#sharebuybacks

Harley’s horrible huffing contains plenty of puffing

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When companies won’t give guidance, we must find ways to see where we were relative to history to get a picture of the future. Harley-Davidson (HOG) makes a good case study. Coronavirus may be one factor but the company has already produced results that have undercut the worst levels experienced during the GFC. We have long criticised HOG for fuzzy maths under the disastrous leadership of the recently ousted CEO Matt Levatich.

While there are strictly no direct apples for apples comparisons on the timing of coronavirus and the GFC (the latter requiring no lockdown), we note the weakness in Q1 2020 unit sales in the chart above.

This is what the trend of Q2 looks like.

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If we assumed a similar slowdown for April and May then theoretically the company would comfortably breach the Q2 2009 unit sales level of 58,179 which is only 18.6% below the Q2 2019 level. Q1 2020 global sales fell by 17.7%, even though the company made a very misleading statement which we’ll get to in a moment.

One thing that struck us was the steadily rising value of quarterly inventory as a percentage of quarterly non-finance revenues since Q1 2014. While the former value is a balance sheet item and the latter P&L, Q1 is generally a period where new models are rolled out ahead of the busiest Q2 & Q3 seasons to ensure the distribution network can move metal.

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Shipments reflect this. The inventory metric drops off into Q2 although exhibits a similar type of trend to Q1. Given Q2 2009 was the beginning of the tough times post-GFC, will we see the high watermark breached or will the slowdown in production offset it? How badly are revenues affected such even flat inventories lead to a deterioration of this measure?

In Q4 2019, inventories to motorcycle revenues surged to 69.1%.

We note that Q1 2020 shipments equated to an inventory of 12,534 units (+29.0%YoY).

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Here is where it gets interesting. By HOG’s own admission in the quarterly investor presentation pack (p.7), it noted that Q1 2020 US retail sales were on target to be one of ‘the strongest quarters in the last 6 years through to mid-March‘, until COVID. 6 years ago US Q1 unit sales hit 35,730 units. US sales in Q1 2020 ended up at 23,732.

By deduction,

In Q1 2014, over 90 days HOG shifted on average 397 bikes per day. (35,730/90 = 397)

In Q1 2020, over the 74 days to mid-March, HOG was moving on average 321 bikes per day. (23,732/74 = 320.7027).

If we assumed that HOG was to hit that magic target over the 16 days stolen by COVID19, it would have had to punch out 750 bikes a day. (11,998/16 = 749.875).

We would love to see the order book for these magical beasts that were waiting for a home…it would seem the sales and marketing department cherry-picked one strong day and multiplied it over the quarter to create such a questionable statement.

Here is a chart of motorcycle related revenue for Q1 since 2008. No wonder the shares have underperformed since 2014, even with a small fortune squandered on share buybacks.

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The Q2 revenue book doesn’t look too flash either if April is wiped out. At present 50% of dealers are shut since late March. Is the market prepared for a sub Q2 2009 print? The share price has rebounded strongly after the Q1 results even though there is no guidance to speak of.

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But it gets worse. So poor has the Q3 season become for HOG that its unit sales have missed the Q3 2009 post-GFC low for seven out of the last 10 years. Are we to believe if the world is out of lockdown by Q3 that there will be a miraculous surge in new bike sales when unemployment is likely to remain at troubling levels potentially above that of GFC?

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HOG is a great example of a divine franchise. It wasted far too much money on share buybacks (now suspended) and sits with a credit rating just two notches above junk.

The annualised Q1 2020 loss experience for the finance business sit at 10-year highs even before it has been thumped by the coming turndown. People buy HOGs as a hobby, not transport. A purely discretionary purchase. We imagine that restoring household balance sheets will take precedence to stumping up serious coin for a Harley cruiser.

Sadly Levatich and his 2027 vision have not been consigned to the dustbin of history which is the only logical filing cabinet for it. Completely unrealistic, devoid of reality and totally in denial of the shifting sands in the global motorbike market.

The new “Rewire Plan” (p.5) while sketchy on detail (as it would with an interim CEO) is a reheat of Levatich’s plan. Sad.

In our view, the entire motorcycle industry needs a strong HOG. New management is a good start but it won’t help if they intend to convince investors that they were on course to shoot Q1 to its best level in 6 years with questionable math. How quickly can inventory be pared? What models will revive its fortunes?

HOG needs to get in touch with its core customer base the way Willie Davidson did after the dark days of AMF ownership. It needs to build products which hark back to its former glory rather answer questions in segments that no one is asking it to fill.

