Harley-Davidson stock could be headed for a serious wipeout

The bearish outlook reflects concerns that the economic fallout of Covid-19—the record unemployment and retail weakness—could create trouble for both the company’s sales and its financing for customers.

At a time when each day seems to bring news of more corporate layoffs and economic difficulties, buying an expensive motorcycle probably doesn’t rank high on most people’s immediate shopping lists. A Harley-Davidson 2020 CVO Street Glide, for example, costs $40,539.

In addition to an expected reduction in future demand, Harley may have trouble with some existing customers who bought and financed their purchase through the company, Shawn Quigg, a derivatives strategist at J.P. Morgan, told clients in a recent note. Harley-Davidson Financial Services, which allows consumers to apply for credit online, represents a big part of the company’s operating income.

Harley-Davidson didn’t respond to requests for comment. The Street expects the company to report earnings of 58 cents per share for the first quarter, compared with 98 cents for the year-ago quarter.

According to Quigg, the financial-services business represents about 48% of Harley’s operating income, even though it accounts for only 15% of total revenue. Of the total receivables, he wrote, about 18% have credit scores below 640, which is considered to be subprime.

Manufacturers are incentivized to sell to customers when economic trends are favorable and credit stresses are low, the strategist noted. “However, the immediate incentive to sell units may come at the expense of the longer-term risks, which can create a mismatch, increasing the probability of tail-events in times of heightened credit stress, such as that exhibited with COVID-19,” Quigg wrote.

The economic troubles created by the virus, and the significant contribution that financing makes to the company’s operating income, could drive investors to reconsider how shares are valued. Quigg argued that “significant operating risks…support a case for HOG to trade at or below its tangible book value per share ($11.34).”

To monetize his thesis, he suggested clients buy Harley-Davidson’s May $17 puts that cost $1.40 when the stock was at $18.28. Should the stock trade at its $11.34 tangible book value at expiration, the put is worth $5.66. The trade will fail if the stock is above the put strike price at expiration.

During the past 52 weeks, Harley’s stock has ranged from $14.31 to $40.89. Shares are down about 50% this year.

In addition to the earnings report, Harley implemented new accounting rules in January that require a front-load recognition on credit losses on loans and other financing assets. This could bring greater negative attention to the company’s financing operation, Quigg wrote.

Investors are likely aware that Ally Financial (ALLY), one of the nation’s largest prime auto lenders, reported that as of April 16, 25% of its auto-loan customers requested payment deferral—70% of whom have never been delinquent. “ALLY carries a higher FICO clientele than HOG,” Quigg noted.

The implied volatility of Harley’s options that expire in one month and are 5% below the stock’s price are not priced with a significant fear premium relative to the S&P 500 index—or those of General Motors (GM) and Ford Motor (F). Quigg wrote.

Harley-Davidson is priced in the options market as if the stock will move about 10%, up or down, in reaction to earnings, compared with an average move of 4.7%, up or down, over the past three years.