Harley-Davidson Inc (HOG) 2013 Q3 法說會逐字稿

Good morning.

My name is Will and I will be your conference operator today.

At this time, I would like to welcome everyone to the third-quarter 2013 earnings conference call.

(Operator Instructions)

Thank you.

Amy Giuffre, you may begin your conference.

Welcome to Harley-Davidson's third-quarter 2013 earnings conference call.

The audio for today's call is being webcast live on Harley-Davidson.com.

The supporting slides can be accessed on our website by clicking on Company, Investor Relations, then Events and Presentations.

Our comments today will include forward-looking statements that are subject to risks that could cause actual results to be materially different.

Those risks include, among others, matters we have noted in our latest earnings release and filings with the SEC.

Harley-Davidson disclaims any obligation to update information in this call.

This morning you'll hear from Harley-Davidson's CEO, Keith Wandell; CFO, John Olin; and President of Harley-Davidson Financial Services, Larry Hund.

Then we'll open the call for questions.

So let's get started.

Keith?

Thank you, Amy.

Good morning and thanks for joining us today on the call.

As you saw in the earnings release, Harley-Davidson had a great third quarter.

We had strong financial performance; we had a strong 2014 new product launch, which resulted in good retail sales; and we celebrated the 110th anniversary in Milwaukee.

And all the credit goes to our employees, our dealers, and our suppliers, who all continue to do an outstanding job of delivering on our key strategies in manufacturing, product development, and retail.

All these folks come to work every day with the relentless focus on providing our customers a great experience.

Just two months ago in Denver, we introduced our new 2014 motorcycles, including the Project Rushmore bikes, and these have generated tremendous excitement from dealers and customers alike.

The 2014 model year roll-out was the biggest launch of new motorcycle models in the Company's history and we executed the most comprehensive marketing reveal ever to support it.

The results at retail speak for themselves.

In the initial 45 days at retail since launch, the Rushmore motorcycles sparked the largest year over year new model sales increase in 20 years.

Sales were up strongly in both the United States and internationally and it was the best international model year launch ever in terms of initial volume.

These motorcycles sold extremely well among both our traditional core customers in the US, as well as our outreach customers, consisting of young adults 18 to 34, women, Hispanic, and African American riders.

For each of these demographic groups, the top selling model year 2014 bike has been the Rushmore model.

It all added up to a great quarter at retail.

The third quarter was big for Harley-Davidson in other ways too, especially the 110th anniversary weekend in Milwaukee.

Just 10 days after the 2014 model year launch, thousands of riders converged on Milwaukee over Labor Day weekend for the kind of huge party and experience that only Harley-Davidson can throw.

The event brought riders together from all walks of life, including H.O.G.

members from Egypt, Taiwan, Greenland, Germany, and beyond.

In all, more than 40 countries were represented.

It was the culmination of a year-long global 110th anniversary celebration on six continents that connected millions of Harley-Davidson fans around the world.

And it was covered by the media far and wide, resulting in 1.2 billion media impressions for the Milwaukee event alone.

The 110th anniversary and the 2014 new model launch were the latest milestones in what has been a great year so far, and as we look at the remainder of the year and beyond, we are excited about the opportunities for the brand and the Company.

And while we've achieved a lot, we expect to continue to reap the benefits of our product development, manufacturing, and retail strategies for the Company and for our customers alike.

As always, there's more to do and we take nothing for granted.

We continue to double down on the progress we've made and remain focused on building a successful Business for the long term.

So again, I want to just thank all of you for your continued interest and investment in Harley-Davidson and now I'll turn it over to John Olin to give the details behind the numbers.

Thanks, Keith, and good morning, everyone.

I'll review the third-quarter financial results, starting on slide 9.

During the quarter, Harley-Davidson Inc.

consolidated revenue was up 7.5% to $1.34 billion.

Our third-quarter net income improved to $162.7 million, an increase of $28.7 million, or 21.4%.

Similarly, diluted earnings per share rose to $0.73 per share, up 23.7% from the year-ago quarter.

Operating income from the motorcycle segment was $175.5 million, up 21.2% compared to last year's third quarter.

The strong increase in the motorcycle business was driven by an 8.4% increase in revenue behind a shipment increase of 2.3% and a favorable shift in mix.

Additionally, motorcycle segment operating income benefited from higher gross margin and lower restructuring spending, partially offset by an increase in SG&A.

Operating income at Harley-Davidson Financial Services was up 5.1%, behind increased net interest income.

The net income also benefited from a favorable tax adjustment in the quarter.

In all, we are very pleased with our third-quarter financial results.

Now let's take a look at retail sales on slide 10.

Worldwide retail sales of new Harley-Davidson motorcycles were up 15.5% during the third quarter, driven by an increase in both the US and international retail sales.

Third-quarter retail sales results reflected a very positive response to our 2014 model year motorcycles and improved product availability in the US.

