Description

I believe HOG is a short due to its long-term secular issues, emerging competition, elevated dealer inventories, and issues in their financing segment. I believe sell-side numbers for 2017 have to come down significantly and that this will play out over the next 3-6 months. My fair value estimate of $35-45/sh represents 14-33% downside but I believe the stock price could overshoot this to the downside on poor 2017 guidance.

Here are the key thesis points:

1. HOG has long-term secular issues that won’t go away (bad demographics, weakening brand value)

2. HOG is facing emerging competition

3. Issues appear to be emerging in the financing segment which generates ~25% of profits and drives significant sales volumes

4. Retail unit sales are weakening despite unprecedented “pushing” by HOG

5. Dealer inventories are extremely elevated which will result in a destocking cycle

6. Q2 “meet” was driven entirely by one-time items

7. Sell-side numbers for 2017 have to come down significantly

1. HOG has long-term secular issues that won’t go away (bad demographics, weakening brand value)

• Broader trends for motorcycle ridership have never been worse from a demographics perspective

• Motorcycle ridership is concentrated in the 45-64 year old age cohort (primarily white males)

  • 55%/60% share amongst 35+ white male/female riders

  • 42% share amongst younger adults

  • 52% share amongst African Americans

  • 54% share amongst Hispanics

• HOG skews even further toward the slower growth “middle-aged white people” demographic than competitors:

• The midpoint of the baby-boomer generation was born in 1955 – these members were in HOG’s core demographic from 2000 to 2019 driving sales gains in the early part of the century that are now tailing off

• 2003-14: +1.9% annualized population growth in core demographic vs. 1.0% for the U.S. as a whole

• 2014-20E: +0.1% annualized population growth in core demographic vs. 0.8% for the U.S. as a whole

• 2020-30E: (0.2%) annualized population decline in core demographic vs. 0.7% for the U.S. as a whole

• Combined with poor demographic trends, HOG’s brand value appears to be weakening - Tenet Partners measures the top 100 brands by awareness and positive perceptions – HOG has been falling:

• 2007: #4

• 2008: #3

• 2009: #6

• 2010: #5

• 2011: #3

• 2012: #3

• 2014: #5

• 2015: #10

• 2016: #11

2. HOG is facing emerging competition

• HOG is facing more aggressive competition from two sources, Indian-brand motorcycles and traditional Japanese competitors

• Indian-brand motorcycles (re-launched by PII in 2013) have made a resurgence

• They are very comparable bikes to HOG and are probably the only brand that a loyal HOG owner would consider riding instead of HOG

• Sales have been growing dramatically since the re-launch in 2013 – they now make up ~4% of total U.S. heavyweight bike sales (vs. ~51% for HOG) and grew retail sales by 80% in 2015

• Interest in the brand has showed no signs of slowing, with Indian continuing to gain ground on HOG (evidenced by relative google searches for the brand):
  
  
  

• In addition to Indian, HOG has faced more aggressive competition from the traditional Japanese players (Honda, Suzuki, Kawasaki, etc.)

• Part of this is FX-driven – the Japanese competitors had to drastically retrench post-2008 as the Yen strengthened significantly – HOG gained tons of share in this period both due to this as well as due to having an internal financing arm that could drive sales (when third party lending dried up)

• Weakening of JPY in 2013 and late 2014 caused aggressive pricing from these manufacturers which is continuing today

• Recent JPY strengthening in 2016 could be a risk, though mgmt says they have seen no respite at all in terms of promotional and aggressive behavior
  

3. Issues appear to be emerging in the financing segment which generates ~25% of profits and drives significant sales volumes

• HOG has an internal financing arm which generates 25% of total profits

• HOG finances both wholesale (floor inventory) as well as retail

• Almost 100% of dealers utilize HOG financing for floor inventory at some point in the year, but this is relatively low-risk lending against brand new bikes

• Bigger risk is on the retail side – ~60-65% of U.S. retail sales are financed, and HOG will finance the purchase of used HOGs as well

• 20% of originations are subprime (FICO below 640)

• Typical loan is for 5-6 years and are made at ~100% LTV (often higher because parts & accessories can be financed as well)

• Average interest rate is ~9-10% which HOG borrows at ~2.7% to finance

• Annual loss experience was 1.4% in 2015, peak loss experience in 2009 was 2.9%

• In the last couple of quarters, there have been some troubling trends in delinquencies and loss experience which management is attributing to oil-dependent markets, “normalizing” subprime performance, and lower bike values at auction

• 30+ day delinquencies up to post-2008 record levels on a seasonally-adjusted basis

• Annualized loss experience up 42bps y/y in 1H 2016

• I believe this credit normalization will continue and that provisions will need to be taken up

• Currently 2.54% of receivables are provisioned; off the lows of ~2% but below the 3.2% in FY2009

4. Retail unit sales are weakening despite unprecedented “pushing” by HOG

• Retail sales (distinct from shipments to dealers which is how HOG recognizes revenue) have continued to be weak

• I estimate Q2 hit a ~3 year low on a seasonally-adjusted basis
  

• Recent checks suggest that Q3 is not going any better

  • “Financing promotions ceased in mid-August, leaving dealers with no promotions to clear inventory before Model Year ’17 shipments”

  • “Continued weakness across all categories for HOG raises possibility that Polaris’s Indian brand was successful in taking market share during July, August”

• Longbow cut HOG to sell last week on bad dealer checks

• HOG announced a cut of 200 jobs (3.2% of workforce) last week, due to lower volumes

• Notably, this unit weakness is happening in the middle of absolutely unprecedented “pushing” of volumes from HOG from expanded financing and dramatically increased marketing spend

