Polaris Industries, Inc. Q2 2009 Earnings Call Transcript

| About: Polaris Industries (PII)

Polaris Industries, Inc. (NYSE:PII)

Q2 2009 Earnings Call

July 16, 2009 10:00 am ET


Scott Wine – Chief Executive Officer

Bennett Morgan – President, Chief Operating Officer

Michael Malone – Chief Financial Officer


Edward Aaron – RBC Capital Markets

Gregory Badishkanian – Citi

Hayley Wolff – Rockdale Securities

Robert Evans – Craig-Hallum Capital

Timothy Conder – Wells Fargo

Craig Kennison – Robert Baird

Joseph Hvorka – Raymond James


I would like to welcome everyone to the Polaris second quarter earnings results conference call. (Operator Instructions) At this time it is my pleasure to turn the conference over to Richard Edwards.

Richard Edwards

Good morning and thank you for joining us for our second quarter 2009 earnings conference call. As in past quarters we will be showing a slide presentation that is accessible at our website at www.polarisindustries.com/irhome which has additional information for this morning's call.

The speakers today are Scott Wine, our Chief Executive Officer, Bennett Morgan, our President and Chief Operating Officer and Mike Malone, our Chief Financial Officer. During the call today we will be discussing certain topics including product demand and shipments, sales and margin trends, income and profitability levels and other matters including more specific guidance on our expectations for future periods which should be considered forward-looking for the purposes of the Private Securities Reform Act of 1995. Additional information regarding factors that may influence results can be found in Polaris' 2008 annual report and in the 2008 Form 10-K which are on file with the SEC.

Now I'll turn it over to Scott.

Scott Wine

Good morning. Thank you for joining us and for your interest in Polaris. Earlier today we reported results for the second quarter of 2009 that slightly exceeded our expectations. The results were primarily driven by the strong performance of the Polaris team and our dealer network as we continue to face significant headwinds in nearly every market we serve.

Earnings per share came in at $0.53, down 26% from the prior year period. Sales for the quarter were down 24% to $345.9 million from the second quarter of 2008. We saw weak demand across almost all regions and markets with Canada being the one bright spot with sales to dealers down only 8%.

Retail credit availability metrics actually improved in the quarter. The dealer floor traffic continues to be weak. Creating demand is one of key priorities for the remainder of the year and our dealer show next week here in St. Paul will feature a great deal of product news that we expect will once again lead the industry.

I'll go ahead and cover one bit of product news that we announced this morning with the press release which is our entry into low emission vehicle space with our first electric neighborhood vehicle. This is the initial new product launch by our on-road division and is yet another example of Polaris innovation and product development capability.

This product puts us into a small but growing market and also provides technology expertise that has many potential applications across our business. We will launch the new product, which will be named the Polaris Breeze with a small sample of unique dealers that have prime access to the important master plan communities where these products will be used.

This is an attractive market expansion for Polaris, providing access to a new and growing customer base. It also provides the opportunity to participate in the growing demand for low emission vehicles in what we believe is an under served and fragmented market with few purpose built vehicles.

We do not anticipate a significant impact on our financials in the near term, but see this as a start in the low emissions vehicle space which we fully expect to evolve into a growth business for Polaris.

The press release provides additional information on the product, but I will quickly highlight the key features of the Breeze. The vehicle was designed for multiple customer uses. It offers the type of innovative and utilitarian neighborhood vehicle that you would expect from Polaris with our renowned ride and handling capability that will immediately be a market leading feature.

Many other key differentiators for this vehicle were designed with residents and master plan communities in mind. Primary among these is an industry first three-in-one rear seat conversion which can be performed with ease and speed. The conversion feature allows for the vehicle to be quickly and easily changed for use as a golf cart, a four passenger vehicle or for carrying cargo.

We are excited about bringing this product to market and this technology to other applications in our business and look forward to sharing our future growth plans in more detail in the weeks and months ahead.

While it would be nice to spend the next hour talking about the rest of our product news, we do have important results to share. It is these product advantages that are enabling Polaris to gain share and outperform in our power sport space. Looking more closely at second quarter sales which were slightly better than our expectations, off road vehicles were the big volume driver in the sales decline, although we continue to gain share in both ATV's and side-by-sides in the quarter.

On a percentage basis, it was our Victory motorcycle business that was down the most, off 55% versus the prior quarter of 2008. Our international sales were down 30% with nearly half of that coming from currency impact. We continue to benefit from product mix and price, but these only partially offset the volume weakness. Currency remained a headwind in the quarter with a 4% negative impact on total sales.