In the US, retail sales were up 20.1% versus the third quarter of 2012.

And international retail sales were up 6.5% versus prior year behind improved sales across all regions.

On a year-to-date basis, worldwide retail sales were up 4.1%.

As we look forward to the remainder of the year, we feel great about our brand, our Business, and our future.

We expect continued momentum behind our very exciting model year 2014 motorcycles.

On slide 11, you'll see retail sales in the US were up 20.1% in the third quarter.

Retail sales growth in the quarter were positively impacted by the exciting and well-received model year 2014 motorcycles; significantly improved motorcycle availability; and relatively easy comps to last year.

Our share of the US heavyweight market increased 1.7 percentage points to 56.5% in the third quarter, which represents another record quarter of market share.

On a year-to-date basis, retail sales in the US were up 4.1%.

We exited the first half of 2013 with retail sales down 2.7%, which was below our expectations, (inaudible) to a very weather-challenged second quarter.

At that time, we said we believed that a portion of the 2013 selling season's retail sales may not be recovered by the end of 2013.

Despite the strong third-quarter results, we continue to believe that the lost sales in the second quarter of this year will continue to put pressure on achieving the high end of shipment guidance.

Turning to US dealer retail inventory.

Retail inventory was up approximately 4,200 motorcycles at the end of Q3, compared to 2012.

Availability of some new models was very tight in the quarter, which is to be expected following a model launch of this magnitude.

We do not believe tight inventory levels on select models will result in lost sales.

Overall, we have been comfortable with dealer retail inventory levels throughout 2013.

We believe the dealer inventory levels in Q1 through Q3 are approaching the levels that we believe are aligned with our flexible manufacturing.

We continue to expect Q4 retail inventory to be down compared to last year as we prepare to implement surge production at our Kansas City facility early next year and as we remain committed to aggressively managing supply in line with demand.

On slide 12, you'll see third-quarter retail sales in our international markets were up 6.5%.

In our EMEA region, Q3 retail sales were up 1.6%, driven by our investment in emerging markets, which were up 28.3%.

Our European markets remain down by 2.7% on a year over year basis.

We continued to see some modest growth in the Northern European countries, led by the UK and Germany.

While the Southern European companies remain down, Italy posted its first year over year quarterly increase after being down for eight consecutive quarters.

During the first 9 months of 2013, our heavyweight market share in Europe was 12.6%, up 0.8 percentage points versus the same period last year.

Our market share gains in Europe are encouraging, especially in light of the economic situation and promotional discounting by our competitors.

We remain concerned with the ongoing economic challenges in Europe and the potential impact on our European business.

We will continue to focus on what we can control, which includes building our brand experience across Europe and expanding our distribution network in emerging markets in the region.

In the Asia-Pacific region, retail sales were up 10%, driven by strong growth in emerging markets, especially India and China.

Latin America region retail sales were up 15.6%, driven by Brazil and Mexico.

At the end of this quarter there were 15 dealerships operating in Brazil versus 11 dealerships in the year-ago quarter.

Finally, retail sales in Canada were up 7% in the third quarter.

As we have discussed, we are very focused on investing in our international businesses.

We are targeting 100 to 150 international new dealer points through 2014, and over the last 3.75 years, we have opened 110 new dealer points with two-thirds being in emerging markets.

We are very excited about the growth prospects in our international businesses.

On slide 13, you will see wholesale shipments of Harley-Davidson motorcycles in the quarter were around the midpoint of our expected range of 51,000 to 56,000 motorcycles and up 2.3% compared to last year.

During the quarter, the mix of Touring motorcycles increased 7.6 percentage points over the prior year to support the initial shipments of new Rushmore models, and as we lap last year's Touring production, which was impacted by the implementation of the ERP system at our York facility.

As a percent of the total, international shipments were 3.5 percentage points higher than Q3 2012.

On slide 14, you'll see revenue for the motorcycles and related products segment was up 8.4% in the third quarter, including a 10.7% increase in motorcycle revenue, largely driven by the strong mix of our Touring bikes.

During the quarter, we introduced our new 2014 model year motorcycles.

Wholesale and MSRP prices have increased by an average of about 3.5%.

By region, US prices are up roughly 4.25%, EMEA up 1.5%, and Asia-Pacific and Latin America, each up about 2.5%.

The significant content, which was added to the 2014 model year motorcycles, is expected to increase costs by 2.75%, resulting in wholesale pricing in excess of cost of about 0.75%.

Despite the strong revenue and profit improvement that we expect from these pricing actions, it is important to note that we expect our model year 2014 price increase, net of related cost, will dilute motorcycle gross margin percent by roughly 0.5 of a point over the next year.

For the quarter, average motorcycle revenue per unit increased $1,203 from the prior year period, primarily driven by favorable mix and higher pricing, partially offset by unfavorable currency exchange.