Indian, its rival of 100 years ago is killing it with the FTR1200. Indian’s parent company, Polaris Industries, posted a small single-digit increase for motorcycles in Q1 2020. Enough excuses HOG. You are running out of time and your retained earnings are 1/5th what they were 5 years ago!

Why is the market giving it the benefit of the doubt when the worst is still ahead?

HOG

Harley needs a crisis manager. Will the incoming CEO possess those skills?

The Fed firemen are also the arsonists

Jim Grant of Grant’s Interest Rate Observer has a great article pointing out the irresponsibility of the US Fed. It criticises the very conditions that made the outcomes of coronavirus way worse than had they administered sensible monetary policies decades ago. FNF Media has been saying this for years. Now we are facing long overdue nemesis. It is true of the overwhelming majority of unimaginative MMT ‘me too’ central banks.

Grant wrote,

It took a viral invasion to unmask the weakness of American finance. Distortion in the cost of credit is the not-so-remote cause of the raging fires at which the Federal Reserve continues to train its gushing liquidity hoses…But the firemen are also the arsonists. It was the Fed’s suppression of borrowing costs, and its predictable willingness to cut short Wall Street’s occasional selling squalls, that compromised the U.S. economy’s financial integrity.

FNF Media keeps on hearing tales about the failure of evil capitalism. When the actions of central banks stifle the free market from achieving price discovery, distorted capitalism will inevitably backfire.

From hereon, sharp pain will be the only effective – and quickest – way to resolve this mess. Governments need to ensure bad companies go bankrupt by rejecting bailout money to zombie companies that will just be a drag on the economy.

Instead of doling out tax dollars, the government should take equity in any business that receives money. Taxpayers deserve a return and by this methodology, it will enforce a mindset that always rejects propping up companies with failed business models. Instead of the government calling the shots, the expertise of commercial lenders should be tapped, a valid point made by Jonathan Rochford.

Unfortunately, this will cause huge short-term disruption and impact large swathes of the community but it will allow markets to clear and provide a platform for risk to be priced appropriately. It is like yanking off a Band-Aid. It stings at first but the recovery becomes far more sound, based on rational economics. Failure to do so will just lead to a protracted Frankenstein economy which will frustrate the majority.

The sad reality will be that Western governments will try to emulate Japan’s lost two decades by crawling on our belly making marginal inches forward. This is somehow seen as superior to hitting the giant “reset” button.

The only major difference being that the Japanese monoculture is experienced and better suited than any other nation to share grief. Western cultures are not remotely close to being able to tolerate such conformity. Japan is not capitalism with warts. It is socialism with beauty spots. It will pay to remember this. In the West, we will demand that others atone for our mistakes. Moral hazard will be the order of the day. This mentality must be stopped dead in its tracks.

Grant reinforced our long-held view on distorting capital markets with this,

The Fed commandeered investment values into the government’s service. It seeded bull markets in the public interest…But investment valuations don’t exist to serve a public-policy agenda. Their purpose is to allocate capital. Distort those values and you waste not only money but also timeLike a shark, credit must keep moving. Loans fall due and must be repaid or rolled over (or, in extremis, defaulted on). When the economy stops, as the world has effectively done, lenders are likely to demand the cash that not every borrower can produce.

We must not forget that post-GFC authorities have been asleep at the wheel even after the introduction of poorly thought out red tape designed to protect us.

Right before the regulators’ eyes, so many blue-chip corporations (e.g. Boeing, GE) binged on ultra-cheap debt to buy back their own shares just to chase short term performance incentives. In recent years, companies like Boeing and GE spent around $45 billion each aggressively buying back their own stock despite being in the midst of severe balance sheet deterioration. Both are trading in a state of negative equity today.

Ford Motor has a junk credit rating. GE & Boeing won’t be far behind them. Over 50% of US corporates are trading one-two notches above junk.

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The financial community has merely taken advantage of all of this short-termism. Where were the financial analysts doing forensic work on companies? All of this balance sheet deterioration was plain to see.  Why couldn’t they see the obvious long term deterioration in cash conversion cycles? How could they miss that aggregate corporate after-tax profitability has been trending sideways since 2012? Where were the biopsies? We will be witness to plenty of autopsies that were preventable.

Corp Profits After Tax

For Australia’s part, 28 years of unfettered economic growth has bred untold complacency. Only now will we realise the conceited arrogance of government and industry alike. One day we will realise that all of the onerous regulations dripping in ideology (e.g. climate/environment) to confound foreign investment will blow up in our faces. They will not have forgotten that Australia is an unfriendly place to conduct business.

