Sub-Prime Loan Nostalgia: Harley-Davidson Might Be A Sell

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

Summary

A brief look at the company’s historical operating performance might make one question the justification of the recent sell-off. The devil is in the detail, however.

Despite having a strong brand and solid margins, the company might have reached its peak potential for at least the next couple of years.

Even though the long-term revenue trend is still unclear, the recent performance might be a precursor to a significant pullback in sales. Harley-Davidson’s market share is weakening.

Finance receivables, 20% of which are sub-prime motorcycle loans, are a major red flag.

The recently-announced shift in the company’s marketing strategy is way too aggressive and might prove to be a drag on the company’s profits over the next couple of years.

Motorcycles and related products segment

Back in 2009-2010, Harley-Davidson (NYSE:HOG) suffered a significant decline in volume of motorcycles sold and has been in a recovery phase ever since. As the chart below demonstrates, the company's U.S. selling volume dynamics (stacked columns, r-axis) have been to a certain extent tracking the build-up in the number of U.S. heavyweight motorcycle registrations over the course of 2010-2015 (green line, l-axis). Meanwhile, Harley's European selling volumes (+2.7%) have been lagging behind the rapid increase in the region's heavyweight motorcycle registrations (+24.8%) in 2013-2015 (blue line, l-axis). In addition, the overall growth of new heavyweight motorcycle registrations in the two regions has been quite weak since the Great Recession.

Made by the author using the data from the company's website.

But what about the company's share in the new heavyweight motorcycle registrations? The data from the U.S. and Europe are not too encouraging.

Made by the author using the data from the company's 10-K's. Excludes data for Harley-Davidson Street 500® registrations.

Even though the decent margins continue to be one of the key Harley-Davidson's strengths, company's profitability topped in 2014.

Made by the author using the data from the company's 10-K's.

In 2015, company's margins experienced additional pressure from a change in the product mix, as sales of the touring motorcycle segment, which has been historically enjoying the highest margins, edged lower by 6.3 percent. The situation saw a major improvement during the first quarter of 2016, however. Whether the improvement will be short-lived or not remains to be seen. Meanwhile, additional margin pressure has been coming from the implementation of the ERP (enterprise resource planning) system at the manufacturing plant in Kansas City, which is expected to be completed by the end of Q3.

Made by the author using the data from the company's 10-K's.

Google Trends data support the product mix argument as the street segment is scoring quite well on search query basis. However, even though the searching data might seem quite bullish at first glance, sales data is still what matters the most.

Source: made by the author using the Google Trends data.

Financial services segment

From the company's latest 10-K: "HDFS provides retail financial services to customers of the Company's independent dealers in the U.S. and Canada. The origination of retail loans is a separate and distinct transaction between HDFS and the retail customer, unrelated to the Company's sale of product to its dealers. Retail finance receivables consist of secured promissory notes and secured installment contracts and are primarily related to sales of motorcycles to the dealers' customers. HDFS holds either titles or liens on titles to vehicles financed by promissory notes and installment sales contracts. As of December 31, 2015 and 2014, approximately 12% of gross outstanding finance receivables were originated in Texas; there were no other states that accounted for more than 10%."

Due to the oil price-related job cuts, Texas, in particular, might not be the best location for new loan origination. In fact, certain fund managers (such as Brad Lamensdorf of the AdvisorShares Ranger Equity Bear ETF (NYSEARCA:HDGE)) are shorting Harley exactly because of its exposure.

If only the company's revenues grew as rapidly as its finance receivables did. Oddly enough, the last time the company was only showing its charge-offs net of recoveries (and not as 2 separate figures) was when the things were pretty bad (suggesting lower-to-none recoveries?). Credit loss provisions, which have a direct impact on the company's profits, have been following a strong uptrend lately. A significant part of the company's receivables is sub-prime (with FICO scores below 640).

Made by the author using the data from the company's 10-K's.

A large part of the receivables is being transferred to SPE's (special purpose entities) for liquidity purposes.

Made by the author using the data from the company's 10-K's.

The Internet is full with motorcycle loan offerings for people of almost any income. Meanwhile, the presence of a car loan bubble and overall debt dynamics are not too encouraging. Even Jamie Dimon has recently expressed skepticism in the sustainability of the auto loan growth: "Auto is clearly a little stretched, in my opinion […] Someone is going to get hurt. [...] We don't do much of that." Given the company's exposure and high revenue sensitivity, Harley might be ill-prepared for any economic downturn.

Source: WolfStreet.com, Jesse Colombo (@TheBubbleBubble) and Andrew Teasdale, CFA ‏(@depthdynamics).

From the company's latest 10-K: "The Company expects operating income for the Financial Services segment to be down modestly in 2016 as compared to 2015 as a result of increased borrowing costs and unfavorable credit losses, partially offset by higher revenues."

Financial position

A gradual deterioration of the company's balance sheet is taking place.

Made by the author using the data from the company's 10-K's.

The company continues playing with debt and will most probably have to issue even more in order to cover the dividend and the principal payments for 2016.

Made by the author using the data from the company's 10-K's.

Total inventory has grown with a CAGR of 12.41% since 2010, fueling a 7.77% CAGR for Inventory-to-Sales ratio over the same period.

Made by the author using the data from the company's 10-K's.

A sudden shift in the Harley-Davidson's marketing strategy

It is hard to deny that the company is still doing great when it comes to brand strength. The common bearish argument that average Harley-Davidson buyers are getting older is (1) old and (2) incorrect. In fact, Harley holds a leading position in the following demographical segments (on-road motorcycle sales in the U.S.):

  • Young adults aged 18-34.
  • Women.
  • African Americans and Hispanics.
  • Caucasian men aged 35-plus.