With the exception of Victory, sales across the business are in line with our expectations through the first half of 2009.

Earnings also slightly beat expectations with net income down 28% to $17.5 million. This is a more than 100% improvement from our first quarter results which included the KTM impairment charge. We also made several tough calls in the second quarter as well to support our customers and our dealers.

Gross margin percentage expansion of 40 basis points was somewhat below our expectations in part because we took a charge for snowmobile warranty to provide customer insurance for snowmobile issue on our high performance 800CC sled.

We also increased our Victory promotional reserves to provide additional support to our Victory dealers as we deal with what is what we like to call a brutal motorcycle market. On a positive note, we continue to aggressively execute our cost down plan yielding a 17% year over year decrease in operation expenses and another strong quarter of product cost reductions.

Retail sales are the most closely watched metric within Polaris. We have stabilized over the last nine months in a down 20% to 23% range. Retail in the quarter was again choppy, but almost every region of the country is down significantly. Throughout North America, side by side sales continue to perform better than core ATV's.

As previously mentioned, Victory retail got worse in the quarter, down to mid 30% range compared to last year, and similar to the 1400 CC and above segment of the motorcycle market where we compete.

Overall, we have moderate expectations for retail improvement in the second half which will primarily be driven by exciting new model year 2010 products and easier comparables in the fourth quarter. We have no illusions of a strong market recovery in the near future, and have factored this into our very reasonable assumptions for the second half order period.

Closely tied to retail performance is the health of our dealer network. Maintaining the strength of our dealers is a top priority for Polaris. Our Max Velocity program continues to go well with strong support from almost all dealers who are participating. Bennett will provide more color on MVP when he discusses our operational excellence.

We continue to drive down dealer inventory with a 10% reduction from the previous quarter and an 8% reduction from the second quarter of 2008. Victory dealer inventory improved the most, down 24% although the weak market requires significantly more reductions in our dealer motorcycle inventory.

Inventory reductions is not the only area where we are working closely with our dealers. We are reducing the overall floor plan receivables and have even accelerated their hold back payments in the quarter to help with their cash flow. Access to wholesale financing remains solid and Mike will update you with our Polaris Acceptance venture with GE.

Losses across our network remain low both in receivables and actual dealer count. We have seen dealer repossessions drop from the spike we saw in the fourth quarter of last year and still expect the overall decrease in dealers in 2009 to be approximately 5% which is in line with our historical annual turnover.

We are watching our dealer health closely, particularly in Victory so that we can respond as appropriate. With that, I'll turn it over to Chief Operating Officer, Bennett Morgan who will provide additional insights into our operations and business unit performance.

Bennett Morgan

I want to begin with operational excellence. Our focus on quality, costs and speed continue to pay dividends. Despite the challenging retail industry environment, our speed has allowed us to reduce both dealer and factory inventory significantly throughout the second quarter.

Scott has already reported on the positive dealer inventory results, but in addition, factory inventory decreased year over year by $59 million or 21%. We were also able to further reduce supply chain lead times in our ORV business by another 13% this quarter and made even more significant reductions in snowmobile and Victory supply chain lead times.

We expect to continue to reduce our factory and dealer inventory levels using our speed and flexible manufacturing capability to run Polaris at more efficient levels of system wide inventory as we move into the future.

Our speed and cost reduction focus continue to drive gross margin percentage expansion, up 40 basis points in the second quarter of 2009. We're having good success in this environment in finding opportunities to reduce our costs and improve our quality simultaneously through the efforts of our engineering and supply chain partners.

Commodity costs remain stable and improved from 2008. We remain confident in our guidance on gross margin expansion for full year 2009. As Scott noted, our focus on reducing waste resulted in operating expense reductions of 17% in the second quarter.

We also continue to improve our speed to market in new product development. We are now 22% faster to market in new product development versus 2008 and we are over 40% faster than we were just three years ago.

Our upcoming dealer meeting in St. Paul will showcase our again industry leading model year 10 new product news and innovation. While most of our competitors have cancelled their annual dealer meetings, and cut back on virtually all new product releases, Polaris remains on the gas.

Almost every new model year 10 product announced at our show in St. Paul would not have been ready for another year or more without our enhanced product development speed that we've undertaken over the past couple of years. We believe we've begun to build legitimate and significant competitive advantage in power sports product development.

Our MVP, or Max Velocity Program tests with our dealer network which is essentially a whole new way of doing business in power sports, continues to perform to our expectations. The objective of the test group of dealers is to continue to grow market share while operating with lower levels of inventory.

