According to today’s press release, Harley Davidson (HOG) issued $600 million senior unsecured notes to fund its wholly owned finance company, Harley-Davidson Finance Service (HDFS). The note will be repaid in 2014 and the annual interest is 15%. Warren Buffett’s company Berkshire Hathaway (BRK.A) (BRK.B) and Davis Selected Advisers, L.P. each snapped up $300 million.
Now, 15 percent per annum for a five-year note is a very high interest rate. This is how the CFO of the Harley Davidson, Thomas E. Bergmann, justified the move:
“This offering represents an important next step in executing our stated strategy for funding the lending activities of HDFS".
Impressive business talk, but it does not conceal the fact that one has to be in desperate need for the money to borrow under those terms.
The Borrowing Will Not Increase Profit
The borrowing probably won’t bring more earnings to the share holders in its life time of the next five years. What is the interest is Harley Davidson lending to its customers? 1% or 2%? So we are borrowing high and lending low. It doesn't make sense to me.
According to GuruFocus data, HOG managed to make a little over 15% on its assets during boom years (2003-2007), but ROA has dropped to less than 10% at the end of 2008. 2009 will be another challenging year for the company. On January 23, 2009, the company announced that it saw for 2009 a reduction of 10-13% in motorcycle shipment and a shrinkage of gross margin to 30.5-31.5% from 34.5% in 2008. If the company couldn’t make more 15% on its assets (borrowed fund or equity), what is there left for share holders after paying the 15% in interest?
Harley Dividson Is Funding Its Own Sales
Instead, the loan has more to do with surviving in the current credit crunch. In the good old days, customers typically bought motorcycles from Harley Davidson Motor Cycle division; HDFS financed the purchases; HDFS turned around, securitized the loans and sold them to the Wall Street. Since 2008, “securitization” became a one of many dirty words and no one on Wall Street had much appetite for “securitized loans” of any kinds. As a result, in despite of declining revenue, HOG had to retain much more of the receivable on its balance sheet: its “Finance Receivable held for sale” more than tripled from $781 million at the end of 2007 to $2.4 billion at the end of 2008. In 2008, HOG resorted to short term borrowing and long term debt to fund this ballooned asset. Its short term liability increased from $1.9 billion to $2.6 billion; its debt increased from $980 million to $2.2 billion. The combine increase of $1.9 billion is compared to a total annual revenue of $5.6 billion, that is more than 33%.
Keeping more receivable on its balance sheet had its toll on HOG’s net income. In the final quarter of 2008, HDFS, its financing arm, had a $35.1 million write-down of retained securitization interests and a $28.4 million write-down to fair value of finance receivable held for sale. The $63 million write-down is significant compared to the quarterly net income of $77.8 million. The company wouldn’t retain so much receivable on its balance sheet if it had better choices.
Harley Dividson Has Been Credit Squeezed
It is worrisome to see its short term debt increase by $700 million. A typical loan for the motorcycles is for 5 to 7 years; apparently the company increased the short term borrowing in 2008 to financing the loans. Indeed, the company was squeezed to re-pay a $400 million mid-term note that matured in mid of December 2008. In the January 23, 2008 conference call, the company’s CFO Thomas E. Bergmann stated:
Turning to funding for HDFS, during last quarter's conference call I explained specifically the options we had for repaying the $400 million of medium-terms notes that matured last December. Those options included accessing the unsecured debt capital market, utilizing our unsecured commercial paper program, and establishing an asset-backed commercial paper conduit facility. We continued to access the commercial paper market throughout the quarter, including participation in the Fed's CPSS program. By mid December it was clear that the unsecured term debt market was not accessible, so on December 12th we entered into a $500 million asset-backed commercial paper conduit facility. The funds generated from this facility were primarily used to repay the medium-term notes that matured in December.
In other words, the company borrowed short term to repay mid-term. Great band-aid corporate financing strategy.
How Long Can $600 Million Last
How long can the $600 million borrowed today from Warren Buffett’s Berkshire Hathaway and Davis Selected Advisers last? It looks like Harley needs to re-pay that $500 million asset-backed commercial paper mentioned above by March 31, 2009. Even if it can extend the terms for that loan, at the 2008 burning rate of $1.9 billion per year,, it won’t last for long unless the other options become available. In the fourth quarter conference call, CFO Thomas E. Bergmann stated:
To meet the remaining HDFS funding needs for 2009, we are pursuing three preferred paths. The first is for HDFS or Harley-Davidson, Inc., to access the unsecured debt capital market. We continue to carefully monitor these markets for opportunities. The second preferred path is to seek to increase the $500 million asset-backed commercial paper conduit facility we entered into in December and extend the term beyond the March 31st maturity date. Expanding and extending this facility would supplement our existing unsecured commercial paper program. And finally, we are working diligently to gain access to the asset-backed securitization market via the term asset-backed securities loan facility or TALF program. We are actively evaluating the program to further understand the details and learn how we may benefit from it. Retail motorcycle loans have been included as eligible assets in the program; however, exact details of the TALF program are not yet finalized. The general expectation is that the program will be clarified in the next few weeks.
Right now the TALF option seems to offer a more plausible mid-term solution. The Federal Reserve Board on November 25, 2008 announced the creation of the Term Asset-Backed Securities Loan Facility (TALF), a facility that will help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA). It is not fully functional yet, it remains to be seen how effective that might be.
Why Not Cut Dividend?
It is bewildering to try to rationalize the HOG management decision today: as near as December 9, 2008, Harley Davidson announced a quarterly dividend of $0.33 per share. That is $1.32 per year. With 232 million shares outstanding, the company is paying out a little over $300 million each year as dividend. Cut the dividend, don’t borrow from Warren Buffett at 15%! Berkshire Hathaway never paid a dividend, nor had it ever had to borrow at 15% interest.
Bad For Harley Davidson, Good For Bershire Hathaway
Apparenlty, HOG share holders considered it a great endorsement from Warren Buffett. HOG stock is up $1.87 (15.77%) today. Perhaps investors took it as a hint that it is Warren Buffett’s opinion that the company will survive the ecomonic crisis for at least another five years. Probably so, but much less profitably so. As a matter of fact, I think Warren Buffett just fed the thirsty Harley Davidson some motor oil. It tastes bad, it does not really stop the thirst. It is simply not a healthy drink.
On the other hand, the 15% interest on $300 million is a good return for Berkshire Hathaway’s share holders.
Go Berkshire Hathaway!
Filed Under: BRK-A, HOG, BRK-B,
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