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When a Bad Quarter Signals Worse News Ahead

When a Bad Quarter Signals Worse News Ahead

There are times when a company announces quarterly results that miss expectations and the stock rallies. This could be because management raises expectations for the future or other good news is announced with earnings.

At other times, a company misses expectations and it is simply the result of factors that will affect the company one time. This could be the case when a retailer reports weakness because of unexpected adverse weather.

But, sometimes a bad quarter is merely the continuation of bad news that signals a market reversal for the company. This could happen when demographics of a company’s core customer change, or when technology makes a product obsolete. An example of how demographic shifts can hurt a company are playing out right now in Harley-Davidson, Inc. (NYSE: HOG)

Lowering Guidance is a Bad Sign to Analysts

Harley-Davidson is best known for the lifestyle incorporated in its stock symbol. The company sells motorcycles and membership in the Harley Owners Group, or HOG. Motorcycle owners are drawn to the product because, as one owner noted, “the Harley brand stands for freedom. The high value driven into the brand is about rebelling against the status quo and establishment, and that’s why those very participants gladly pay the high price for a piece of an American heritage brand.”

It’s a unique brand, holding a unique place in American pop culture, and the company is not doing well.

On Tuesday, Harley-Davidson reported its second-quarter financial results and the results were below expectations. The reported $1.48 in earnings per share (EPS) and $1.58 billion in revenue, compared with consensus estimates of $1.38 in EPS and $1.59 billion in revenue.

But, the numbers masked some problems. Worldwide sales were down 6.7% in the quarter compared to the same three months a year ago. Sales in the US were down 9.3%. Management attributed the drop in the US because of weak industry conditions. Those industry conditions could weigh on the company.

The chart below shows the industry woes have been building for some time.

Harley-Davidson reported total sales of 81,388 motorcycles for the quarter, down from 87,266 last year. The company lowered its outlook for the full year to 241,000 to 246,000 motorcycles, down 6%-8% from last year’s sales. This will be the third straight year with a drop in both sales and cuts in the outlook from management.

For at least four years, analysts have been warning that the company was running out of potential buyers. One analyst was quoted in an interview from July 2013 that the average age of riders was still rising at that point and average age is important because “that’s ultimately the core customer. She said, “that’s one of the reasons they [management] don’t want to talk about it.”

Where to Go From Here?

Demographics point to continued weakness for Harley-Davidson. Perhaps its most important group of potential buyers is men in their late 40s. This age group is becoming an increasingly smaller share of the market.

A shrinking customer base for a premium priced, discretionary purchase is a bad combination. Harley-Davidson probably won’t go out of business. It will probably retain its position as an American icon. But, it could be a significantly smaller company in the future.

But, even a good company is not always a good investment. The stock price of HOG has been showing the pressures on the company for some time.

The stock price peaked in 2014. This was shortly after the time when analysts began questioning the company’s ability to grow its brand in a shrinking market.

This is also about the time that the stock’s valuation began to contract. In 2010, HOG traded with an average price to earnings (P/E) ratio of 25.8. By 2014, the average P/E ratio had contracted to 16.5. It fell to 15.1 the next year and 12.9 last year. Now, the P/E ratio is about 13.5.

A declining, and low P/E ratio, is appropriate for a company that is seeing its business contract or grow less than average. It is difficult to determine which will apply to HOG but the demographics make it likely that the company is no longer growing.

Trading a Company in Decline

As earnings suffer and the average valuation of the stock declines, it is likely HOG is in a long term down trend. The question for investors is how to benefit from this.

One way to trade the long term decline is with long term put options. A put option gives the buyer the right, but not the obligation, to sell a stock for a predetermined price before a specified date. There are options in HOG available that expire in January 2019, offering about 18 months until expiration.

A trader could simply buy a put on HOG. The stock closed Tuesday at $48.95.  A January 2019 put with an exercise price of $50 is trading at about $8.20. To break even on this trade, the price of HOG would need to be below $41.80 at expiration. That is possible but this is an expensive trade.

The January 2019 $45 put is also expensive with a price of about $5.50. The breakeven price on this trade, the difference between the exercise price of the option and the premium or amount paid for the option, is $39.50, a decline of about 17% in HOG from its current price.

These examples demonstrate the problem of trading options with months to expiration. The trades will require a large amount of capital and will usually require a large move in the stock price in order for the option to be profitable.

Using options with a shorter amount of time to expiration is one way to solve this problem. To maintain long term exposure, the trader would simply open a new trade in the stock when one option expires. This provides the benefits of longer term options but reduces the costs of the trade and potentially generates larger returns in the long run.

For HOG, there are a number of shorter term options available. We will look at options expiring on August 18, about one month from now. The August 18 $50 put is trading at $3 and the $45 put for that expiration date is trading at $0.60. The break even price of the $50 put is $47 and the $45 put will be profitable if the stock falls by at least 6% to $44.40.

While such large moves are possible, there is a safer way to trade options. Instead of buying a put, a trader can sell a call to obtain bearish exposure to the stock. In the case of HOG, the August 18 $50 call could be sold for about $0.55. This represents immediate income of $55 since each contract represents 100 shares of stock.

The risk of selling a call can be high since the seller is obligated to deliver the shares at the exercise price. If the stock moves up significantly, for HOG, as an example, to $70, the loss could be large. In this example, the call seller would need to sell shares valued at $70 for $55, a potential loss of $15 per share.

To limit the risk, the trader could buy a $55 call for about $0.05. This limits the risk to the difference between the two exercise prices less the premium, or $450 in this example.

Selling the August $50 call and buying the August $55 call will generate about $50 in income and generate a return on investment of about 10% in one month. This strategy could be repeated 18 times to obtain long term exposure to HOG and potentially generate hundreds in income even if HOG remains unchanged.