Based on our success and our learning, we are going to expand the MVP program significantly on a geographic and dealer criteria basis to 50% approximately of our off road vehicle North American retail volume beginning with this upcoming order period.

Also, for those dealers not yet eligible for MVP, we are making significant improvements to help drive out inventory waste and reduce dealer order risk using our improved speed and manufacturing flexibility.

Off road vehicles – our ORV business performed to our expectations in the second quarter with sales down 25%. The ORV industries remain weak. North American ATV industry was down about 30% and while we don't have clear industry data for side by sides, we believe it was down mid to upper teens percent for the second quarter.

Our innovation continues to drive market share gains year over year in both ATV's and side by sides. North American ATV dealers inventories continue to improve both year over year and sequentially from the first quarter with inventory down 19% year over year. Side by side dealer inventory while higher than 2008, are down sequentially from the first quarter and remain at appropriate levels.

Industry ORV promotion levels are up year over year, but remain with our expectations. Polaris continues to have success moderating ATV promotion spending and we expect to continue this trend going forward thanks to lower inventory levels, improved age and mix of that inventory and new and more innovative products in the marketplace.

We are making good progress on ORV cost improvements in both operating and product cost areas which is helping us at the lower demand environment. And as I mentioned earlier, we remain on the gas in new product development in off road vehicles and will announce a number of new models next week, and expect to continue to outperform the overall ORV market based on these introductions and innovations. We are narrowing our full year 2009 sales guidance for ORV's to down 21% to 25%.

Snowmobiles – due to the time of year, there's not a lot to report about snowmobiles and not a lot has changed from 90 days ago. Model year 10 North American dealer orders were within our expectations while international orders were slightly lower than our expectations, largely due to pressures in the Russian market.

Dealer inventories are at acceptable levels and we're excited to bring our new Rush snowmobile with pro-right suspension, the industries' first and only rear suspension into the marketplace later this fall. With dealer orders complete, we are narrowing our sales guidance to down 15% to 20% for full year 2009.

Victory motorcycles – the overall motorcycle industry in Victory had a disappointing second quarter. Total North American motorcycle industry retail sales were down in excess of 50% with the segments that Victory competes in, heavy weight cruiser and touring segments, performing better but still down mid thirties percent.

Victory retail sales declined at a similar pace to our segments in the second quarter which was below our expectations. Second quarter sales to dealers declined 55% as we continue to aggressively reduce shipments as we had previously communicated to you to assist dealers in reducing their inventories.

Dealer inventories continue to come down. They're down 24% from a year ago, but remain higher than we and our dealers would like.

In light of the motorcycle weakness, we are making significant reductions to our expectations for the Victory business for 2009. We now expect full year 2009 sales to be down 40% to 50% as we make additional build reductions for model year 10 to assist in inventory reductions, and additional investments to improve our dealers' competitiveness during this market slowdown.

We remain committed and excited about the Victory business. Next week we will announce key new models at our dealer show that will allow us to reach a broader motorcycle audience and segments with heavy weight cruisers and touring. We also announced recently the formation of our new on road division designed specifically to get more resources focused on our Victory business and other on road opportunities.

No doubt this is a challenging time in motorcycles, but facing up to the industry realities, getting more resources dedicated to the business and continuing to invest in new product, have us optimistic our Victory business will be stronger as a result in the long run.

Parts, garments and accessories – PGA sales declined 13% in the second quarter due primarily to lower retail sales in all product lines. Our PGA business continues to expand its gross margins impressively in a lower volume environment and as we expected, continues to outperform our overall Polaris business. Our focus on innovation continues and we will launch almost 200 new accessory products next week at our show.

We are lowering our sales guidance for 2009 to down 13% to 17% and continue to expect our PGA business will modestly outperform our overall Polaris business.

International – international sales were down 30% in the second quarter as Europe and the rest of our international markets continue to deal with difficult macro economic conditions. Unfavorable currency movement accounted for about 12% of this sales decline. The European off road vehicle industry continued to be soft, down low 20's%, but Polaris continues to gain market share versus our competition.

There are a number of bright spots in our international business. Our subsidiaries continue to outperform their markets from both a market share and profitability perspective. Our Victory business has seen significant retail sales growth and market share expansion in every country in which we are currently selling Victory and our international factory inventories are down significantly year over year. We also continue to invest and make progress on our global new market development initiatives.

Adjacencies – Scott has already discussed our newest adjacency, our neighborhood vehicle for master plan communities which is our first entry into an exciting low emission vehicle space. Beyond that, we remain pleased with our progress and success in our other adjacencies. The military business continues to grow nicely.

