Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations

Harley-Davidson, Inc. is the parent company of the groups of companies doing business as Harley-Davidson Motor Company (HDMC) and Harley-Davidson Financial Services (HDFS). Unless the context otherwise requires, all references to the "Company" include Harley-Davidson, Inc. and all its subsidiaries. The Company operates in two reportable segments: Motorcycles & Related Products (Motorcycles) and Financial Services.

The “% Change” figures included in the “Results of Operations” section were calculated using unrounded dollar amounts and may differ from calculations using the rounded dollar amounts presented. 

(1) Note Regarding Forward-Looking Statements

The Company intends that certain matters discussed in this report are “forward-looking statements” intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can generally be identified as such by reference to this footnote or because the context of the statement will include words such as the Company “believes,” “anticipates,” “expects,” “plans,” or “estimates” or words of similar meaning. Similarly, statements that describe future plans, objectives, outlooks, targets, guidance or goals are also forward-looking statements. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially, unfavorably or favorably, from those anticipated as of the date of this report. Certain of such risks and uncertainties are described in close proximity to such statements or elsewhere in this report, including under the caption “Risk Factors” in Item 1A and under “Cautionary Statements” in Item 7 of this report. Shareholders, potential investors, and other readers are urged to consider these factors in evaluating the forward-looking statements and cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included in the Outlook section are only made as of January 30, 2018 and the remaining forward-looking statements in this report are only made as of the date of the filing of this report ( February 21, 2018 ), and the Company disclaims any obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

Overview ⁽¹⁾  

The Company’s net income for 2017 was $521.8 million , or $3.02 per diluted share, compared to $692.2 million , or $3.83 per diluted share, in 2016 . Operating income from the Motorcycles segment was down $157.4 million compared to 2016 primarily due to a 7.9% decrease in wholesale motorcycle shipments. Operating income from the Financial Services segment in 2017 was slightly lower than the prior year, decreasing $0.2 million , or 0.1% .

Worldwide independent dealer retail sales of new Harley-Davidson motorcycles decreased 6.7% in 2017 compared to the prior year. U.S. retail sales fell 8.5% and international retail sales decreased 3.9% compared to 2016. In the U.S., the 601+cc motorcycle industry continued to face significant challenges and international retail sales finished below the Company's expectations.

    

In 2017, the Company remained committed to a disciplined supply management approach focused on allowing U.S. dealers to achieve the right quantity and model-year mix of motorcycle inventory. The Company also focused on positioning its cost structure to better compete in the current environment. At the same time, the Company remained grounded in its long-term strategy and made good progress on its long-term objective to build riders globally. In 2017, the Company finished the year with a net increase of over 32,000 Harley-Davidson riders in the U.S. compared to the prior year. (Source: IHS Markit Motorcycles in Operation (MIO) data for On-Highway and Dual Purpose bikes in the U.S. as of January 1, 2018)

    

In 2018, the Company expects new Harley-Davidson motorcycle retail sales to grow internationally, but continues to expect challenges in the U.S. The Company's global retail expectations and disciplined supply strategy are reflected in its expectation for reduced wholesale shipments in 2018. In addition, to further improve its cost structure and maintain its world-class manufacturing operations, the Company is commencing a significant, multi-year manufacturing optimization plan anchored by the consolidation of its final assembly plant in Kansas City, Missouri into its plant in York, Pennsylvania. As the operations are consolidated, the Company expects approximately 800 jobs will be eliminated with the closure of Kansas City operations and approximately 450 jobs will be added in York by 2019. As part of this manufacturing optimization plan the Company will also close its wheel operations in Adelaide, Australia. Refer to the "Manufacturing Optimization Costs and Savings" below for further information.

As the Company looks forward, it will continue to focus on its long-term strategy of growing ridership in the U.S. and growing its reach and impact internationally, while growing market share and profitability globally. In 2018, the Company will continue to expand its independent dealer network outside the U.S. In addition, operations will begin at the Company's new facility in Thailand. This plant, like the Company's facility in Brazil, will support more competitive retail pricing in some of the

emerging markets that this plant will serve by reducing the tax and tariff burden that fully assembled imports carry in those markets.

In 2018, the Company will also continue to invest in new products. A portion of the benefit from the 2017 Tax Cuts and Jobs Act (2017 Tax Act) enacted in the U.S. in late 2017 will support the Company's objective to invest in high-impact product by redefining product in traditional spaces and expanding into new spaces such as the rapidly evolving electric vehicle landscape. The Company plans to bring Project Livewire, an electric Harley-Davidson motorcycle, to market within 18 months and will increase its investment in electric motorcycle technology, products and infrastructure in 2018 and beyond. The Company expects its increased commitment and investment will help accelerate the development of this market and assure its leadership in electric motorcycles.

Outlook ⁽¹⁾

On January 30, 2018 the Company announced the following expectations for 2018 .

