More Pain Ahead For This American Icon

Jared Levy's picture

Tuesday, November 3, 2015 - 7:30am

by Jared Levy

As an avid motorcycle rider and Harley enthusiast, it almost feels like sacrilege to bet against Harley-Davidson (NYSE: HOG). But with a seasonal sales lull on the way, increasing competition and too-rich valuations, I'm expecting continued weakness from the iconic motorcycle manufacturer. The good news is I've got the perfect strategy to capitalize on it. 

Harley is the world's largest manufacturer of heavy motorcycles, but it's hardly invincible.

Case in point: On Oct. 20, the company reported third-quarter net income fell 6.5% year over year, while diluted earnings of $0.69 were flat and missed analysts' estimates by 11.5%. Revenue also came up short and management lowered shipment guidance. Shares plunged 14% on the day as investors rushed for the exits.

That day, the company also announced it would lay off 250 employees, about 4% of its workforce, increase marketing spend and work to expand its network of dealerships.

While these tactics may pay off in the long run, they will cost money in the short term. Harley expects to spend $30 million to $35 million on the layoffs alone in the current quarter. 

The timing of that hit is far from ideal. As you can see in the quarterly revenue chart below, the December quarter is by far the weakest.

The company and the stock have been under pressure for some time, and Harley is facing slowing motorcycle sales and increasing competition. 

While auto sales have been making record highs this year, Harley's global motorcycle sales fell 1.4% year over year in Q3. This was primarily due to a 2.5% decline in U.S. sales. About two-thirds of Harley's net shipments are in the United States, so this weakness on the company's home turf is problematic to say the least.

At the same time, Harley's relatively expensive bikes are seeing increasing competition from the likes of Honda, Yamaha, Polaris, Suzuki, Victory and even the rebirth of the historic Indian brand.

While analysts have cut estimates for the current quarter in half since the company reported earnings last week, they've made only minor downward revisions to their 2015 and 2016 estimates. Given the headwinds the company faces, I expect more to follow ahead of the January report.

Despite the 24% year-to-date drop in shares, the stock is still trading at a premium compared to its peers. Based on Zacks estimates, HOG has a forward P/E of 13.4 versus an industry average of 11.4. 

The bottom line is that Harley is in a tough spot coming into the historically weak fourth quarter and is not deserving of premium valuations. Seasonal weakness combined with the timing of its restructuring is likely to weigh down shares for at least the next few months. 

I see HOG heading down toward the $45 area by year end, but for today's trade to generate the maximum profit all it has to do is remain below $50 through mid-December.

Make A Potential 44% On HOG In 50 Days

The strategy I plan to use is known as a bear put spread, and it involves simultaneously buying one put option and selling another with the same expiration date but a lower strike price. The option premium from the put sold (short put) decreases the cost of buying the long put.

For this trade, I am interested in buying one HOG Dec 52.50 Put and selling one HOG Dec 50 Put for a net debit of $1.70 or less ($170 per pair of contracts).

Note: Be sure to use limit orders when entering and exiting a bear put spread to get the desired prices.

HOG Bear Put Spread

The breakeven for a bear put spread is the strike price of the long put ($52.50) minus the net debit paid ($1.70), or $50.80, which is 2% above HOG’s current price.

The maximum possible profit for a bear put spread is the difference between the strike prices ($2.50) minus the net debit paid to enter the trade ($1.70), or $0.80. This is achieved as long as HOG is below the strike of the short put ($50) at expiration on Dec. 18.

If HOG is above $50.80 at the close on Dec. 18, we will experience a loss. However, no matter how high the stock goes, the maximum loss is limited to the amount paid to initiate the trade, or $1.70 in this case.

I like to set my profit target slightly below the maximum profit to automate the trade and allow for an early exit if HOG continues to fall. Therefore, when you enter the trade, place a good 'til canceled (GTC) limit order to sell (close) the spread at $2.45. This would result in a profit of $0.75 for a return of 44% in 50 days, or an annualized gain of 322%.

A bear put spread is the perfect strategy to reduce risk while still benefitting from potential weakness in this struggling American icon.

Recommended Trade Setup:

-- Buy one HOG Dec 52.50 Put
-- Sell one HOG Dec 50 Put
-- Enter trade for a net debit of $1.70 or less
-- Set GTC sell limit order at $2.45 for a potential 44% return in 50 days

Note: We hope you liked today's trade from options expert Jared Levy. While it's not the typical trade we've featured on Profitable Trading in the past, it's an incredibly lucrative strategy that you'll likely be seeing much more of in the future.

We've prepared a short fact sheet about Jared and how he has used options to become a millionaire several times over. It takes no more than a few minutes to read. Click here to access it.

This article was originally published on ProfitableTrading.com: More Pain Ahead For This American Icon

Jared Levy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.