Wednesday, February 4, 2009

Warren Buffet’s Investment in Harley-Davidson, don’t get too excited about it

Shares of Harley Davidson, which is a dividend achiever, got a big boost yesterday, after legendary investor Warren Buffett snapped half of the company’s $600 million in bonds that will be issued. The bonds will mature in 2014 and carry an annual interest rate of 15%.
Warren Buffett made similar investments in fixed income equivalents (preferred stock) in General Electric and Goldman Sachs, both of which carried a 10% interest rate. Unlike GE and GS’s investments however, the 300 million-bond position that Buffett’s Berkshire Hathaway (BRK.a) is taking won’t come with a warrant to purchase some of Harley Davidson’s stock.

The money will help Harley Davidson in its three-part strategy that it issued in January, after losses in its finance unit led to a 58% drop in 4Q earnings. The strategy includes investing in the Harley-Davidson brand, getting a leaner cost structure as well as securing additional funding for its finance unit, which makes loans to dealers and customers.

The investment in Harley by Warren Buffett led to a huge increase in HOG stock, as it provided a huge dose of support for the brand. Investor’s shouldn’t get too excited about this deal however by purchasing Harley-Davidson stock. Buffett is definitely getting a sweet deal in Harley’s effort to capitalize on his name and get enough cash to sustain the company through the tough times. If Buffett believed that Harley’s stock is undervalued he would have purchased the stock directly. Since he is only purchasing bonds, without any warrants that would convert the bonds into equity, it definitely looks that he doesn’t believe Harley is undervalued enough for him to take an equity position. For ordinary investors however, getting in on a deal with similar terms is close to impossible.

In 2008 Buffett took perpetual preferred stock positions in General Electric and Goldman Sachs, for $3 billion and $5 billion respectively. According to the deal with Goldman, which was announced on September 23, the preferred stock has a dividend of 10 percent and is callable at any time at a 10 percent premium. Berkshire Hathaway (BRK.a) also received warrants to purchase $5 billion of common stock with a strike price of $115 per share, which is exercisable at any time for a five-year term.

According to the deal with General Electric, which was announced on October 1, the perpetual preferred stock has a dividend of 10% and is callable after three years at a 10% premium. Berkshire Hathaway (BRK.a) also received warrants to purchase $3 billion of common stock with a strike price of $22.25 per share, which is exercisable at any time for a five-year term.

Investors who mistakenly believed that these investments in General Electric and Goldman Sachs could be replicated by purchasing the common stock have lost a lot of money in the process. GE shares lost almost half of their value, while GS stock lost roughly one third.

Several pundits have also expressed concerns that Buffett suffered major losses on his investments in General Electric and Goldman Sachs. This delusion comes from confusing option strike prices with actual purchase prices. The options to purchase GE and GS stock give Buffett the right, but not the obligation to acquire shares in both companies at $22.25 and $115 per share respectively by 2013. In the meantime he is being paid $800 million/year in dividends.

As a dividend and value stock, Harley Davidson does appear undervalued. The dividend is well covered and the P/E is only at 5. This reflects investors’ worries that the downward EPS trend from 2006 record earnings of $3.94/share might continue over the next few years.

It will be interesting to see how the company copes with the uncertain economic climate. Harley Davidson is a great american brand, with a loyal customer base, which is most probably why Buffett bought 300 million in bonds in the first place. Since the company’s products are discretionary however, its target audience might delay purchases of new bikes for the time being.

Full Disclaimer: Long GE stock

Relevant Articles:

- Analysis of General Electric
- Warren Buffett – The Ultimate Dividend Investor
- Berkshire Hathaway Portfolio Changes for the quarter
- Don’t chase High Yielding Stocks Blindly

5 comments:

  1. You state that Buffet is being paid $800 million/yr in dividends for holding options - how is that possible. I thought you could only receive dividends if you actually owned the stock?

    ReplyDelete
  2. Brad,

    The 800 mln in dividends comes from his 8 bln investment in GE and GS perpetual prefered stock at 10% yield. He is getting the best of both worlds - a fat dividend yield, limited downside with plenty of upside.

    ReplyDelete
  3. You make a very good point. Several investors don't make the distinction between the kind of deal Buffet gets and the kind of deal they will get - if they simply buy the stock directly.

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  4. Harley-Davidson is one of the those great businesses, whose customers are fiercely loyal, and go so far as to dress themselves in brand paraphrenalia on a regular basis.

    The problem is that they dipped too deeply into tomorrow's sales when they offered such low financing terms from 2004-2007. So now, they have credit problems and market saturation problems.

    I love the business, but the price probably is still too rich. Normalize the non-financial free cash flows over a five year period and then put a reasonable multiple on that, then I may be ready.

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  5. While I agree that customers are fiercely loyal and it's a great brand/business, I am concerned whenever I actually see the customers riding Harley's - they are the same people who rode Harley's in the 50's, 60's, and 70's. Their customer base is aging and young bikers don't seem to be flocking to the brand.

    This leads me to think that this company will have a big problem once baby-boomers go from active retirement to inactive retirement and beyond.

    Great blog by the way.

    ReplyDelete

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