Quite impressive, isn't it? The company understands the necessity of focusing its marketing efforts on the younger generations.

Source: company's website (2016).

However, it is probably the company's past success what makes it consider implementing questionable decisions. Even though the decline in sales should be put much emphasis on, the company is already engaged in numerous promotional activities that are quite successful.

A fact one certainly cannot deny is that the company's sales are subject to strong cyclicity and have a strong connection with business cycles. Lowering promotional spending at the point when sales are declining amid lower-cost competition from foreign producers would indeed bring disastrous consequences, but this is not what the company is planning to do.

On the contrary, the company plans to "significantly increase its spending to drive demand", which seems quite reasonable at this point. However, the company is acting rather aggressive: "In 2016, the Company expects to increase its spending on customer-facing marketing by approximately 65% from 2015 levels and it expects to increase its spending on new product development by approximately 35% from 2015 levels. This spending reallocation would represent an approximate $70 million increase in the Company's spending to drive demand compared to 2015." Moreover, the company plans to increase its present dealership count (1435) by 10%-14% by 2020.

Even though the company's decision might definitely be viewed as a logical response to weaker sales dynamics, it makes one question 2 things:

  • Timing of the decision, since both auto and motorcycle sales seem to have already peaked, while the pace of new loan issuance (which has been a major sales driver since the Great Recession) might be undermined by the upcoming rate hikes and rising delinquency rates.
  • Scale of the spending increase, since (1) no advertising can completely change the course of the sales dynamics if we have already reached the new peak and (2) promotional budgets might be spent less wise if the sales decrease has more financial, rather than preference-based roots (people do like Harley but might be just incapable of paying the price tag at the moment). If an economic downturn follows, it might easily undermine the company's efforts.

Finally, by no means does the marketing campaign challenge these 2 crucial issues:

  • The company faces intense design competition from the likes of Indian Motorcycle.
  • Even though the new model reviews are predominantly positive, the pricing is often questioned (and viewed as excessive) on the Internet.

On a side note, the increase in the first quarter's SG&A expenses was nearly twice lower the amount stated in the company's guidance. Should we expect an increase over the next quarters?

Made by the author using the company's website and the latest 10-K.

Stock's performance

The following charts demonstrate the stock's performance against the S&P 500 as represented by the SPDR S&P 500 ETF (NYSEARCA:SPY). The stock has been underperforming the index since the recent net profit high has been reached in 2014. At around 0.5, the stock's correlation with the index has been relatively weak over the last 30, 90, and 250 days.

2000 - Present:

Made by the author using the data from Yahoo Finance.

March 3, 2009 - Present:

Made by the author using the data from Yahoo Finance.

May 2, 2014 - Present:

Made by the author using the data from Yahoo Finance.

On the technical side, the recent rally looks somewhat weak and might be easily followed by a continued move lower.

Source: StockCharts.com

TRV coefficient analysis

For a detailed description of my coefficient, its formula and implications, please see here. It is a different way of assessing the return volatility by putting more emphasis on the outlier performance occasions and the volume impact, which I view as crucial determinants of the long-term riskiness of particular stocks.

The TRV coefficient analysis for Harley-Davidson was strongly impacted by the value of average price change over the period, which does not indicate the true character of HOG stock's returns. Over the last 250 trading days, the stock has been on average demonstrating a tendency to perform substantially worse during the down days, with volumes and absolute daily changes supporting this argument. To sum up, the stock cannot be viewed as a particularly safe investment and may experience substantial day-to-day price changes, primarily to the downside. The coefficient's value for HOG is nearly twice as large as the value for Coca-Cola (NYSE:KO) that was calculated in the introductory article for TRV.

Made by the author using the data from Yahoo Finance.

Valuation and sentiment

At the time being, the stock only has 1 "Sell" rating. With 13 "Hold" and 8 "Buy" ratings, there is a lot of room for downgrades should the stock continue to disappoint. The stock has been following a continued downtrend, which was to a certain extent fueled by numerous post-earnings price decreases.

Made by the author using the data from Yahoo Finance.

Institutional money has been leaving HOG of late. High ownership level might suggest additional pressure on the company's stock if the trend continues. Meanwhile, not a single share has been bought by the company's insiders over the last 12 months.

Source: Nasdaq Website.

Speaking of the stock's valuation, it is important to point out the low amount of intangibles on the company's balance sheet, which, given the company's brand strength, makes the use of book value-related valuation ratios less useful in Harley-Davidson's case.

At around 12, HOG's Price/Earnings (TTM) might seem quite attractive. However, before buying on weakness, one should take into account the following:

  • Declining profitability (the ratio's denominator).
  • History might indicate that the company's TTM P/E, after almost reaching the value of 3 in 2009, has all chances of falling even further.

Conclusion

It is difficult to come up with catalysts that might undermine the following negative factors:

  • Strong exposure to sub-prime loans.
  • Falling revenues and balance sheet deterioration.
  • Weakening market share and rising competitive threats.
  • Rising marketing costs and potential of further gross margin weakness due to the product mix changes.
  • Abysmal cash generation and rising debt levels.
  • The stock has had a reasonably low correlation with the markets of late, increasing the probability of HOG underperforming even if the stock market reaches new highs in the nearest future.

I assign HOG a Sell rating.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in HOG over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not an investment advice. I am not an investment advisor.

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