Australia has behaved like a bloated drunk bishop looking down upon his destitute disciples climbing the stairs on hands and knees putting what is left of their pitiful savings into the collection tin. From now, the roles will be reversed at prices that will be highly unfavourable such will be our desperation. Not to mention our currency could well depreciate to a degree which makes us even more vulnerable to foreign predators. Setting our FIRB at $0 will be irrelevant if we fold to the whims of the first suitor that shows interest. The show will be on the other foot.

In press conference after press conference, we continue to be told that hibernating companies will spring back to life and it will all be a case of ‘keep calm and carry on!’We hate to sound negative here.

However, we believe that we are merely being realistic about what is to unfold. The coming depression will force us to become truly appreciative about just how well we have had it while governments have distorted our markets. Had we truly reflected on decades of prosperity instead of wailing about how life has never been worse, things might have turned out differently. We are about to get a true taste of the latter.

On reflection, some positives will come out of this tragedy because we will focus on things that matter rather than getting enmeshed in the theatre of the absurd – identity politics and the cancel culture.

Coronavirus might be a black swan event to the global economy but we have been complicit by allowing our lawmakers and regulators to play slalom with the icebergs. We all knew our overloaded ship was in danger of listing before we left the safe harbour but it was simpler to be suckered into the weather forecasts that predicted endless sunshine and eternal millponds. The engines have now stalled because the tanks are empty. We find ourselves in the middle of a pitch-black, stormy night with howling gale-force winds and a 40-foot swell. Some continue to cling on to the blind hope that the incumbent crew can bail fast enough to avoid the economy capsizing.

It will be all in vain because the ship’s crew left a tape recorder playing on a loop over the tannoy promising passengers to stay in their cabins while they secretly slipped away in the early hours on the only lifeboats available.

Central banks had one mission – create confidence. They have been complicit in the failure. They doubled down on all of the same policies that got them in trouble in the lead up to GFC. They had a simple task of telling governments to embark on structural and tax reform. Instead, they appeased their masters by endlessly cutting rates.

Never again must central banks be allowed to use QE to rescue the economy in a downturn. Central bank balance sheets should be forced to unwind all QE assets. Interest rates must be allowed to set at normalised rates which allow positive returns but avoid reckless borrowing.

While a lot of this piece might sound pessimistic we simply view it as being a realist with experience.

Harley has another Howler

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Harley-Davidson (HOG), perhaps the most iconic form of discretionary spending, came out with a howler set of Q4 numbers.  Revenue down 9% and operating losses in the last period. FY operating income fell 30% on revenues that finished 1% up. Domestic sales for the 2018 year fell 10% while international sales were flat. Worse was guidance pointed to unit sales falling between 217,000 & 222,000 units down from 228,000 in the fiscal year just past. This new range of unit targets would mean a decline for five consecutive years. If this pattern continues into 2020, luxury competitor BMW, which targets 200,000 units, will likely even up the tally, despite being less than half HOG was in FY2012.

Operating margin guidance for the motorcycle segment is forecast at 8-9% in 2019 down from 12% in 2017.

In June 2018, CM wrote, ““Harley-Davidson (HOG) is the classic case of a divine franchise. While still the world’s largest maker of cruiser motorcycles, it is being swamped by new competition. HOG’s EBIT performance has slid for the last 4 years and is even below the level of 2012…Sadly for HOG, 1Q 2018 has revealed even worse numbers. Global unit sales were 7.2% down on the previous year and 12% down at home.  Japan and Australia were soft. Looking at the strategy it looks like throwing spaghetti at a wall and hoping it sticks.

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Harley may have a grand master plan to incubate 2,000,000 new riders and launch 100 new bikes out to 2027, but all the while they remain stuck in a design studio, the competition, including the Japanese, keep stealing sales away from the Milwaukee icon.

The strategy looks completely unrealistic because growing 200,000 new bikers a year for a decade in the domestic market would mean that based on 2019 global unit sales projections,  92% of customers would need to be brand new, not repeat or existing. However the plan is to grow in the US where it had 138,000 sales in 2018 that would mean new customers would need to be 145% of all current sales in the US. No auto maker on the planet has ever had such pie in the sky assumptions for cultivating new customers, much less at that pace for 10 straight years. How can the board of HOG honestly think this is even remotely achievable? Sadly the company has been too eager conducting buybacks to flatter EPS. Net income for HOG was +1.8% for FY2018, diluted EPS was +5.6%. Time to stop playing games and properly delivering for shareholders.

Why didn’t GE use the $45bn in buybacks to take care of the $31bn negative equity?

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After GE’s monster $22bn goodwill impairment charge, the company remains in negative equity to the tune of $31.3bn. $79.2bn in goodwill remains on the balance sheet with $31.5bn in shareholders equity and $16.4bn in non-controlling interests. To think GE spent $45bn on buy backs over 2015 & 2016. Imagine if the company had used those funds to shore up the balance sheet and go back to positive equity?