On average, our key currencies during the third quarter were weaker against the US dollar by approximately 7% compared to last year.

During the quarter, parts and accessory sales were up 7% driven by the success of certain innovative product categories such as LED lighting and audio.

General merchandise was down 12.6% compared to Q3 2012, due to lapping the strong sell-in of 110th anniversary apparel and accessories which began in Q3 of 2012.

Turning to restructuring on slide 15.

Since 2009, we have been intensely focused on improving our cost structure and transforming the Business to be stronger, more flexible, and more profitable.

As we exit our restructuring activities, we will continue to focus on improving the retail customer experience, strengthening our world-class distribution channels, and accelerating our product development capabilities.

We have established a culture of continuous improvement and will continue to look for ways to operate in the most efficient and profitable manner.

We continue to expect annual savings in 2013 from all restructuring activities of approximately $305 million, and approximately $320 million on an annual ongoing basis beginning in 2014.

For the third quarter, we recorded a restructuring expense of $0.6 million, versus an expense of $9.2 million in Q3 of last year.

We also experienced approximately $3 million in temporary inefficiencies, versus approximately $11 million in last year's third quarter.

On slide 16 you'll see gross margin in the quarter was 35.3%, which was 0.6 percentage points higher than last year.

Volume, price, mix, raw materials and manufacturing were all favorable for the quarter, partially offset by unfavorable foreign currency exchange.

Foreign currency exchange continued to be unfavorable during the third quarter as a result of the sizable devaluation of the yen, the real, and the Australian dollar on a year over year basis.

Foreign currency exchange impact reduced our third quarter's gross margin by about $4 million or approximately $0.01 of EPS.

As we look forward, we continue to expect foreign currency to adversely impact gross profits in the fourth quarter.

Favorable manufacturing costs reflect the benefits from restructuring and lower temporary inefficiencies as compared to last year's third quarter.

Manufacturing costs, however, were adversely impacted by higher than normal start-up costs for our new model year motorcycles.

Start-up costs were approximately $7 million higher than normal, driven by the extraordinary level of content added to our new models.

On slide 17, operating margin as a percent of revenue for the third quarter was 14.9%, up 1.6 percentage points compared to last year's third quarter.

Operating margin for the quarter was favorably impacted by higher gross margin and lower year over year restructuring expense, partially offset by higher SG&A spending.

SG&A dollars were up $16.2 million or 7.2% compared to Q3 2012.

The increase included incremental spending to support the Rushmore product launch, the 110th anniversary, and continued investment in our growth initiatives.

We continue to expect SG&A spending will increase on a year over year basis in 2013 as we continue to invest in growth.

Additionally, last week we issued two voluntary recalls affecting roughly 29,000 Trikes, Touring, and Softail motorcycles.

We anticipate a one-time $4.9 million charge to SG&A in the fourth quarter.

Now moving on to the financial services segment on slide 18.

In the third quarter, HDFS operating profit increased $3.7 million or 5.1% compared to last year.

The two primary factors impacting Q3 results were, first, net interest income was up $6.8 million driven by a lower cost of funds; and second, the change in the provision for retail credit losses was unfavorable by $6.5 million on higher credit loss reserves due to increased receivables and higher retail credit losses.

We are pleased with HDFS's third-quarter performance.

On a full year basis, we continue to believe HDFS's 2013 operating income will be modestly lower than 2012, which benefited from approximately $17 million of 2012 credit loss reserve releases.

Going forward, we continue to expect pressure on HDFS's operating income as a result of increased competition and modestly higher retail credit losses due to lower recoveries, changing consumer behavior, and HDFS's funding of additional sub-prime loans, which we believe are prudently structured.

Finally, while key benchmark interest rates have increased during the year, we continue to believe HDFS is well-positioned to navigate the changing interest rate environment.

Given its diversified funding portfolio, we expect higher interest rates to only have a minimal impact on HDFS's earnings in 2013, but we believe rising interest rates will result in compression of HDFS's lending margins over time.

Now Larry will provide more detail on HDFS's operations on slide 19.

Larry?

Thanks, John, and good morning.

During the third quarter, HDFS retail motorcycle loan originations increased 29.9% or $190.2 million compared to the same period last year.

The increase was primarily driven by higher year over year new retail motorcycle sales and a 7.7 percentage point increase in retail financing market share.

For the third quarter, HDFS retail financing market share of new Harley-Davidson motorcycles sold in the US increased to 60% compared to 52.3% in the third quarter of 2012.

The primary drivers of the market share gain during the quarter were the pricing changes in the prime segment, which were initiated in the second quarter in response to increasing competition and the strong sales of Touring product.

Finance receivables outstanding increased 4.5% compared to a year ago, driven by growth in the retail and wholesale portfolios.

We believe the overall loan portfolio is solid, comprised of profitable loans funded in both the prime and sub-prime segments.

