Harley-Davidson in the Mire and Likely to Stay There

Jul.22.09 | About: Harley-Davidson, Inc. (HOG)

Last week, Harley-Davidson (NYSE:HOG) reported earnings (see conference call transcript here). U.S. retail sales fell 35%. International sales fell just 18% as HOG was aggressively pursuing sales in Latin America, Europe, and China. This translated into a 91% decrease in profit year over year.

The major solace HOG can derive from these numbers is that overall motorcycle sales decreased 48% in the U.S. In other words, HOG picked up market share. HOG’s market share in Q2 2009 was 51.5%, an increase of 10.3% over last year’s Q2. The increased market share was really the only bright spot in HOG’s report.

HOG also mentioned some restructuring. This has a lost of associated costs. HOG is expecting to spend $160M to $190M on restructuring over the next two years. HOG is expecting to incur $130M to $150M of that this year.

Eventually HOG expects this to lead to cost savings of $140M to $150M per year. As part of this, HOG announced further layoffs of about 1000 employees (300 salaried and 700 hourly). These layoffs are on top of the 1400 to 1500 already announced. I’m sure these are all painful, necessary, and good management moves.

However, they likely do not tell the story of what will happen with HOG.

What is going on in HDFS may be more indicative. The delinquency rate increased from 4.65% in Q2 2008 to 4.97% in Q2 2009. The annualized credit losses for H1 2009 were 2.69% vs. 2.14% in 2008. There was higher frequency of loss and higher average loss (due to the decline in the value of repo’s). The increasing unemployment in 2H 2009 means that these losses will get worse.

Gross Margin was 33.5%, which was down from 35.7% in Q2 2008. Operating Margin was 14.5%, which was down from 20.1% in Q2 2008. HOG’s guidance is for FY Gross Margins to be 30.5% to 31.5% (or a median of 31%). By my math this means Gross Margins will be approximately 28.5% in 2H 2009.

HOG’s situation starts to look uglier when you consider this. It makes me think that HOG may very well lose money in 2H 2009 (based mostly on margins). HOG actually had an Operating Loss in Q2 of $37.1M vs. a profit of $62.1M a year ago. HOG losing money is even more likely, when you consider HOG cut its shipping guidance by 25% to 30% for FY2009 (from 2008 numbers).

The above is not the only way HOG may lose money though. HOG (HDFS) used to have its receivables listed as assets held for sale. It was not able to sell these in today’s tighter credit markets. It instead converted them for accounting purposes to assets held for investment.

This means that HOG will now be much more likely to incur losses on these now riskier debts. These total $5.12B, and they are growing. HOG will also now have to set aside reserves to cover the likely percentage of bad debts. It is no wonder that Fitch recently downgraded HOG’s debt from A- to BBB+.

On top of this HOG is having trouble getting the money to lend for these loans now. It has secured the approximately $1B it needs for the near term, but it is unclear what will happen by this time next year, when the unemployment rate is still high. Credit for HDFS may be still harder to get by that time.

Many people worried that HOG would not be able to manage to get the money it needed for this year. HOG stands a chance of literally going under. HOG is dependent on its credit arm to lend people the money to buy its product. There will be many fewer buyers without an effective HDFS.

People should not dismiss HOG’s troubles out of hand by saying the good times are coming back. They should not point at the increased market share with glee. This may be a very slow recovery. Companies in HOG’s situation may die very slow deaths.

If you want to be tortured along with HOG, buy the stock. Otherwise I would avoid it.

HOG is wallowing in slimy, slop. It cannot get its footing. Its retail arm is bleeding. Its credit arm may go under. It may be gaining market share, but it is doing it at the cost of the cache of its name and its actual margins. It is selling more of its cheaper, lower margin motorcycles. This migration of the product mix will be hard to undo. The bigger emphasis on the cheaper motorcycles will tend to destroy the very differences HOG has sought to emphasize in order to differentiate itself from its competition. It may gain market share short term, but the strategy is likely a loser longer term. People will see the lack of differentiation. They will begin to buy still cheaper competitor models in time.

Let’s take a quick look at the numbers. HOG only earned $.08/share in Q2. It is predicted to earn $.23 and -$.12 in the two subsequent quarters. HOG is predicted to earn $.68/share for FY 2009 and $1.31 for FY 2010 (this last is down from $1.74 just 3 months ago). These numbers translate into PE’s of $19.98/$.68 = 29.4 for FY 2009 and $19.98/$1.31 = 15.3 for FY 2010. In this market, HOG should not be trading at more than 15 times 2009 earnings.

The outlook is negative for sales, for margins, for credit, for earnings, and for employment. If the credit card issuers are supposed to do badly over the next two years, HDFS will do badly. If the auto credit companies are supposed to do badly over that time. HDFS will do badly. HOG is likely at least two years away from seeing much improvement.

Instead, virtually every earnings estimate revision for HOG lately has been negative. It is not beyond the realm of possibility that the currently predicted near term 30 PE for 2009 for HOG could turn into negative earnings. It is unclear at this time how high the predicted PE for 2010 will end up going in actuality.

However, it seems clear from the analyst revision trends that the 2010 PE will be much higher than predicted currently. Why would you want to buy this stock now? Wait until it actually starts to show some signs of turning around. Laying off people in a bad market may be a sign that management is taking the corrective action it should, but it is not a sign of a turnaround. HOGs are gas guzzlers. It could be that gas savings will be a new and powerful trend in two years. It could be that HOG will never fully come back from this downturn.

The unemployment rate is predicted to be above 10% through 2010. HOG, credit card issuers, auto finance units, and automakers will all continue to have problems under these conditions. You can’t see the light at the end of the tunnel for this stock yet. Wait until you do (if it ever comes). The short interest in this stock is already 18%. It is not a buy. With the Fitch downgrade, there should be minimal chance for a short squeeze. Wait on this stock, or short it.

Let’s take a quick look at the technical side of this stock. HOG appeared in Bespoke’s list of stocks that were farthest from their 50-day moving averages. This means that it is likely this stock is over bought. Many other technical indicators give this same indication. These include Bollinger Bands, Stochastics, Williams %R, and RSI.

The only contrary indicator that I looked at was the Money Flow Index. It still looks like money is flowing into the stock. You may wish to wait for a more definite downturn to pick your entry point for a short.

Disclosure: I have a small short position in HOG.