Harley-Davidson Gives Investors Ample Cause to Be Cautious

Harley-Davidson, Inc. (HOG) stock has been crushed over the last three months, losing more than 60% of its value. The iconic motorcycle company is dealing with a challenging economic environment and consumers who are less willing to make major expenditures, especially on nonessential purchases. When evaluating HOG, it is easy to see that the stock is at very depressed levels compared to its historical norms; however, it may be some time before Harley-Davidson’s underlying fundamentals levitate undervalued HOG shares.

First of all, we rate HOG Undervalued because its price has fallen very rapidly. Even though the company’s fundamentals, such as sales and earnings, are showing weakness, they have not deteriorated so much as to warrant this big of a price drop. When looking at the stock from a long-term perspective, in this case 10 years, HOG is selling well below historically normal valuation ranges. For example, over the last ten years the stock has normally traded in a price-to-sales range of 1.95x to 3.2x but, as of the most recent sales results, the stock is trading at just 0.7x. Furthermore, the company has normally traded in the price-to-cash flow range of 9.8x to 16.4x yet its current price-to-cash flow is only 3.9x. Rarely do we find these metrics at such depressed levels compared to historical precedents, even in this market!

Harley-Davidson pays a substantial dividend (eight percent plus yield) and that dividend appears safe for now. Also, Harley-Davidson has recently reaffirmed its earnings estimate for the full fiscal year to come in at just above $3.00 per share. So, the company is trading at a P/E of just over five. It is easy to see why the company is buying back stock, HOG is extremely cheap! However, it is always to important to resist looking at valuations in a vacuum. After a little bit of digging, we found sufficient reason to be cautious in recommending this stock.

In addition to a weak consumer discretionary spending environment, the company’s financial services branch has significant exposure to so-called “subprime loans”. An industry report states that as many as one third of loans outstanding from the Harley-Davidson financial services branch have gone to borrowers with suspect credit history. It seems that as the consumer spending environment started to slack, Harley-Davidson began offering loans with interest rates as low as 3% or sometimes without making the borrower put money down on purchases. These are not the sort of sales we were hoping to see factored into our ratings methodology. This sort of activity prompted Business Week to claim that Harley financial services operated, “in a pattern eerily similar to the housing bust.”

Now, we know that in the last quarter the company reported $6.3 million in write-downs for loan defaults. We do not want to overreact to a few million dollars in loan losses because, in the grand scheme of things, this is a relatively small amount. However, if there is anything that we have learned from the misery of the last year, it is that credit crises of this sort take time to fully unwind. There are far too many good companies with solid fundamentals that truly warrant our Undervalued rating and that do not have this potential liability for us to recommend HOG.

When you combine the potential credit issues confronting HOG and the fact that consumer spending is expected to be weak for at least the next two quarters, we do not recommend buying HOG shares right now. Although the valuation of HOG looks quite appealing based on what the market has traditionally paid for the shares, we think that there is ample reason to be cautious. You may be able to buy these shares even lower in the coming quarters.

Comments

[fatcat:]

HOG is dead...for the last 15yrs they depended on boomers to buy their over-priced toys.There is an abundance of these bikes on the secondary(used)market and like excess housing inventory,it will take awhile to work off.Harder times are ahead for this company,IMO...

2008 Dec 14 10:18 AM

[Motosceptical:]

This article highly underestimates the risk to Harley. The entire motorcycle industry has been dependent on easy credit for many years. Harley Davidson Financial Services is dependent on their ability to sell off the loans they originate in exactly the same way that subprime loans are sold off. HDFS is having trouble doing this. As per the 9/30/08 10-Q, they now have $2.2 billion in "Finance Receivables held for sale" vs $781 million as of 12/31/07 and $431 million in on 9/30/07. Harley has clearly been unable to offload their loans. And who would want them? Motorcycles are fundamentally a sub-prime industry. Financing will be cut way back both to dealers and customers. This will lead to lower sale. This is already being seen across the industry.

To offset this potential risk, HDFS put aside $8.0 million up from $2.0 MM in Provision for Credit Loss. $8 million in reserves to cover losses on $2.2 billion in Finance Receivables. That is well under 1%. HDFS is essentially asking us to believe that their underwriting is perfect. I can only compare that to the sign in the Harley dealership I saw yesterday that offered no money down and no interest for six months. I have trouble believing that is good lending.