The Company expects to ship between 231,000 and 236,000 motorcycles to dealers in 2018, which is down approximately 2% to 4% from 2017. The Company's shipment expectation assumes that U.S. dealer retail sales will be down, partially offset by growth in international retail sales. The Company expects 2018 year-end U.S. retail inventory to be flat to 2017 and flat to up in international markets as it continues to add new dealers.

During 2018, the Company expects retail sales to be positively impacted by:

However, these positive impacts are expected to be more than offset by strong headwinds including:

    

Operating income as a percent of revenue for the Motorcycles segment is expected to be approximately 9.5% to 10.5% for the full year 2018. This reduction of approximately 2 to 3 percentage points compared to 2017, is primarily due to expected manufacturing optimization plan costs of $120 to $140 million. Also, operating margin will be reduced by approximately 0.2 percentage points due to the adoption of an accounting standard update that will require the Company to present the non-service cost components of its pension and postretirement plan expense as non-operating income. The Company estimates this will result in approximately $10 million of non-operating income in 2018 that would have been included in operating income under existing accounting standards. The new presentation will be applied retrospectively to prior periods in the Company's results for 2018 and forward.

Gross margin as a percent of revenue in 2018 is expected to benefit from pricing on model-year 2018 and 2019 motorcycles, a more favorable foreign currency exchange environment than 2017 and positive mix. However, the Company expects these positive impacts to be more than offset by rising steel and aluminum costs and increased manufacturing expense.

Manufacturing expense is expected to be higher than in 2017, due in part to increased depreciation from recent capital investments related to the new model-year 2018 Softail motorcycles. However, the larger driver of increased manufacturing costs in 2018, as compared to 2017, will be higher costs of $20 to $25 million due to temporary inefficiencies related to the manufacturing optimization plan.

The Company expects selling, administrative and engineering expense to be higher in 2018 compared to 2017, but level with 2017 when expressed as a percent of revenue. The Company expects selling, administrative and engineering expense to be up behind increased investments in marketing and product development as the Company works to grow ridership globally.

    

In the first quarter of 2018, the Company expects to ship 60,000 to 65,000 motorcycles to dealers, which is down approximately 8% to 15% percent from 2017. While the Company expects U.S. retail inventory will be tighter than in the first quarter of 2017, it believes the composition of previous and current model-year motorcycles will be considerably improved from last year. The Company expects Motorcycles segment operating income as a percent of revenue in the first quarter of

2018 to be down approximately 5 percentage points due to approximately $57 million of restructuring expense related to the manufacturing optimization plan, lost absorption from lower production and higher selling, administrative and engineering expense as marketing and product development expenses increase.

Additionally, as the Company increases its investment in electric motorcycle technology, products and infrastructure it expects to spend an incremental $25 to $50 million per year over the next several years.

The Company expects operating income from Financial Services to be down in 2018 compared to 2017 due to lower net interest income, partially offset by a lower provision for credit losses.

Capital expenditures in 2018 are expected to be $250 to $270 million, which includes approximately $50 million to support the manufacturing optimization plan. The Company anticipates it will have the ability to fund all capital expenditures in 2018 with cash flows generated by operations.

Finally, the Company expects its full year effective tax rate will be approximately 23.5% to 25%, down approximately 10 percentage points from the rate that would have been expected excluding the impact of the 2017 Tax Act. This guidance excludes the effect of potential future adjustments associated with revisions to the $53.1 million tax expense recorded in the fourth quarter of 2017 related to the 2017 Tax Act, other new tax legislation or audit settlements. Given the complexity and timing of the 2017 Tax Act, the Company has recorded the impact of the 2017 Tax Act in the fourth quarter of 2017 based on reasonable estimates and considers these estimates to be provisional under SEC Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (SAB 118). Future guidance, interpretations and pronouncements may add clarity to the numerous aspects of the 2017 Tax Act. This future clarification may give rise to additional unanticipated considerations and revisions to the Company’s provisional estimates related to the 2017 Tax Act included in the Company’s 2017 income tax provision. Any such adjustments will be recorded as discrete income tax expenses or benefits in future periods.

The Company expects total capital expenditures of $75 million associated with the manufacturing optimization plan through 2019.

Results of Operations 2017 Compared to 2016

Consolidated operating income was down 15.0% in 2017 driven by a decrease in operating income from the Motorcycles segment which was down $157.4 million compared to 2016 . Operating income for the Financial Services segment decreased by $0.2 million during 2017 as compared to 2016 . Please refer to the “Motorcycles and Related Products Segment” and “Financial Services Segment” discussions following for a more detailed discussion of the factors affecting operating income.

