Harley-Davidson Buys Back Old Debt – is it a fair deal?

A interesting piece of news caught my eye recently, about the announced repurchase of debt by Harley-Davidson:

What made me worry is the third paragraph, the claim that “… would have incurred total principal and interest payments of approximately $438 million…”. We all know Harley-Davidson is good in generating positive marketing hype, but here the spin doctors even took over the finance department.

Harley-Davidson did not save 438 million, such assumption would be ridiculous, and as we know how easy complex financial structures can be sold to the ignorant public, I went on to dig a bit deeper in the announcement to better understand what exactly went on here, and if its good or bad news for Harley-Davidson, its customers and shareholders.

Let us start in the past, when Harley issued these notes that ended up with Davis Advisors:

A simple transaction, Harley issues notes, and receive the cash price. During the next years, Harley pays the agreed interest. Interesting here – although not clearly mentioned – is the interest rate Harley-Davidson agreed to pay, it must have been about 15% (45mio / 297mio = 15%). This sounds like quiet a lot and the funding rate for a desperate company. But that was the agreement, and Davis Advisors is holding on to the note promising exactly this.

All went fine for some time, when now in December 2010, Harley-Davidson agrees a deal with Davis Advisors to buy back the notes for $381 million.

The real question is: “Was this a good deal?” and “Why has it been agreed?” For Davis to give up 15% interest per year, there must be very some good reasons, so lets analyse them in more detail:

Ok, here I must call for your understanding of the difference between present value and future value. The basics are pretty simple to get your head around: if you have 100 bucks today, and put them into some kind of saving account, you will receive interest, and after 1 year, in the future, you have i.e. 105 bucks, after 2 years 111, and so on, the future value. The rule is quite simple: the future value is higher then present value, and the higher the interest rate is you receive, the higher the future value will be.

Understood? Ok, now lets turn this around, as in our Harley-Davidson case study above, we know the future values, totalling the contractual $436 million (interest + nominal), but not their present value. But using what we just understood, the present value must be lower. The critical question is, by how much?

Well, Harley-Davidson is telling Davis that they think the contractual future cash flows they agreed to pay in the note is worth 381 million, and Davis agreed and sold the notes back to Harley at this price. But is this their real value, who made a good deal, Harley or Davis?

Note: I rounded the calculation at some places, this can result in a few  of millions left or right, but will not change the big picture.

Each future cash flow can be discounted to its present value, and – see what we learned above – the underlying interest rate is critically important. Now using in the calculations a internal interest rate of ~ 5.25%, well below the initial interest of 15%, the present value is suddenly identical with the amount Harley paid, $381 million!

So it looks like a really fair deal for Harley-Davidson and Davis, but is it? What motivated them to agree to such a deal?

None of them is a charity, and there is no free lunch in this business, and to understand one reason is to look at the underlying interest rate which makes this deal break even, the 5.25%. The point is on of outlook. Harley must think interest rates will go further down, and Davis must think they will go up. Because if rates go up, Davis will invest the received $381 million at a higher rate of 5.25%, and make a profit. And Harley must think they can get funding cheaper. Like with the asset backed securities they just launched? See my post on these here: “Harley-Davidson plans to sell $600 million of what?

Who is right only the future will show, meanwhile some clever banker organising these deals will make some nice fees…


One Response to “Harley-Davidson Buys Back Old Debt – is it a fair deal?”

  1. No wonder they charge around 13% interest to us, they pay 15% themselves …wow. Very glad I was able to pay my way out of financing after a year.

    Good looking out on the numbers, B – guess we’ll all be watching which way the rates go.

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