The new Bobcat alliance and product development effort is off to a great start. We have a number of other ideas in our funnel. While these will not drive significant sales growth and profitability in 2009, we are very excited about the sales and earning growth potential these adjacencies provide and how they fit into Polaris' growing portfolio of businesses.

With that, I'm going to turn it over to Mike, our CFO.

Michael Malone

Thanks Bennett and good morning everyone. I'll begin with our financial services business. Income from financial services for the full year 2009 is expected to decline 20% to 30% from the full year 2008. This guidance has improved somewhat from the previously issued guidance expectations for financial services income.

As discussed in previous calls, the decline in income for 2009 is primarily due to our revolving retail credit provider, HSBC eliminating the volume based fee income payment to Polaris in the first quarter of last year. No income is expected in 2009 from HSBC.

For the full year 2009, our expectation for the wholesales financing generated from Polaris Acceptance has improved from prior guidance issued. I'll talk more about that a bit later.

For the second quarter 2009, we financed through our retail credit programs, HSBC, GE and Sheffield combined, about 33% of Polaris products sold to consumers in the United States which is slightly better than the penetration rate we experienced the last few quarters.

The approval rate in the second quarter of 2009 increased to 48% compared to 44% for the first quarter. Both the penetration rate and the approval rate are somewhat lower than historical levels and somewhat weaker than desirable due to the credit tightening by our retail credit providers.

It is obviously having some dampening impact on our retail sales levels. We continue to feel our retail credit relationships are relatively stable given the overall uncertainty in the consumer retail credit markets.

Our recently added retail installment credit provider, Sheffield Financial continues to increase its share of its installment financing provided to our consumers and GE has recently relaxed their down payment requirements.

For the second quarter of 2009, the wholesale portfolio related to floor plan financing for dealers in the United States was approximately $574 million, a decrease of 5% from the end of the second quarter last year reflecting the decline in the dollar amount of dealer inventories. This 5% decline is in dollars. The units outstanding in the portfolio in the United States are actually down 12% compared to last year due to the mix change to the higher priced side by side inventory. Credit losses in the dealer wholesale portfolio remain very reasonable, averaging well less than 1%.

During the second quarter 2009, we continued to see a modest number of dealer failures, repossessions of inventory and credit losses similar to the first quarter, but these issues were well within our expectations as Scott mentioned earlier.

Additionally, during the second quarter we had conversations with our wholesale credit joint venture partner, GE which resulted in increases in the interest rate paid to Polaris Acceptance by both Polaris and our dealers in the second half of 2009. These interest rate increases were agreed to, recognizing the increasing funding cost environment for GE's debt that finances the portfolio and GE's desire to maintain an acceptable level of return from the Polaris Acceptance joint venture.

Overall, we are very pleased with our stable, long term wholesale financing partnership with GE and our joint venture structure of Polaris Acceptance and do not expect and dealer capacity issues to materialize.

The actual gross profit margin percentage generated in the second quarter was 24.1 compared to 23.7 in the second quarter of a year ago, a 30 basis point improvement. During the quarter, we continued to adjust our manufacturing capacity and cost structures to help minimize the fixed cost absorption impact of the lower production volumes and have been successful in reducing these manufacturing related costs at a similar pace to the second quarter sales decline.

Gross margin percentage in the second quarter continued to benefit from commodity and transportation cost decreases, higher selling prices, lower ATV sales promotion costs and positive product mix change. These gross margin benefits were somewhat offset by the unfavorable currency movements in Canada, Japan and Europe compared to a year ago, which created some headwinds for us in the second quarter and will likely continue through the third quarter, but are expected to actually turn favorable in the fourth quarter of this year given the dramatic move in the currencies a year ago.

In addition, as Scott mentioned, our second quarter gross margin percentage was negatively impacted by an increase to the snowmobile warranty reserve to cover warranty repair for snowmobile models that have the 800CC liberty engine introduced a few years ago.

However, we continue to expect the gross profit margin percentage for the full year 2009 to improve up to 130 basis points over the 22.9% generated a year ago which is unchanged from our previously issued guidance.

The mix of positives and negatives experienced in the first half of the year combined with our aggressive product cost reduction efforts which will become more evident in our model year 2010 product offerings, are expected to continue to generate gross margin percentage expansion throughout the remainder of the 2009 year.

Moving now to our balance sheet and liquidity profile for 2009, our net debt position finished the quarter at $220 million which is $19 million lower than a year ago. We continue to have ample borrowing capacity under our attractively priced $450 million banking arrangement comprised of a strong and stable corporate banking group.