In the third quarter of 2013, between 75% and 80% of our new loan originations were prime.

Moving on to credit performance on slide 20.

The 30-day delinquency rate for retail motorcycle loans at September 30, 2013 was 3.11%, or 13 basis points lower than 2012.

This is the lowest third-quarter 30-day delinquency rate in over 10 years.

Year-to-date annual retail credit losses increased by 23 basis points to 0.88% compared to 2012, primarily driven by lower levels of recoveries from accounts charged off in prior years.

This was expected, given the lower level of credit losses in the past few years, which left a smaller pool of potential 2013 recovery dollars.

In addition, in the third quarter, HDFS experienced a modest increase in losses due to lower recovery values of repossessed motorcycles following the launch of our new Rushmore motorcycles.

We are pleased with the progress at HDFS, as we continue to maintain a strong liquidity position, deliver solid credit performance, and contribute strong profitability.

We remain focused on enabling sales of Harley-Davidson motorcycles while providing an attractive return to Harley-Davidson Inc.

Now, let me turn it back to John.

Thanks, Larry.

Now let's take a look at cash and liquidity on slide 21.

You will see that at the end of the quarter, we had $1.15 billion of cash and marketable securities.

In addition, we had $1.56 billion of available liquidity through bank credit and conduit facilities.

We currently have and intend to continue to maintain a minimum of 12 months of projected liquidity needs in cash and/or committed credit facilities.

During the third quarter, we repurchased approximately 1.6 million shares of Harley-Davidson stock for $92.8 million.

As we have stated, returning value to our shareholders through increasing dividends and share repurchases is a top priority.

We will continue to evaluate opportunities to enhance value for our shareholders.

Now, I'll review the remaining Harley-Davidson Inc.

financials on slide 22.

I would like to highlight two items on this slide.

First, with regards to operating cash flow, the Company generated operating cash of $825.1 million during the first 9 months of 2013.

Operating cash flow was up $112.6 million from last year, primarily driven by increased earnings.

And second, the tax rate through 9 months was 34.3%, compared to 35.3% in the year-ago period.

This reflects the benefit of the retroactive reinstatement of the Research and Development Tax Credit and an adjustment of the valuation allowance on deferred tax assets in the third quarter of 2013.

We now expect our full-year effective tax rate to be approximately 34.7%.

On slide 23, you'll see that for 2013, we continue to expect Harley-Davidson motorcycle shipments to be between 259,000 and 264,000 motorcycles on a worldwide basis, up approximately 4.5% to 6.5% from 2012.

During the fourth quarter, we expect to ship between 45,000 and 50,000 motorcycles, which is in line with last year's fourth-quarter shipments of 47,067 motorcycles.

We believe the underlying demand fundamentals for Harley-Davidson motorcycles in the US are strong.

However, as I said last quarter, we believe we lost sales volume as a result of poor weather in the second quarter, which will put pressure on our ability to reach the high end of our full-year shipment guidance.

We continue to expect full-year 2013 gross margin will be between 35.25% and 36.25%.

As we look forward to the fourth quarter, we expect our gross margin percent will be in line with last year's fourth quarter.

Gross margin will reflect the ongoing benefits from restructuring savings and lower temporary inefficiencies.

However, as we have discussed, production will be lower than last year's fourth quarter as we prepare to implement surge manufacturing in Kansas City earlier next year.

Q4 mix is expected to be unfavorable as we lap the higher than normal 46% Touring mix in last year's fourth quarter, due to the Q3 2012 ERP implementation.

We also expect currency exchange to have an adverse impact on the fourth-quarter gross margin.

And finally, we expect Q4 gross margin percent will reflect the dilutive impact of our model year 2014 price increase, net of related costs.

Capital expenditures in 2013 are expected to be between $200 million and $220 million.

Looking back, we are pleased with our third-quarter results and our key accomplishments.

During the quarter, we launched the most significant new model year in our history, celebrated our 110th anniversary in Milwaukee, and delivered shareholder value through dividends and share repurchases.

We continue to position the Company for the long-term success by remaining focused on executing our growth strategies and delivering strong margins, strong returns, and value to our shareholders.

Thank you for your continued confidence and investment in Harley-Davidson.

And now, let's take your questions.

(Operator Instructions)

Your first question comes from the line of Felicia Hendrix from Barclays.

Your line is open.

Hi, good morning.

Thank you for the question.

If I could just ask a question on gross margins for a moment.

I really appreciate all the color that you've given.

It's very helpful.

Just wondering if we could understand a bit how long you think it might take to just get up the learning curve on the new bikes?

And then you gave us color on the fourth quarter.

I know you don't like to give guidance.

I'm not asking for guidance but just wondering if you could frame for us perhaps some pluses on the gross margin side to think about next year, and I'm asking specifically because The Street has almost a 90 basis point improvement in gross margin expectations for next year?