The effective income tax rate for 2017 was 39.6% compared to 32.4% for 2016 . The higher effective income tax rate was primarily due to the impact of the 2017 Tax Act enacted in December 2017. The 2017 Tax Act reduces the federal corporate income tax rate beginning in 2018 from 35% to 21%; however, because the 2017 Tax Act was enacted in 2017, the Company was required to remeasure its net deferred tax assets in the fourth quarter. The impact of remeasuring the deferred tax asset balances combined with other adjustments related to the 2017 Tax Act resulted in a non-cash income tax charge of $53.1 million in the fourth quarter of 2017.

Diluted earnings per share were $3.02 in 2017 , down 21.1% compared to 2016 . Diluted earnings per share were adversely impacted by the 24.6% decrease in net income, but benefited from lower diluted weighted average shares outstanding. Diluted weighted average shares outstanding decreased from 180.5 million in 2016 to 172.9 million in 2017 driven by the Company's repurchases of common stock. Please refer to "Liquidity and Capital Resources" for additional information concerning the Company's share repurchase activity.

 

In the U.S., retail sales of new Harley-Davidson motorcycles were lower than in 2016 driven by ongoing industry weakness and limited availability of model-year 2018 product. The Company believes the industry for new motorcycles continued to be adversely impacted by soft used motorcycle prices, although prices did improve in the fourth quarter of 2017 on a year-over-year basis. In addition, retail sales of used Harley-Davidson motorcycles in the U.S., which the Company believes is an important indicator of overall demand for the Company's motorcycles, were up through November 2017 year-to-date. Combined retail sales of new and used Harley-Davidson motorcycles in the U.S. were down slightly on a year-to-date basis through November 2017, as compared to the same period in 2016. However, the Company's 2017 November year-to-date share of combined new and used motorcycles registered increased for the ninth consecutive year. (Source for used data: IHS Markit Used Registrations for On-Highway and Dual Purpose motorcycles with engines 601 and greater in the U.S. from 2008 through November 2017).

Strong prices for used Harley-Davidson motorcycles in the U.S. are key to the Company's focus on driving value for its riders, dealers and the brand. In the fourth quarter of 2017, positive momentum in used motorcycle pricing continued from the third quarter. Used Harley-Davidson motorcycle wholesale prices at auction remained above year-ago levels, and third-party pricing services continued to publish higher retail values year-over-year for used Harley-Davidson motorcycles. Finally, for the second consecutive quarter, dealership data in the fourth quarter indicated that prices for used Harley-Davidson motorcycles in the broader used motorcycle market were up in aggregate, particularly in the Harley-Davidson dealer network.

The Company's U.S. market share of 601+cc motorcycles for 2017 was 50.7%, down 0.5 percentage points compared to 2016 (Source: Motorcycle Industry Council). 

International retail sales in 2017 were below expectations; however, the Company continues to believe that its strong brand, products and expanded distribution will drive growth in international markets over time. In EMEA, retail sales in Europe were down slightly from 2016 while other EMEA markets decreased 12.4% behind softness in emerging markets including Russia, Middle East and South Africa. In Asia Pacific, retail sales were down compared to 2016 on softness in Japan and Australia and lower retail sales in emerging markets compared to 2016. Retail sales in Latin America during 2017 were down on softness in Mexico partially offset by an increase in Brazil. Canada retail sales were down slightly from the prior year.

Despite the difficult year in international markets, there were positive developments. The Company believes its new model-year 2018 Softail motorcycles are being very well received by customers internationally. In the fourth quarter of 2017, the Company experienced strong sell-through rates with limited availability throughout the quarter. The Company believes the strong customer response to the new Softail models, coupled with the fact that international retail sales generally include a greater mix of Softail models than in the U.S., is a good early indicator of the potential impact of these new models. ⁽¹⁾ Additionally, in line with the Company's strategy to increase brand access internationally, it continued to expand the international dealer network. The Company added 57 and 40 new international dealers during 2017 and 2016, respectively. The Company plans to add a total of 150 to 200 new international dealerships from 2016 through 2020. ⁽¹⁾ The Company remains committed to its long-term international growth strategy and expects to return to international retail sales growth in 2018. ⁽¹⁾  

Motorcycle Registration Data - 601+cc ^(a)  

The following table includes industry retail motorcycle registration data:  

During 2017 , wholesale shipments of Harley-Davidson motorcycles were down 7.9% compared to the prior year, slightly more than the 6.7% decrease in dealer retail sales of new Harley-Davidson motorcycles. International shipments as a percentage of the total were up slightly in 2017 as compared to 2016. Shipments of Cruiser motorcycles increased as a percentage of total shipments in 2017 behind the launch of the new model-year 2018 Softail motorcycles. The Softail motorcycle platform was completely redesigned for model-year 2018 and merged the former Softail and Dyna platforms.

Dealer inventory of new Harley-Davidson motorcycles in the U.S. at the end of 2017 was down approximately 3,000 motorcycles compared to the end of 2016. The Company believes its supply management discipline delivered the intended results and the dealer network is well-positioned for 2018. ⁽¹⁾