium price.

Its enduring popularity and premium reputation allows the company to produce growing profit and enviable margins, which then leads to growing dividends.

Getting into that, the company has paid an increasing dividend for seven consecutive years.

That might seem short after what I just discussed – and that’s because it is a short track record.

A major ding against the company’s dividend growth story is the fact that they cut their dividend rather significantly during the Great Recession.

While they produce a popular and premium product, it’s also an expensive product. And it’s a discretionary purchase that can easily be delayed or altogether canceled when the economy is tight and people don’t have the discretionary income necessary to make sense of a motorcycle purchase.

That said, the Great Recession was likely a once-in-a-generation type of financial crisis, and the company’s dividend appears to be in great shape right now.

That’s evidenced by a fairly low payout ratio of 45.8%.

And the company has made up for some lost ground through an aggressive dividend growth scheme since they felt comfortable growing the dividend again (post-cut).

The five-year dividend growth rate stands at a stout 24.1%.

But much of that growth was the company lifting the dividend off of its post-crisis lows, and so we shouldn’t really build any kind of forward-looking dividend expectation off of this.

To add perspective to the matter, the most recent dividend increase was just a little over 4%.

While I believe that’s lower than what investors should come to expect from Harley-Davidson, one can see the dramatic deceleration that’s already occurred.

So future dividend growth may not be what it was as the dividend was restored to its former glory.

But that’s okay, because the stock yields a very appealing 3.05% right now.

That’s well in excess of both the broader market and the industry average, and it’s also more than 110 basis points higher than the stock’s own five-year average yield.

So keeping that in mind, the deceleration in the dividend growth rate is moderated by the much higher yield. Or said another way, one doesn’t need double-digit dividend growth to make sense of a stock when the yield is this appealing. A dividend growth rate in the upper single digits would be more than enough, and I think Harley-Davidson could deliver on that.

When building out that expectation, though, we must first look at what kind of underlying growth Harley-Davidson is generating, as it’s ultimately business growth that will fuel dividend growth. Dividend growth relies on profit and cash flow growth over the long run.

And in order to get a full picture of the company’s growth, we’ll look at both what they’ve done over the long term (using the last 10 fiscal years as a proxy for the long term) as well as what is expected to come to pass looking out over the near term (using the next three years as a proxy for the near term).

First, let’s take a look at revenue.

Harley-Davidson has increased its revenue from $5.727 billion to $5.996 billion between fiscal years 2007 and 2016. That’s a compound annual growth rate of 0.51%.

Fairly disappointing revenue growth here. While the US market is mature, and while Harley-Davidson will probably not be able to capture much/any domestic market share moving forward, I’d expect something at least in the low single digits here.

The problem for Harley-Davidson was mentioned above. They’re simply heavily exposed to economic conditions due to the expensive, premium, and discretionary nature of their products. In addition, the majority of the company’s sales occur inside the US (a mature and competitive market), which means they’re heavily exposed to the economic cycles of just one country.

The Great Recession therefore really walloped the company.

But revenue has been steadily recovering since bottoming out in FY 2009. Looking at the period between FY 2009 to FY 2016, revenue has grown at a compound annual rate of 3.28%, which is more in line with what I’d expect from the company.

The company’s bottom-line growth is similar to what the top line shows. There’s very little 10-year growth, but results coming off of the post-crisis low have been more favorable.

That said, EPS has remained roughly flat between FY 2007 and 2016 – up from $3.74 to $3.83 over this stretch.

But that $3.83 looks a lot better when compared to the loss of 24 cents the company took in FY 2009.

I’ve often remarked in articles and videos that the last 10 years is a pretty rough period to look at for a lot of companies, due to a number of challenges therein. However, I think this period has been particularly difficult for a company like Harley-Davidson.

As such, I view this company as a turnaround play, which is sort of an odd thing to say about a company that’s been around for more than 100 years, but they’re more or less finding their footing again after taking it on the chin a few years ago. Moreover, there’s a lot of international growth potential here.

Looking forward, CFRA anticipates that Harley-Davidson will compound its EPS at a 9% annual rate over the next three years, which would obviously be an incredible acceleration off of the 10-year result we see above.

International growth is mentioned as a key part of that outlook. Harley-Davidson has plans to open between 150 to 200 new dealerships in international markets by 2020.

Fundamentally, the rest of the business is fairly solid, if not high in quality.

The balance sheet may appear to be stressed at first glance, but this is largely due to the fact that the company has a large financing arm.

The long-term debt/equity ratio is 2.43. But the interest coverage ratio, at over 35, is outstanding and showing no signs of financial/debt stress.

Profitability, as probably expected, is robust. Numbers are excellent for the industry.

Over the last five years, the firm has averaged net margin of 12.25% and return on equity of 29.70%.

Harley-Davidson has brand recognition, pricing power, economies of scale, and a loyal customer base. International growth potential and more recent numbers paint a nice picture here.

It’s a legendary and dominant business.

However, its products are very expensive and discretionary, limiting its customer base to a niche.

Moreover, that customer base is aging, and there are valid concerns as to whether future generations will find motorcycling in general (especially the more traditional styling/size of Harley-Davidsons) appealing/feasible.

To combat some of these issues, Harley-Davidson is planning on launching 100 new models by 2027 (so as to appeal to a broader base of riders).

With these concerns in mind, though, we want a stock that’s apparently undervalued. We want that margin of safety and higher yield.

Well, the stock does indeed appear to be undervalued right now…

The stock is trading hands for a P/E ratio of 14.98 after dropping almost 15% this year. That obviously compares very favorably to the broader market. But it’s also well below the stock’s own five-year average P/E ratio of 16.8. And the company’s cash flow is priced at a level that’s almost half its three-year average. Plus, the yield, as noted earlier, is significantly higher than its own recent historical average.

All signs point to undervaluation, but by how much?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7%.

This long-term dividend growth rate is hinged on the go-forward look (albeit erring on the side of caution) at the company’s underlying growth potential. The payout ratio is moderate, the company has a great balance sheet, and gobs of cash flow are generated. I think this is a fair expectation.

The DDM analysis gives me a fair value of $52.07.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

I don’t believe the company has to stretch to meet the expectation I just set up, yet the stock still appears at least modestly undervalued right now. But let’s see what some professional analysts think about the stock’s valuation, which will add depth and value to the entire article.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates HOG as a 3-star stock, with a fair value estimate of $50.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates HOG as a 3-star “HOLD”, with a fair value calculation of $51.53.

There’s a pretty tight consensus here. Averaging the three numbers out gives us a final valuation of $51.20, which would indicate the stock is potentially 7% undervalued.

Bottom line: Harley-Davidson Inc. (HOG) is one of the most enduring and well-known brands in the world. Its customer base is rabidly loyal. The company has many of the fundamentals and competitive advantages you want to see in a high-quality business fit for long-term investment. International growth potential and the attempt at the broadening base of its ridership offset some of the lingering questions surrounding the business. With the possibility shares are 7% undervalued on top of a market-beating yield, this dividend growth stock is worthy of a good look right now.

— Jason Fieber

Note from DTA: How safe is HOG’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 32. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, HOG’s dividend appears unsafe, with a heightened risk of being cut. Learn more about Dividend Safety Scores here.

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