While the kitchen sinking of GE Power should be deemed a positive (although somewhat expected) it is interesting to see the reaction to the shares (-9%) which flirted with April 2009 lows. Cutting the 1 cent dividend from 12 cents in the grand scheme of things was optics.

Although the goodwill charge is a non cash item on the balance sheet, she is clearly not in a position to deal with the rest of the goodwill just yet.

The brand new CEO has done the right thing to restructure the former largest company in the world but he has drawn attention to the most gangrenous wound that needs to be cauterized.

It is still a rough ride from here for an industrial stock at the top of the megacycle to have such a dreadful balance sheet.

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Harley – the Milwaukee Anvil

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Harley can blame tariffs for ruining margin but the rot set in well before. 2Q motorcycle shipments came in at 72,593 (-11.3%). The other luxury brands continue to climb. Its long time American arch rival Indian continues to grow. Indian’s parent Polaris Reports Q2 tonight. Indian sales were up double digit in Q1. The limited edition Indian Jack Daniels Scout Bobber sold out in 10 minutes. Product anyone?

Harley is losing share in America, it’s largest market, and Australia and Japan remain soft. Harley used to sell 16,000 units in Japan. In 2018 it will be lucky to ship 9,500. Ironically Europe is its most encouraging growth area yet tariffs will impact it.

Luxury motorbike brands BMW Motorrad, KTM, Ducati, Triumph etc are ALL growing.  Just Harley is flailing – the best motorcycle brand in the business (one where customers are prepared to tattoo the brand to their bodies) is chasing dreams from some consultant inspired long term plan which misses one core ingredient – listening to customers.

Expect the Harley management to keep the excuses rolling. It suffers from the divine franchise and its leadership seem more willing to point to external factors for its issues when internal complacency and resting on the laurels of the glory days seem the biggest factor. It is so obvious.

So Harley met its Luke warm 2Q EPS guidance. Maybe shareholders should reflect on the $103mn (1.3% of outstanding) of the $700mn in planned share buybacks which flatters EPS. E is not rising, S is falling. 10% of the stock is being shorted.

Why discontinue?

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This is a chart of the change in the US Fed balance sheet, a series that has just been discontinued. Is this because the Fed is about to step up its activity and offering wider disclosure on tapering activity might spook markets? Given that 72% of the growth in S&P earnings has been driven by buybacks since 2012, it stands to reason the market is not exactly providing the type of confidence inducing organic lift the index reflects. Bank of America revealed that “net buying of Tech sector in the 1H was entirely buyback-driven.” 

Kind of reminds CM of the day Bernanke’s Fed announced it would no longer report M3 money supply a year before the financial markets headed into the GFC. CM estimated on p.4 of a report several years ago that M3 money supply by 2018 on constant long-term growth rates would turn into around $35 trillion from the $10 trillion at the time it was discontinued.

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Nothing to see here? Throw a deteriorating fixed income market with fewer buyers and corporates that have binged on cheap credit to fuel buybacks, it doesn’t look like the stuff dreams are made of. The chart below shows that quarterly pre-tax US profitability is struggling since 2011. Earnings (E) are not doing so well. It is by the grace of falling number of traded shares (S) that makes the EPS look flattering.

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We took the liberty of comparing corporate profitability since 1980 and correlating it to what Moody’s Baa rated corporate bond effective 10yr yields. An R-squared of almost 90% was returned.

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Why not use the Aaa spread instead? Well we could do that but looking over the last decade the average corporate debt rating profile looks like this. We have seen a massive deterioration in credit ratings. If we look at the corporate profitability with Baa interest rates over the past decade, correlation climbs even higher.

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We shouldn’t forget that the US Government is also drunk on debt, much of it arriving at a store near you. $1.5 trillion in US Treasuries needs refinancing this year and $8.4tn over the next 3.5 years. Couple that with a Japan & China pulling back on UST purchases and the Fed itself promising to taper (but now hide the results of) its balance sheet. So as an investor, would you prefer the relative safety of government debt or take a punt on paper next to junk heading into a tightening cycle?

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Discontinuation of series always carries a sense of deep cynicism for its true intention. It is not an onerous data set to cull. Sure we can fossick around and try to find it hidden in the archives of the Fed website but the idea is that they probably don’t want to publicise how much more they intend to flog.