Thank you.

Okay, this is John.

Thanks, Felicia.

With regards to -- the first question was centered around gross margin in the third quarter, and in the preamble we had talked about increased costs in the third quarter due to starting up the Rushmore model year.

So given the complexity, the size, the number of models of both Rushmore and ABS on our Sportsters and some of the other models that we introduced, we had higher than typical start-up costs of about $7 million.

So on a year-over-year basis, the quarter benefited from lower temporary inefficiencies in terms of restructuring.

We had $11 million in the prior year versus $3 million this year.

And a lot of that favorability was really taken up by the fact that the start-up costs were higher than they typically would be.

They the are up-to-speed.

The plant is up-to-speed and we don't expect any additional costs -- so a one-time start-up for Rushmore.

We don't expect any costs on a go-forward basis.

As we look at next year's gross margin, we'll provide more guidance in our Q4 conference call, but some of the positives that we anticipate for next year, certainly the pricing and incremental volume that we would anticipate.

Some of the headwinds may continue to be currency and then perhaps raw material costs.

But again, we'll give more insight to that at the end of -- the first-quarter conference call.

Your next question comes from Kevin Milota from JPMorgan.

Your line is now open.

Was hoping you could just clarify, John, the negative impact from the model year 2014 bikes.

Was it a 50 basis point negative impact on the gross margin front?

Thanks, Kevin.

With regards to the start-up costs, about $7 million would have been about 60 basis points, 0.6 of a margin point.

Your next question comes from the line of James Hardiman with Longbow Research.

Your line is now open.

Hi.

Thanks for taking my call.

A follow-up to that last question.

Could you help us frame what the net pricing impact would have been to gross margins in the third quarter?

It sounded like that was a negative.

You gave us that for next year or over the next year, what that negative impact was.

Can you help us out with that in the third quarter?

And then just also, from a capacity perspective, the guidance that you gave us for the fourth quarter, is that the extent of what you could possibly produce?

Or if you see some upside to retail, could we potentially see upside to shipments in the fourth quarter?

Thanks.

Thanks, James.

We talked about net pricing.

Number one is, it has a dilutive impact on gross margin percent but we shouldn't talk about this in a negative light.

We've increased revenues by 3.5% with our model year 2014 pricing.

Now, with that came higher costs at about 2.75%.

So pricing net of cost is up 0.75%.

Basically when you look at 0.75% increase in profit and 3.5% increase in revenue, that comes out to a gross margin of about 21%.

And given the fact that the Business operates at a 35.25% to 36.25% gross margin, it is a somewhat dilutive of that gross margin.

So James, what you had asked is how much.

That's about 50 basis points, about a 0.5 point of gross margin.

Now, again, with that we're getting a fair amount more revenue and more profits and certainly delivering more value to our shareholders.

But it is a slight drag on gross margin that we saw in the third quarter and we'll see again in the fourth quarter and the first half of next year, as well.

The second question that you asked is with regards to capacity.

When we look at our shipment guidance in the quarter of 45,000 to 50,000, we're certainly taking into consideration surge manufacturing coming up at Kansas City in the first half of next year and are looking to take overall retail inventories down, meaning that we will retail more this year.

Our dealers will retail more this year than we ship in.

With regards to capacity, we have certainly plenty of capacity in the fourth quarter that if we needed to or chose to, that we could make more units.

Your next question comes from the line of Craig Kennison with Robert W. Baird.

Your line is now open.

Good morning.

Thanks for taking my question.

With the new products, the strong retail trends, and what we think is lean inventory, you would seem to be in a position to allocate your inventory to those dealers that are optimizing your priorities.

How much flexibility do you have in terms of inventory allocation in an environment like this?

Overall, inventories -- we feel good about where we're at in terms of inventory.

We are seeing some tightness in select models, in particular Rushmore models.

We've got an allocation system that we believe is fair to all our dealers and we continue to execute against that allocation system.

Your next question comes from the line of Rod Lache with Deutsche Bank.

Your line is now open.

Good morning, everybody.

Was hoping that -- you've commented before on the 50% incremental margin that you expected in the motorcycle business and I was just hoping that you might be willing to reconcile that to the gross margin bridge that you provide on slide 16.

Presumably we should take some -- take the volume and take the manufacturing and maybe add back in the $7 million of start-up costs.

But your motorcycle revenue was up by $90 million.

Your motorcycle revenue ex parts and accessories was up $83 million.

Can you just walk that for us?

From a directional standpoint, Rod, when we look at that bridge on page 12, and translate it into gross margin percent, right?

You see the overall dollars adding up to the $38 million.

Volume would be -- have no impact on gross margin percent.

Motorcycle pricing is unfavorable by about a 0.5 point in terms of gross margin percent, even though it's delivering $10 million of profit to the Organization.

Mix would be slightly favorable.