For the year to date period, we made investments in the business through capital expenditures and new product development tooling totaling $25 million which is 33% lower than a year ago. For the full year, we expect to continue to moderate our appetite for capital expenditure spending and realize a significant decline to be in the $50 million to $55 million range.

We will continue to invest in tooling for innovative new products, some of which we will introduce next week and targeted investments in capital projects to reduce our production costs and improve efficiencies and product margins. We continue to expect depreciation for the full year 2009 to be in the range of $60 million to $65 million.

Cash flow provided by operating activities was $24.4 million for the second quarter '09 compared to $53.3 million in the second quarter of last year. During the six months ended June of '09, $8.7 million in net cash was used for operating activities compared to $21.7 million of net cash provided during the first half of last year.

The decreases in net income and the decreases in the dealer hold back accrued liability for the 2009 second quarter and year to date periods compared to the same periods last year are the primary reasons for the decline in operating cash flow.

We continue to expect cash flow provided by operating activities to decrease for the full year 2009 in line with percentage decline of net income. But notably, operating cash flow generated will remain well above the net income level.

As Bennett mentioned, factory inventories are at $220 million, a 21% decrease from a year ago. We continue to expect factory inventory levels to decline consistently throughout the year as we have adjusted and will continue to adjust our production capacity and build schedules for the challenging demand environment that we're experiencing.

During the first half of the year, we repurchased only a minimal number of shares under our share repurchase program. We still have approximately 3.8 million shares authorized form our Board but as I stated in our last call, we're taking a different approach this year and are being more conservative given the uncertain overall economic environment.

During the second quarter we once again paid a cash dividend of $0.39 which represents a 3% increase over a year ago and we expect to continue to pay the dividend at that rate for the remainder of 2009.

Guidance for the full year 2009 has been narrowed to reflect the actual results generated during the first half of the year and our current outlook for the remainder of 2009. Total company sales guidance has been narrowed and lowered somewhat and is now expected to decline 20% to 25% in total for the full year with the individual business as follows; off road vehicles, down 21% to 25%, snowmobiles down 15% to 20%, Victory motorcycles down 40% to 50% and PG&A down 13% to 17%.

As Bennett mentioned, Victory motorcycle sales expectations have been lowered from previously issued guidance. This is a reflection of the deteriorating industry retail sales for heavy weight touring and cruisers in the second quarter and our intention to reduce productions levels for model year 2010 to help our dealers adjust their Victory inventory levels. In addition, PG&A sales guidance has been lowered somewhat.

Gross margins are expected to expand up to 130 basis points for the reasons explained earlier. Our operating expenses are expected to decrease significantly in dollar terms as we continue to aggressively deal with reality of a lower volume environment. Operating expenses will increase as a percentage of sales for the full year 2009 primarily due to the lower sales.

Income tax provision was recorded at a rate of approximately 34.4% of pre tax income for the second quarter which is lower than last year due to the Federal Research and Development tax credit which had not been extended by the U.S. Congress in the second quarter a year ago.

For the full year 2009, our expectation is for the income tax provision rate to be in the range of 34% to 34.5% of pre tax income which is unchanged from our previously issued guidance.

In the third quarter 2009 the income tax provision rate is expected to be higher than the 29.3% rate experienced in the third quarter of a year ago, primarily due to the favorable settlement of certain income tax examinations last year which are not expected to repeat again in 2009.

Earnings per share for the full year 2009 are now expected to be in the range of $2.70 to $2.90 per diluted share which is a decrease of 23% to 17% compared to the $3.50 per share earned for the full year last year.

We expect the third quarter 2009 to look a lot like the second quarter did. Guidance for the third quarter 2009 for the company is as follows.

Sales are expected to decrease in the range of down 25% to 30% from the third quarter of a year ago due primarily to the continued to the weak industry trends in North America and in our international markets in the third quarter.

Earnings are expected to be in the range of $0.76 to $0.86 per diluted share in the third quarter of '09 compared to the $1.13 in the third quarter a year ago.

As Bennett mentioned, the move to 50% of our ORV retail volume on MVP during the upcoming order session will have a dampening impact on third quarter sales volumes as we make that transition. And I will remind you that the third quarter of last year was the best quarter in the company's history.

As you will note, this third quarter EPS guidance implies very strong earnings per share results in the 2009 fourth quarter which we are confident we can achieve given the momentum generated to date on our cost reduction efforts and innovative new products when compared to a relatively easier comparable from the fourth quarter 2008.

