Harley-Davidson (HOG) reported earnings on January 23rd, and the numbers were worse than the headlines indicated. Much worse. The cash flow statement and the balance sheet show a very different picture of the company than the income statement. The core operating activities burned $684,649,000 of cash in 2008. Investing activities burned another $393,247,000, and the company only reduced capital expenditures 4.1% as the economy headed into the worst recession since the great depression. On top of this Harley bought back $250,400,000 worth of stock and paid out $302,000,000 in dividends. Total cash burned in 2008 was $1,630,296,000. The company had to finance this cash burn with borrowings.
Harley was able to increase sales and profits during the credit boom of the last decade by increasing the percentage of loans its financial services unit originated. Harley-Davidson Financial Services (HDFS) originated 22% of the loans for its bikes in 1999. HDFS originated 55% of all new Harley Davidson’s sold in the United States during 2007. During the securitization boom of the past decade Harley was able to sell the vast majority of the loans it originated for a profit. Now that the market for securitized loans has all but evaporated Harley is forced to hold all these loans on its books. Finance receivables increased $1,437,921,000 for the year end in December 2008, from $3,201,607,000 to $4,639,528,000. Finance receivables now account for 77.69% of 2008 revenue up from 52.11% of revenues in 2007. Total liabilities increased $2,432,000,000 in 2008. Current liabilities and borrowings increased $537 million in the fourth quarter alone. This occurred in a year where worldwide motorcycle sales declined 7.1%.
HDFS is financed by operating cash flow, asset-backed securitizations, the issuance of commercial paper, revolving credit facilities, medium-term notes, and the availability of advances and loans from the Company. In asset-backed securitizations, HDFS sells retail motorcycle loans and records a gain or loss on the sale of those loans. HDFS also retains an interest in the excess cash flows from the receivable and recognizes income on this retained interest. After the sale, HDFS performs billing, customer service and portfolio management services for these loans and receives a servicing fee for providing these services.
Harley-Davidson is now as much a lending institution as it is a manufacturing company. It is a financial in drag. This begs the questions, what is the company recording for its bad debts expense, and how much more can the company borrow to fund its motorcycle sales? Unfortunately for Harley’s shareholders the answer to both these questions is not much. HDFS uses discounted cash flow methodologies to estimate the fair value of finance receivables held for sale that incorporate appropriate assumptions for funding costs and credit enhancement, as well as estimates concerning credit losses and prepayments, that in management’s judgment, reflect assumptions marketplace participants would use. This means the company does not use mark to market accounting that financial institutions are forced to use. Harley only wrote down the value of its financial receivables 63.2 million dollars in the fourth quarter, 1.36%, as the world fell apart around them. ABS of all types sunk like a stone in the fourth quarter. One can extrapolate that the losses that Harley is realizing mean that cash flow those borrowers are at least 90 days or more past due. These losses will increase dramatically in the future. If Harley was forced to sell these loans at fair market prices due to a cash crunch, the company would have to record large losses.
In July 2008, the Company and HDFS entered into a $950.0 million 364-day facility and a $950.0 million three-year facility HDFS can issue unsecured commercial paper of up to $1.90 billion as of September 28, 2008. Maturities may range up to 365 days from the issuance date. Outstanding unsecured commercial paper may not exceed the unused portion of the Global Credit Facilities. Harley had $1,169,200,000 outstanding as of September 28th, 2008. Short term debt increased $599,667,000 in the fourth quarter. One can only assume that a substantial portion of this debt came from its commercial paper facility. This means that Harley only has a few hundred million dollars left of borrowing ability for its HDFS unit. The company also has $200,000,000 of debt coming due in 2010. There is a very real possibility that Harley will not be able to access the credit markets in 2009 to increase the lending capacity of HDFC. This puts over half the company’s revenues at risk. Credit is hard to come by so many potential buyers will have difficulty obtaining financing from other lenders. There is also the distinct possibility that the line of credit is pulled at year end. The dividend at Harley will have to be cut if it is not able to access credit or Harley will have to liquidate a portion of its loan portfolio at a large loss. The coming cash crisis at Harley Davidson makes it a legitimate contender to be the first major American vehicle manufacture to declare bankruptcy. This is a value trap that should be avoided or shorted.
Disclosure: Short HOG