EU tariffs the least of Harley’s worries

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Two weeks ago CM wrote, “Harley-Davidson (HOG) is the classic case of a divine franchise. While still the world’s largest maker of cruiser motorcycles, it is being swamped by new competition. HOG’s EBIT performance has slid for the last 4 years and is even below the level of 2012…Sadly for HOG, 1Q 2018 has revealed even worse numbers. Global unit sales were 7.2% down on the previous year and 12% down at home.  Japan and Australia were soft. Looking at the strategy it looks like throwing spaghetti at a wall and hoping it sticks.

There is a touch of irony in that Harley was starting to do better in EMEA markets in Q1 2018 (+6.8%). Now EU tariffs are likely to sting the maker some $2,200 a unit average on motorcycles sold there. The company is seeking to bypass this in the short term by sucking up the cost of the tariff to help dealers before arranging (one imagines) for final knock down kit assembly outside the USA. A downturn in EMEA is a nightmare that exacerbates the weakness elsewhere around the globe. H-D Japan shifted 16,000 units at the peak. It will be lucky to do 9,500 this year. The business has lost its compass.

At the moment it seems the brand is stuck in an echo chamber. Harley announced at the start of the year it was closing a Kansas City plant for a net loss of 350 jobs. The rot has been in since before the tariffs. Trump lambasted Harley Davidson on Twitter for waving the white flag too soon but it is probably more evidence of the scatterbrain negative spiral approach to dealing with the predicament it finds itself in. Harley may want half of sales to come from overseas markets but it may not come through growth outside of America, rather a decline from within.

In closing Harley’s are a cult. There aren’t many brands where customers are prepared tattoo it to their bodies. Sadly this mentality means that Harley is still committed to conduct $700mn in buybacks which smacks of denial for a company seeing EBIT dwindle at 40% below peak. Then again, we shouldn’t be surprised when buybacks have made up 72% of all S&P500 earnings growth since 2012!! A recent survey that showed 75% of asset managers have not experienced the tech bubble collapse in 2000. Sure it is nothing to be worried about! Experience is a hard teacher. You get the test first and the lesson afterwards!

GE’s Angolan Kwanza exposure

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Sell-side analysts rarely read through the fine print of an annual report. Hidden away in the prose, one can find some pretty eye-opening paragraphs. From GE’s 2017 Annual Report,

“As of December 31, 2017, we held the U.S. dollar equivalent of $0.6 billion of cash in Angolan kwanza. As there is no liquid derivatives market for this currency, we have used Angolan kwanza to purchase $0.4 billion equivalent bonds issued by the central bank in Angola (Banco Nacional de Angola) with various maturities through 2020 to mitigate the related currency devaluation exposure risk. The bonds are denominated in Angolan kwanza as U.S. dollar equivalents, so that, upon payment of periodic interest and principal upon maturity, payment is made in Angolan kwanza, equivalent to the respective U.S. dollars at the then-current exchange rate.”

On that basis the marked to market figure is actually another $250mn hole in 2017. One wonders what the exchange rate will be in 2020? Furthermore at what level will Travelex or Thomas Cook exchange that for? It would be safe to assume the ‘bid/offer’ spread will be horrendous. GE might find it more useful to run a Nigerian mail scam to hedge the expected losses. For a company as large as GE, potentially losing $850mn should look like a rounding error unless the company is bleeding as the monster is. GE took a pretax charge of $201mn on its Venezuela operations.

We shouldn’t forget that “GE provides implicit and explicit support to GE Capital through commitments, capital contributions and operating support. As previously discussed, GE debt assumed from GE Capital in connection with the merger of GE Capital into GE was $47.1 billion and GE guaranteed $44.0 billion of GE Capital debt at December 31, 2017. See Note 23 to the consolidated financial statements for additional information about the eliminations of intercompany transactions between GE and GE Capital.

As 13D Research noted, “GE spent roughly $45 billion on share buybacks over 2015 & 2016  despite the shares trading well above today’s levels all the while ignoring the $30 billion+ shortfall in its pensions. Management disclosed in a recent analyst meeting that it would have to borrow to fund a $6 billion contribution to its pension plans next year, as well as chopping capex by 26% in 2018.

As mentioned yesterday, there are some who have faith in the sustained turnaround in medical. Indeed it has seen some top line and margin improvement but management seems more concerned with focusing on cutting costs than pushing innovation. Efficiency drives should be part and parcel of all businesses but one must hope CEO John Flannery has far bigger hopes for its market share leading product line (which GE admits facing pricing pressure in some segments) than trimming the staff canteen cookie tin.

GE remains a risky investment. Flannery has it all to prove and to date his performances have been anything but inspiring. GE feels like a business suffering from the divine franchise syndrome synonymous with former CEO Jack Welch. That dog eat dog culture seems to be biting its own tail.