In conclusion, we feel our plan for 2009 remain achievable in the current challenging external market environment. We continue to proactively implement contingency plans and are confident we can adjust production levels and cost structures appropriately.

At this time, I'll turn it back over to Scott for some quick concluding comments.

Scott Wine

Overall, and hopefully as you gleaned from our comments this morning, we had a solid second quarter and I feel good about the way this Polaris team has navigated through the first half of 2009. We have taken significant costs out of our business, but also made investments to support our product innovation and strategic plans.

The product news will be on full display next week at our dealer show, and we are poised to turn innovation into orders. The results of our operational excellence initiatives will continue to show up across our business not only in our P&L and balance sheet metrics, but also in our dealers as we expand our MVP in the months ahead.

We will continue to exploit our flexible manufacturing systems to manage the uncertain demand environment and leverage our strong engineering team and processes to drive product results, cost reductions and product innovations. Both of these initiatives will be part of our Victory turn around effort.

While we are confident in our ability to return to organic growth in the years ahead, we recently created a new corporate development officer role to lead our non organic growth effort. Todd Ballan brings significant experience in business and market development and will be a key resource to help us drive our strategic growth initiatives.

Having and executing the right plan is very important, but it is results that matter. As Mike stated, we are narrowing our sales and earnings guidance and feel comfortable with our ability to deliver full year earnings per share of $2.70 to $2.90 and sales in the down 20% to 25% range.

We remain focused on executing in 2009 and positioning the business to emerge from this economic downturn as a stronger, more profitable company. I look forward to speaking with you again next quarter to talk about our progress.

That concludes our prepared remarks. Can you open up the line for questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Edward Aaron – RBC Capital Markets.

Edward Aaron – RBC Capital Markets

On the new adjacencies, I understand the thought process behind that business opportunity, but I'm a little surprised that a product like that is going to have your brand name on it and be sold through your dealer network. I guess I kind of think of the Polaris brand as a little cooler and tougher than that. Can you just help me understand the thought process behind how you're positioning that from a distribution perspective?

Scott Wine

I think I used the word unique distribution in my prepared remarks. This will not initially be sold through the Polaris dealer network. These products are designed for master plan communities and there are specific dealers that support those markets. We have a small sub set that we've been working with for the initial launch of the product and we actually feel like the Polaris brand name is a strength that we'd like to leverage and we'll play that out over the next several quarters as we launch the product.

But that's the strategy. That's the reason we announced it today. We've got the dealer show next week where we'll announce most of our new product news, but because this is not specifically designed for our current Polaris dealer network, we thought it best to go ahead and announce it on the call today.

Edward Aaron – RBC Capital Markets

Thanks for the clarity on that. To what extent have you challenged your commitment to the Victory business? The market's been cut in half and that's not necessarily unique to the motorcycle industry but the share kind of plateaued even while that was happening. Is there enough demand in that business over the next couple of year? Do you see it to be really sufficiently profitable there? And then also, as far as your dealers are concerned, they have to make a pretty big inventory commitment for that product to have the full line in their stores and perhaps right now the turns aren't enough to support that. Have you thought at all about potentially not staying with that business or what would you need to see to kind of change how you're positioned there?

Scott Wine

Absolutely. We have taken an incredible sober look at it. It's one of the things about being new, you have a chance to look at everything and while it is a very difficult year, we still feel very good about the long term potential of Victory in our business.

If you have a chance to come to St. Paul next week, I think we'll give you a lot of more clarity on both product strategy and execution strategy to see why we have that confidence. But we're not blindly committed to Victory. We are constantly analyzing the business to make sure that we see the potential there, and so far we do.

Edward Aaron – RBC Capital Markets

On your current plan for the back half, do you expect that at the end of the year your inventory at the dealer level will be at a level where you would consider to be balanced?

Bennett Morgan

We feel really good about in this environment where we are with dealer inventory. Dealer inventories will continue to come down throughout the second half of the year. When you see industries under the kind of pressure they are under right now, we'd love to move it even a little further, but you've seen us take inventory down consistently over the last three years. We're down almost 45% from where we were three years ago in the channel.

We've taken it out each and every year even in declining markets and will continue to do so. And as we move towards MVP and as we continue to improve our speed and flexibility capability, our ability to drive further inventory reductions frankly is enhanced as we go forward. So we are feeling relatively speaking very good about our ability to deliver on that promise.


Your next question comes from Gregory Badishkanian – Citi.

