How Harley stock could roar back

By Michael Brush

It turns out that loans made to iffy borrowers aren't just taking down housing stocks.

Since late February, troubles with dodgy loans have contributed to a painful slide of Harley-Davidson shares, taking the stock down more than 15%.

Here's the problem: The iconic American motorcycle company has a financing arm that helps fans buy their pricey Hogs. Enthusiasts often pay $25,000 or more for custom bikes.

Harley-Davidson (HOG, news, msgs) finances about half the motorcycles it sells. Now, many of those customers are having a hard time keeping up with payments -- and the company is getting less for the Hogs it repossesses because used bike prices have been weakening.

The problems may only get worse. As lending standards tighten because of concerns about low-end borrowers, sales growth could suffer. Somewhere between 10% and 15% of bikes sold last year were rolled out of the showrooms by subprime borrowers. Already, the company has taken 2007 earnings growth guidance down to 4%-6% -- a hefty cut from the prior range of 11% to 17%.

This one-two punch has Harley-Davidson investors racing to get out of the stock. Since late February, they've driven it down to $59 from above $70.

The road to Hog heaven

At some point, though, enough will be enough, and I think we are almost there. To be sure, traders could push Harley-Davidson stock down even more on worries that the company may announce bad news with its April 19 first-quarter earnings report.

But since it's impossible to call an exact bottom in any stock dip, I'd buy part of a long-term position in the stock now with limit orders set under $59, and look for possible pullbacks from those levels to continue building a stake. Then I'd sit back and watch the stock return to the $75 high it touched last November, for a 30% gain from the current price.

Here's what's going to put Harley-Davidson on the road to a comeback.

• Harley-Davidson has enviable brand strength that will help it power through the current mess. After all, how many companies can boast of a cult brand so powerful that customers tattoo their logos on their bodies? Besides holding on to a loyal fan base, this brand power should help it in its strategy to woo more buyers among women, African-Americans and Latinos.
• With U.S. growth cooling, Harley-Davidson can focus more attention on international growth. In Europe, sales increased 29% last quarter and around 18% in the two quarters before that. Harley-Davidson is also taking Hogs to China and India. It's already the market leader for large motorcycles in Japan.
• This company has enviable cash flow, and it's not stingy with it. It's no secret that Harley-Davidson will keep boosting earnings per share with big share buybacks. It should keep increasing dividends, as well.

Submarined by subprime

That's not to say the subprime problem isn't worth a bit of study. Lehman Bros. (LEH, news, msgs) analyst Felicia Hendrix summed up Harley's subprime loan problems in a note published last week. In the fourth quarter of 2006, Hendrix wrote, the number of loans on which customers were more than 30 days late rose to 5.18%, compared with 3.61% in the first half of 2006. The number of bad loans rose to 1.4% from 1.29% the year before. So Harley's financing division, known as Harley-Davidson Financial Services, is losing money on more and more bad loans.

• Video: Check out the Harley-Davidson V-Rod custom

But here's why the damage could be limited. Last year, Harley's financing arm provided just 13% of pretax income from operations (which excludes a small amount of investment income), or $210.7 million. So even a 20% drop in financing income would hit earnings by just 12 cents to 16 cents, or 3% of overall earnings, calculates Merrill Lynch (MER, news, msgs) analyst Hakan Ipekci.

Harley's loan problems are cropping up a lot more on 2006 transactions. This tells me the company stretched to make sales last year by extending credit to more borderline buyers.

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