Currency, slightly unfavorable.

Raw materials, slightly favorable.

And then manufacturing, considerably favorable, that $9 million doesn't have a revenue component so that would provide a benefit of about 0.8 of a gross margin point.

So when you take all of those and add them together, you're up about 0.6 of a point versus prior year.

Okay.

But when you've historically talked about a 50% incremental margin on the incremental dollars that come in from your growth.

I would --?

Yes.

Yes.

So what we've said is that for each incremental unit that we sell, that typically has a gross margin of about 50% versus the core businesses that's at 35.25% to 36.25%.

Most of that, Rod, would come through in the manufacturing piece.

So that's where the absorption is of the fixed costs of manufacturing.

Okay.

So you had that manufacturing of $9.3 million, but it was really, if you add back the $7 million, it's $17 million, and you had volume benefit of $4.8 million, so you get up to $21 million.

But your revenue was up something like $90 million.

So is there -- is that something that is not necessarily holding right now because of relatively modest volume changes or how should we be thinking about that?

No, it's certainly holding.

The $4.8 million, though, is strictly on volume.

It has nothing to do with margins so it would not come down and be reflected at all in that manufacturing line.

The manufacturing line, the way to think of it is there's four main buckets.

There's productivity, which includes a restructuring savings.

There's the incremental margin, based on the increased production, not necessarily shipments but increased production.

There's the year-over-year impact of temporary inefficiencies, which is favorable $8 million.

And then there's start-up costs, which are unfavorable by $7 million.

All that together winds up to be $9.3 million and when you divide that by the revenue, it's adding 0.8 of a gross margin point on a year-over-year basis.

Yes, okay.

The inventory build that you talked about, is that basically entirely attributable to the Rushmore units?

And can you give us any color on the -- how significant are the sales of discontinued models, like the Road Glide at this point?

Retail?

At retail.

For the quarter end we had about 4,200 units higher in inventory and the majority of that would be Touring motorcycles.

One, because the overall split is pretty significant in Touring and number two is that certainly the success of those models in preparing for sales into the fourth quarter and beyond.

Yes, some of the discontinued models.

And so the discontinued models -- Road Glide, we had -- with Rushmore -- we came out with 8 models on a year-ago basis, that's comparing to 10 models.

We took two models out of the line-up, which are Road Glide Custom and Road Glide Ultra, which represent on an annual basis, about 10% of Touring volume and 4% to 5% of our total volume.

When we look at the third quarter in terms of retail sales, we had pretty brisk retail sales of the Road Glide.

So I would say that in the third quarter, when you're looking at retail sales, we're not seeing a headwind from Road Glide at this point and we'll start to see that in the fourth quarter and first and second quarter of next year.

Your next question comes from the line of Tim Conder with Wells Fargo Securities.

Your line is now open.

Thank you.

Just a couple of items here.

John, a lot of people have asked about gross margin, and clearly at the Analyst Day, you and Keith alluded that the Rushmore benefit would be to the first half of 2014, but then the back half of the year, you'd get some normalization after that.

So how can we think about gross margin cadence with the restructurings being over on a longer term basis?

And then secondly, with your excess free cash flow here, are -- you're going to start talking about a payout ratio target or is all the incremental free cash going to be returned to shareholders after Mr. Buffett is repaid in February of 2014?

Okay, with regards to gross margin, as we look forward, again, we expect gross margin in terms of incremental volume, pricing, and those are the main drivers.

When we look at Rushmore, Rushmore should provide mix favorability in the short term, but on a long-term basis we would expect mix to be flat over time as we continue to develop products for both our core customers and our outreach customers.

When we look at return of capital to our shareholders, we're not basing it off -- we're not providing a payout ratio but what we have said and will continue to do is return all excess cash to our shareholders in the form of rising dividends or share repurchase.

Tim, you had mentioned that we do have a large debt coming due in February of next year.

That's $303 million of high interest debt that during the downturn we borrowed from Berkshire and that will be paid out of operating cash and we will not look to refinance that.

Okay.

Great.

Thank you.

Your next question comes from the line of Greg Badishkanian from Citigroup.

Your line is now open.

Great.

Thanks.

I'm guessing from your commentary on the new products, that you did not see a drop-off in sales in September.

Is that correct?

And then also, when you talked about the benefits of gross margins in 2014, you mentioned incremental volume.

Does that mean that the volume growth rate is going to be faster in 2014 or you're just saying -- than it was in 2013 -- or is it just an increase year-over-year?

Thanks, Greg.

We typically don't comment on growth rates within a quarter.

Sufficient to say that we were certainly pleased with the overall growth of retail sales in the third quarter, in the US being up 20.1%, and certainly international up [6.5%].

When we look at volume growth --

Next question you had, Greg, was on the 2014 gross margin?