Gregory Badishkanian – Citi

I have a follow up question on the neighborhood electric car. I'm not very familiar with that segment and you might have talked about this in the earlier part of your call but I apologize I missed it. Market size kind of margins of that whole segment and just kind of looking at it and seeing how much you can actually move the needle.

Scott Wine

The market size for this particular type product is about 35,000 units. We are not disclosing or analyzing margins or what we can do there. I will provide a little more clarity next week if you come out but it's an attractive space for us and we certainly like the technology applications across the portfolio.

Gregory Badishkanian – Citi

Maybe just a little bit of color in terms of inventory levels, in terms of promotions. You gave some good color on what you're seeing out there for yourselves, but even just the competition and have there been any changes in terms of how they're approaching promotions in the marketplace.

Bennett Morgan

As we said in the prepared remarks, and I think as we said really for the last couple of quarters, promotion levels in most of our industries are up or elevated. But they're within our expectations. You know some of the guys are doing the surveys. They seem to be picking up feedback from dealers and I think that's just stress in the marketplace.

Frankly we've seen elevated competitive inventory levels for a number of quarters. Frankly going on for a number of years and we've seen aggressive promotion levels. So this phenomena for us is really within our expectations and isn't anything that is beyond our plan. And frankly, as we can continue to enhance our inventory levels and our innovation and our product line, we've actually been able to moderate our levels in ATV's and still gain market share which has us very encouraged even in an elevated promotion environment that the strategy we have is working and will continue to work as we go forward.

Gregory Badishkanian – Citi

Across the board it's more promotional in every segment of leisure.

Bennett Morgan

The other advantage that we have again is as you look at it, as you come to St. Paul and you see the amount of product news we'll have next week, which I don't want to get into details, but it's good. We're selling new product and other guys are selling fairly dated moldy products and that's an advantage for us, a significant advantage.

Gregory Badishkanian – Citi

If you look at the product line up this year versus last year, are you a lot more excited about the new line this year as you were going into the dealer show last year?

Scott Wine

I'm always excited about that. I would tell you in our humble opinion, and it's an internal view, is that we've had industry leading product news in model year '08. We had industry leading product news last year in model year '09 and again, based on the behaviors we're seeing from our competitors, the vast majority of them aren't having a dealer meeting and at least the news we're hearing so far is, is zero to very, very minimal product news.

We clearly have industry leading news and it's again, I think if you get a chance to go to our show, you'll be amazed.

I like the joke that somebody forgot to tell our engineers that there's a recession going on. You'll see the results of that next week.


Your next question comes from Hayley Wolff – Rockdale Securities.

Hayley Wolff – Rockdale Securities

Can you talk a little bit about the investment you're going to put into the Breeze and then on distribution into these master plan communities, how does that work in the current real estate environment where you're not seeing many new communities popping up and distress real estate, and how does that all fit in, in that real estate backdrop?

Scott Wine

We're not going to disclose our investment to get into this although it's certainly moderate in levels compared to our typical product launches. The master plan communities are, there's a demographic shift in the U.S. that's while the real estate markets in those areas are pretty weak, there's still a long term trend of migration to those areas and as I said in my remarks, we really believe this is an under served market.

When you see the competitive advantages of our product, and that's why we were able to set up new dealers. If you think about this environment, asking a dealer to take on a new product line, they wouldn't do so if they didn't feel confident in their ability to retail it. And we've done quite well in getting the dealers that we wanted in the key master plan communities.

Hayley Wolff – Rockdale Securities

Where are they priced vis a vis a golf cart or some other form?

Scott Wine

Suggested retail is $7,499. Let me be clear, we are not competing with golf carts. This is an alternative neighborhood vehicle that can be used for golf, but we think the price is very competitive at $7,499.

Hayley Wolff – Rockdale Securities

And it's a street legal vehicle that I can go to the supermarket with it?

Scott Wine

In master plan communities it's street legal. We're at top speed less than 20 mph.

Michael Malone

The other real key thing to understand about this product news is that it's our first entry into this low emission category. It's an electric vehicle. It's got different technology than what we've had before. We're excited about the opportunity to learn about the technology and learn about the market, and we see the opportunities in low emission and electric to go far beyond this one product that we're introducing today.

Hayley Wolff – Rockdale Securities

Switching gears to motorcycles, why do you think the motorcycle market is so much weaker than some of the other power sport markets with the exception of boats maybe. And when you evaluate Polaris, initially when the product was developed, it was a much larger market and a rapidly growing market, and now you've had significant contraction, smaller market, less growth potential. What are some of the variables you used to consider whether you're going to stay with that business?