  • This has the effect of generating sales from those who otherwise would not be able to afford them - not a sustainable source of sales
    

  • However, this number has climbed dramatically and I estimate that advertising will represent 2.2-2.9% of sales in 2016 – weakness while being this aggressive on advertising suggests deep underlying issues

  • This number also doesn’t include non-advertising promotional spend – in 2016 it was announced that there would be an incremental +65% spent on customer-facing marketing, part of an incremental $70M in spend designed to drive sales, most of which was spent in 1H already
    

• Internal financing of U.S. new bike purchases continues to climb to record levels; I estimate almost 65% of sales will be financed by HOG in 2016, up from the 2007 peak of 55% and the average of 50% from 2004-14

• HOG typically has relied primarily on word-of-mouth and targeted promotions to drive sales – from 2004 to 2014, they only spent an average of 1.55% of sales on advertising

5. Dealer inventories are extremely elevated which will result in a destocking cycle

• While retail sales have been very weak in 1H 16, to-date HOG has been able to report sales that are up 3% YTD due to massive over-shipping into the U.S. dealer channel
  

• Part of this is planned – one of their manufacturing facilities has an ERP implementation planned for Q3, so HOG decided to ship extra units to dealers in Q2 to avoid supply disruptions in Q3

• However, a combination of higher than expected shipments and lower than expected sell-through in Q2 is creating near-record inventories

• Given current retail trends, management’s outlook for 2H shipments will barely put a dent in this number – inventory will have to continue to be destocked in 2017 back to a normal level of ~3 months
  

6. Q2 “meet” was driven entirely by one-time items

• HOG was able to report an in-line Q2 at the end of July, however this was largely driven by three sources of one-time gains, the absence of which would have created a significant miss
• I estimate without the three items, HOG would have reported a miss of 13.5% vs. consensus in their most important quarter (would have been largest miss since Q4 2009) and I expect the stock could have been down ~10% vs. flat

1. “Extra” shipping into dealers ($0.09/sh)

1. Mgmt had guided to shipments of 82,500 – 87,500, elevated because of the ERP ship-in

2. Despite weaker than expected retail sales, shipments were even higher than expected @ 88,160

3. I estimate the incremental 3k units drove EPS by ~$0.09/sh

2. Abnormally low tax rate ($0.09/sh)

1. Mgmt released a tax provision against a prior year

2. A more normal tax rate would have reduced EPS by $0.09/sh

3. Securitization gain ($0.03/sh)

1. For the first time since pre-financial crisis, HOG securitized a portion of their finance portfolio for a one-time gain (essentially a pull-forward of future earning) of $0.03/sh

7. Sell-side numbers for 2017 have to come down significantly

• Despite the weak retail environment, the required dealer inventory destocking and increased provisioning environment, somewhat inexplicably sell-side has 2017 EPS growing 8% to $4.17 next year

• The estimated growth from 2016E to 2017E EPS has not changed materially during the year despite the worsening trajectory of the business – this suggests to me that 2017 is being lazily modeled as “2016 plus” by the street:
  

• In reality, due to the inventory destocking and worsening credit trends, 2017 will probably be a “catch-up” year where results will be even worse than would otherwise be expected for the given retail environment

• I have 2017 EPS at $3.29, 21% lower than consensus at $4.17

I think 20%+ downside is reasonable here given where my 2017 numbers are coming in versus the street. This also aligns with what I believe “fair value” is, which I determine by looking at HOG on an estimated mid-cycle basis.

I believe mid-cycle unit sales are down 7.5% to 12.5% from 2015 levels. The lower end of that range would reflect an average of peak sales in 2014 and trough sales in 2010 while the higher end of that range reflects a lower trough than 2010 – note that in the 2006 to 2010 period, sales were down 35% (and this is with HOG gaining significant share), so I don't think this estimate of mid-cycle is too punitive. I then apply appropriate decremental margins which gets me to an estimated mid-cycle operating margin of 16.4 – 18.1% and mid-cycle EPS of $2.71 – 3.13/sh.

HOG will still be facing demographic and competitive headwinds and this is a cyclical business, so a discount to the market multiple is warranted – at a 13.0 – 14.5x target multiple (vs. 14.5x 10-year average), our mid-cycle “fair value” is $35-45/sh or down 14-33%, in-line with our target downside based on the 2017 EPS revisions.

Risks:

• Continued JPY reversal impairs ability of Japanese competitors to compete effectively

• We may be seeing a bit of this already – HOG gained 2 points of U.S. market share growth in Q2 2016 although that only partially offset an incredibly weak broader market (industry units were down 5.2% y/y)

• However, European competitors are still competing with an advantaged currency and we are not yet seeing any respite in the promotional environment

• Lot of negative sentiment around the name already – this is not a contrarian call:

• High-ish short interest @ 15% (although more or less stable)

• Sell-side already hates this, average rating is a “hold” and is more negative than at any time since early 2009

• Low headline multiple @ 13x

• If I’m wrong about 2017 EPS, this has room to re-rate upwards – traded in the 14-18x range in 2010-2014 but those were in better times

• M&A risk

  • July 2016 – stock up ~20% on rumors that KKR was going to buy them out; subsequently gave up most of the gains as it was uncorroborated and multiple analysts downgraded it

• Always a risk, but moreso for HOG given it was the focus of recent M&A rumors

• FWIW, IR seemed to laugh off the constant M&A rumors as a distraction more than anything

Catalyst

• Miss/guide down in Q3
• Initial guidance on shipment levels for 2017 (should happen in Q3 commentary) - if destocking is seen as necessary and/or if the retail environment is weak, it should show up here
• More detailed 2017 guidance given in Q4 (revised shipments, margins, tax rate, etc.)