Yes, it was on the -- you mentioned that 2014 you'd see incremental volume that would contribute to -- or benefit the gross margins for 2014.

So does that mean you're --?

I'm sorry.

Greg, we will look to provide guidance in the fourth quarter conference call, late in January.

We're not going to provide any guidance at this point.

Okay.

Just wondering when you said incremental volume what you meant by that?

Was it just you're going to see an increase year-over-year or was it a faster growth rate than 2013?

I just want to understand what you meant by your comment?

I was not talking to any comparative growth rates.

We would expect to grow next year and we'll provide that.

Okay.

Perfect.

Thank you.

Your next question comes from the line of Patrick Archambault with Goldman Sachs.

Your line is open.

Yes, thanks a lot, guys.

Good morning.

Just two quick ones from me.

First, on HDFS, would it be possible to at least give us a directional walk about how you're thinking about it.

You mentioned that net interest margins could compress a little bit because of some of the pricing.

Then I imagine you have positive origination volume and I'm not sure what you think of credit.

So maybe putting those pieces together for us, as you see them?

And then my second quick one is doesn't sound like the recall had much of an impact on production in fourth quarter, but can you just clarify that for us as well?

Okay, Patrick, this is Larry Hund.

Just talk a little about HDFS, both on the volume margin side and then on the credit side.

Clearly, we had a strong market share this quarter.

There is a lot of competition out there that we are seeing and clearly we made some pricing adjustments and that helped us drive that share.

So you're making a volume margin trade-off there.

Over time, as John said, what we expect is rising interest rates are going to put some pressure on margins in the Business.

If you look back historically in this Business, your margins tend to widen out in a falling or absolutely low interest rate environment and then they narrow some when you get into a rising rate environment.

On credit losses, we feel very good about where we are right now.

We were 88 basis points year-to-date.

And we feel good about that.

Over time, we expect credit losses to normalize.

And that level, if you look at our 10-year average, is certainly higher than where we are for the first quarters.

And this is Keith.

Patrick, you asked the question about the impact of the recall on production.

There really will not be one.

We had a slight delay in some shipments.

We had some product in the plant in queue for shipment that we had to go in and do the fix on.

So that delayed some shipments by about a week.

But overall, when you wash through this thing, there really will not be a delay.

Okay.

Great.

Thanks a lot, guys.

Your next question comes from the line of Sharon Zackfia with William Blair.

Your line is now open.

Hi.

Good morning.

I wanted to take a step back since we're almost done with the restructuring, to talk about where the potential is for motorcycle operating margin to go over time.

You've clearly seen good improvement last year and it looks like you'll have a 16%-plus motorcycle operating margin this year.

So can you walk through longer term over the next 3 to 5 years, where you think that post-restructuring motorcycle margin target could be?

Thanks, Sharon.

What we've said is over the next 3 to 5 years, we expect gross margin to expand modestly.

We're not providing a hard number at this time.

As we know, there's always puts and takes to these things.

You take the first half of this year and currency exchange has been about a 0.5 point drag on overall gross margins.

So it's something that we're not providing a long-term hard number, but again, when you look at the various pieces of it, we would expect incremental margin and certainly pricing to benefit us into the future.

While the restructuring savings will -- we've still got about $15 million left that will be realized next year.

There's still a lot of opportunity that we have in terms of the cost structure at Harley-Davidson.

Number one is on continuous improvement.

The whole system that we put in is designed to deliver continuous improvement into the future.

And then the other big area is transformation that we've had in product development and the opportunity to continue to design out costs out of our motorcycles.

And we thought the team did a wonderful job this year, when you look at Rushmore, and while the costs were up 2.75%, the content that we added is well beyond that type of cost increase.

So we think there's tremendous opportunities in terms of continuing to focus on the cost structure as well as the revenue side.

And when we look at the revenue side, again, we talk about our overall strategy, the fat in the tail strategy, to continue to bring in customers on both sides.

Certainly, we did that with Rushmore on the core customer side of the scale and you'll continue to see, as we move into the future, a lot more effort on the outreach side as well.

Maybe if I could ask the question a different way.

Pre-recession you had motorcycle operating margins that were over 20%.

Is that something where you think that is fundamentally possible again in the model and is the key delta there just recouping the volume?

We believe that we can continue to expand margins into the future, modestly at gross margin, and we'll expect to get continued leverage off of certainly the SG&A base.

And as we look into the future, we will not grow SG&A at the same rate of revenue, and therefore, drive margins.

Beyond that, we look to -- we feel great about our margin expansion.

Sharon, every morning, 6,000 people wake up here and they're focused on delivering a customer experience, generating the products to drive that as well as to improve our gross margin.

So we're completely focused on delivering it and we will deliver it but I will not provide a number at this time.

Your next question comes from the line of Gerrick Johnson with BMO Capital Markets.

Your line is open.

Thank you.

Good morning everyone.