Further, Harley was dependent on international growth to offset an 18% decline in shipments for the 9 months ended 9/30 compared to the previous period. With a strengthening dollar, why should we expect this to continue?

Lastly, as a motorcycle industry insider, I do not believe the Harley model is equipped to function during a long period of off sales. HD is a lifestyle brand that markets itself to 42 year old accountants who want to scare grandmas. They sell very expensive, very large motorcycles and expensive t-shirts to go along with them. The US motorcycle market has been in a persistent long term decline that the current economy has only accelerated. US consumers are going to be putting off all sorts of purchases and motorcycles are going to be one of the first to go, as they already have. If you own a harley you don't need a new one nor do you need to upgrade your current riding gear. If you don't own one the likelihood that you will buy one has declined.

The used market is flooded with bikes. In my local craigslist ads there are right now, as I write this, 136 HD motorcycles listed for more than $10,000 in the classifieds.

Harley is also one of few of what I term zombie-brands in motorcycles. Think Harley, Ducati, Vespa, Triumph, Indian, etc. These brands get bought up by wealthy enthusiasts when they are bankrupt or dead, money is pumped in, enthusiasts enthusiastically buy their product, they go public under the tutelage of Wall Street, then they eventually wither away to repeat the cycle. Harley is simply the most succesful of these at present. Harley is not, however as strong as Honda, Yamaha, and the other japanese firms. Do not be shocked if at least one of the brands mentioned goes bankrupt in the near future. It could be Harley as easily as any other.

2008 Dec 14 10:41 AM

[stocker:]

HOG burned 221 million in cash before taking cap ex into account. Cap ex was an additional 153 million. The primary asset of the company is 3.36 billion in finance receivables, which they have 36 million of bad debt allocated against in the first 9 months of the year. Bad debt on credit cards and homes are skyrocketing, but only 1% of motorcycle debt has gone bad? It seems impossible.

The correct price on HOG may be 0.

2008 Dec 14 12:40 PM

[stocker:]

HOG burned 221 million in cash before taking cap ex into account. Cap ex was an additional 153 million. The primary asset of the company is 3.36 billion in finance receivables, which they have 36 million of bad debt allocated against in the first 9 months of the year. Bad debt on credit cards and homes are skyrocketing, but only 1% of motorcycle debt has gone bad? It seems impossible.

The correct price on HOG may be 0.

2008 Dec 14 12:40 PM

[slideman:]

Maybe H-D should have stuck to it's 90's philosophy of more demand than supply, and requiring at least 10% for a down payment and a good credit standing when purchasing a hog. There were no rows-and-rows of unsold merchandise.

2008 Dec 14 04:56 PM

[Dexter:]

I agree with slideman. One big reason people were buying a Harley was because they usually would hold their value. When there was a waiting list for the new Harleys you could sell your used one for just about what you paid for it. Now they have flooded the market with their product and the used bikes are hard to sell.

2008 Dec 15 05:16 PM

[33Nick:]

The problem with HOG is the same that has brought Detroit in the current situation, reaching for low hanging fruits. HOG focuses too much on unnecessary after sales product and not enough on development of its technology. Though it seemed promising when they invited Porsche to work on one of the their old design.

2008 Dec 15 06:54 PM

[33Nick:]

The problem with HOG is the same that has brought Detroit in the current situation, reaching for low hanging fruits. HOG focuses too much on unnecessary after sales product and not enough on development of its technology. Though it seemed promising when they invited Porsche to work on one of the their old design.

2008 Dec 15 06:55 PM

[ozcutty2:]

Good post by motosceptical. Declining sales plus rising defaults are not a good combination.
At least other lenders, like Credit card co's are increasing sales and have fee income, Harley doesn't have anything to offset the losses and could well be brought down by this recession.
Only positive is cheaper raw materials.

2008 Dec 15 08:28 PM

[Hanoch:]

There is a lot of pessimism in these posts, undoubtedly some of which is warranted. I wonder, however, if the pessimism goes too far. At the end of the day for H-D, it is all about selling motorcycles. According to H-D's data, retail worldwide unit sales are only down about 10% in 3Q 2008 compared to 3Q 2007. Certainly not outstanding but, given the macro environment, it doesn't seem that the company is mortally wounded.

2008 Dec 16 12:29 AM