We recently took a bearish position on Harley-Davidson Inc (NYSE:HOG) prior to its earnings report on April 21. Like many firms, HOG stock is sensitive to a rising dollar, which was one of the primary catalysts for the trade-entry decision.
This isn’t necessarily a unique point of view, as other analysts and traders have soured a little on HOG stock since the dollar started its run last year. However, the bulls didn’t have an entirely unreasonably argument either.
Yes, the dollar should hurt exports, but falling energy prices could have boosted demand and offset those losses.
We have three problems with the bullish argument for HOG stock that help explain why it dropped nearly 10% following its report, and we believe the stock may continue to weaken over the coming months.
HOG Stock: Custom Motorcycle Sales Are Falling
You may remember the height of the custom motorcycle “boom” through cable-TV shows like OC Choppers and the like. HOG has been uniquely positioned to take advantage of the fad, but the higher profit margin on its own lines of custom bikes (and accessories) attracted competition.
For example, the Indian Motorcycles brand was resurrected by Polaris Industries (NYSE:PII) in 2012 to complement its current Victory bikes.
The pressure on HOG stock from competitors has been pushing down the average price per unit, which has hurt growth expectations. This is part of the normal business cycle, but the full effect often sneaks up on traders.
At this point, the custom segment has been cut from 44% of sales in 2006 to 29% of sales in this quarter’s report. Imagine what would happen if Ford Motor Company (NYSE:F) trucks and Mustangs were experiencing a similar draw down … oh, wait.
HOG Stock Buybacks
The quickest way to goose your stock price is to shrink the pie. If you buy back your own shares, the present value of future dividends and earnings will be greater because they are split across a smaller group of shareholders. This can be remarkably effective for a while, but there are problems with this strategy.
The most common problem is that a company will borrow to buy back their own stock. This may not be a bad idea, but it increases the company’s sensitivity to interest rate changes because leverage has been increased.
Fortunately, HOG hasn’t added debt in the same way other firms have. However, returning assets to shareholders faster than you are growing will still increase your debt-to-equity ratio and can make an impact on profitability for HOG stock when interest rates rise.
Harley-Davidson still been allocating capital to buybacks as the stock rallied, which sounds good, but it means the company has been buying at a premium as it pays higher and higher prices for shares with cash that can’t be plowed back into the company for research, development and marketing. On a cash-flow basis, HOG spent an amount equal to half of all non-COGS expenses on buybacks last year.
Whether shareholders like it or not, management teams tend to focus their time and energy on the greatest cash outflows and inflows. Buyback programs can become a distraction and can obscure other issues that may be affecting the stock. Many firms in this situation are exposed to the risk that moderate shifts in market fundamentals that can unbalance the company.
HOG Stock Hurt by the Rising Dollar
If the U.S. dollar rises too quickly, then exporters are hurt. Last quarter, Harley-Davidson reported an increase in international sales of 9.2%, which partially offset a decline of 1.6% domestically. However, investors can’t expect international sales to continue doing that in 2014 because foreign currencies now have much less purchasing power in dollar terms.
This increases the competitive pressure significantly and cuts international growth.
A rising dollar is a double whammy for Harley-Davidson stock. Not only does this increase the bikes’ costs in foreign currency terms, it also means that a stronger dollar has more purchasing power to buy Japanese and German bikes in yen and euro terms. This is great for Honda Motor Co Ltd (ADR) (NYSE:HMC) and BMW, but it is done at the expense of HOG’s market share, which has dropped 8% since this same time last year.
From a technical perspective, things aren’t much better. After failing to reach new highs last year, HOG stock has been in a downtrend through 2015. The breakout from a bear flag on April 21 sent the stock back towards its October lows, which could be broken in turn if market conditions worsen.
The Bottom Line
Support at $55 for HOG stock may be firm, but a break at that level is likely to push the stock down another 9% to $50 per share — near 2013’s lows. Higher energy prices, continued strength on the dollar or a general downturn in the market could all serve as catalysts for further decline.
Harley-Davidson management is taking measures to protect profits from further deterioration, but the outlook for 2015 and 2016 for HOG stock is still too aggressive in our opinion.
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