Can you talk about the consumer reaction to the Twin-Cooled bikes?

Pretty big deal.

Was it to what you were expecting?

Better?

Softer?

And being that it was only three of the eight new units, how did that impact your mix?

Did you see more demand for Limiteds versus Ultras and Streets?

Or the other way around?

Thank you.

This is Keith.

The response has been very positive.

Not only on the precision cooled engine but on a lot of the changes that were made on Rushmore.

All these changes, and there were probably roughly 100 changes, some big, some small, were all driven by the voice of the customer, right?

It was all driven by things that the customer has been asking for and looking for, et cetera.

And really there hasn't been a noticeable change in the mix, necessarily.

All of the Rushmore bikes have really sold very well.

If you look at, as an example, in Germany (technical difficulty) [significant sales of] Rushmore, just because of the technology, as an example, and that's a market where you think about the brakes, the radio, the luggage, the ergonomics.

That's a market that's highly focused on technology.

There's a saying in Germany -- Germans love their cars, Americans drive their cars.

And that translates to the motorcycle business as well.

So all of the changes that we've made with Rushmore, listening to the voice of the customer, not just the US customer but the international customer, are paying tremendous dividends for us.

Okay.

Great.

Thank you.

Your next question comes from the line of Adam Jonas with Morgan Stanley.

Your line is open.

Good morning, everyone.

This is Vijay in for Adam.

Just a couple of quick questions.

I think you mentioned that HDFS recoveries took a bit of a hit this quarter, potentially because of the introduction of the Rushmore models.

Can you comment a bit more broadly on what you're seeing in the used market?

Another then one on HDFS.

Have you been in contact with or received any communication at all from the CFPB on lending practices?

Hi, this is John.

I'll start out with the first part of it and talk about used prices in general and then Larry can handle the second part of the question.

Any time that we come out with a new model year, we certainly see a devaluation of the old ones out there.

Another model year goes by, right, and they become a little bit older.

And certainly this is no difference, in terms of that devaluation.

But we are seeing a bit of a greater devaluation, which we would expect, given the extreme content that we've added to the motorcycles.

So we are seeing the bikes being devalued.

Still pretty early.

We do not have any concerns from the motorcycle segment perspective -- is that while that price gap is expanding, the content that we've added more than makes up for any of the decline in overall used bike prices.

Now, that's a little bit different, and I'll let Larry comment on it.

It does have an adverse impact when you look at the collateral aspect of it.

Sure.

When you look at recovery values on repossessed motorcycles, those have actually dropped some, as we said.

And that has to do -- dealers with the great introduction of the Rushmore line are a little more focused on new motorcycle sales right now and we've seen a little bit of drop-off in some participation at some of the auctions.

But overall, nothing that's been out of line with what we expected, given that great new model year launch.

Regarding your comment on the CFPB, we have not had any contact with the CFPB.

We actually have a banking subsidiary, so we're regulated by the FDIC.

But certainly we are watching what's going on in the market very closely and their contact with other lenders and we are working to tighten our controls and -- because obviously this is an area that's very important to us, very important to our dealers.

Okay.

Great.

Thanks very much.

Your final question comes from the line of Jaime Katz from Morningstar.

Your line is now open.

Good morning, guys.

I want to piggyback on to that debt maturity question from earlier.

I know there's another piece of debt due at the end of next year.

Are you guys going to look to refinance that, do you think?

Or how should we think about the optimal capital structure going forward?

And then secondly, general merchandise category, while it's small, it was down pretty significantly this year or this quarter.

Could you just comment on that?

Yes.

Hi, Jaime, this is John.

The debt that we have coming due in February, the $303 million, is corporate debt.

That will pay off 100% of our corporate debt.

We've historically run without debt on that side.

We picked it up during the downturn.

When you talk about the $500 million 7.75% MTN that's coming due in December of 2014, that is part of the core funding for the finance subsidiary.

So we would absolutely look to replace that debt.

Okay.

And as interest rates stand now we would look to replace that at a lower interest rate.

That was at 5.75%.

So when we look at the overall capital structure, as we look into the near future, we don't expect any debt on the motorcycle side.

But we'll continue to fund the portfolio at HDFS, including that MTN that will be coming -- we'll refinance that next year.

Second question was on general merchandise.

And general merchandise for the quarter was down by 12.6%.

100% of that decline is explained by the year-over-year impact of the 110th anniversary sell-in.

So every 5 years, we have this anniversary, which is highly anticipated and the apparel is no different.

So we come out with a whole line of 110th anniversary or anniversary apparel and accessories.

That is sold in the year prior.

So that was sold in the third quarter of 2012 and this quarter we're simply lapping that.

And again, 100% of the decline is explained by the year-over-year difference between 110th anniversary product.

Perfect.

Thanks so much.

All right, thank you everyone for your time this morning.

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This concludes today's conference call.

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