Scott Wine

First of all, why the market's down, partly because if you go back a year, motorcycles were selling very rapidly with the higher gas prices. So part of the significant downturn is just really tough comparables.

Also, it's a high ticket item and with many of our products, you can very legitimately argue there is a work use for it, a utilitarian use for it. You can't really do that with a motorcycle. It's just typically transportation if it's your only mean, but it's a little more discretionary we think than some of our other product offerings in the side by side space.

How we look at the future potential is very clearly, do we see profitable growth, and if we see a path, a risk adjusted path to profitable growth, we'll continue to invest and drive the business forward. And that's where we stand today.

Hayley Wolff – Rockdale Securities

Clearly you see that path.

Scott Wine

We do.


Your next question comes from Robert Evans – Craig-Hallum Capital.

Robert Evans – Craig-Hallum Capital

Can you give a little bit more granularity in terms of the ORV market in terms of what segments of core ATV and then the side by side did well, and what areas are struggling this quarter kind of looking forward to the second half.

Bennett Morgan

Just to give you a little bit of detail. In general, surprising the higher CC segments are performing better for us, so 500 CC's and up are doing well. Our new sportsman XP's are doing very well.

Anything in the market place where our sales or our competitors are able to play value, even relative value in the segment is doing well. The Canadian market place is generally out performing the U.S. market place. While we're not thrilled where we are in international, the international market place is relatively stronger still in ORV's than North America.

With that said, the side by side segments continues to out perform the ATV segment and in general, Rangers relatively stable and things like our hot new products are still in high demand.

Robert Evans – Craig-Hallum Capital

I think you gave us market data in terms of core ATV and side by side, can you give us relative to Polaris how trends were this quarter?

Bennett Morgan

We gained market share in both core and side by side.

Robert Evans – Craig-Hallum Capital

Is there one segment you're getting more share in than the other?

Bennett Morgan

As we talked about, we don't get the same kind of monthly granularity in side by sides as we do with ATV's, but you know that we've been able to successfully gain a tremendous amount of market share in side by sides over the last couple of years and in all honesty, I think that trend is continuing. We'll continue to gain a reasonable amount of share in side by side.

Robert Evans – Craig-Hallum Capital

Then on the warranty expense impact this quarter. I think you had mentioned it was a result of the snowmobile side and a little bit on Victory. Can you give us any sense of magnitude there? I was just wondering about a basis point impact, and just overall some color.

Michael Malone

I'm not going to give specifics on that issue itself. That issue was disappointing to us. We hadn't necessarily planned for that as we had done our plans and budgets so that was a detriment to our gross margins.

In total, the warranty expense that hit the P&L for the second quarter was about $9.6 million compared to $9.1 million a year ago, so it was somewhat higher than a year ago even though sales were down 24%, so you'd expect that number to be significantly less, and it wasn't and it wasn't primarily because of the snowmobile issue.

Robert Evans – Craig-Hallum Capital

And was that a one time? We shouldn't see that going forward?

Michael Malone

We believe so.


Your next question comes from Timothy Conder – Wells Fargo.

Timothy Conder – Wells Fargo

On the MVP program, you said 50%. I think that was in dollar terms, a year end goal. Is that still year end or were you saying with the launch of the new model year products here in the third quarter; you'll have 50% in dollar sales.

Bennett Morgan

Generally, just because of the timing on how we're executing that roll out of the program, we'll essentially go to 50% of our retail volume, is how we're describing that and that will be effective with this upcoming order period. That really essentially begins in August and September.

Timothy Conder – Wells Fargo

So a little bit earlier than you originally planned then.

Bennett Morgan

Maybe from what we communicated to you, this is what we had hoped we would be able to stand this plan was around the model year switch over, so we're essentially right on our plan. It's hard to do it in the middle of a traditional order period. You have to kind of break it based on when traditional order period end or begin.

Timothy Conder – Wells Fargo

And the feedback we get from the dealer base on that is that they're just very ecstatic about it.

Bennett Morgan

And I would tell you, I think we're optimistic. Again, we're still learning. We'll probably continue to get smarter and enhanced, but we believe the benefits will become even greater for some of those folks you're talking to six, twelve months from the line, because again, it's an evolution, it's a progress. So we're pretty excited about them.

Timothy Conder – Wells Fargo

It's very good feedback. On the gross margin side, what do you see that progress potential carrying on into 2010 or should we maybe, when you been on the road a little bit here, you talked more about things in terms of a net margin goal. But directionally, looking at 10, obviously 130 basis points improvement year over year is not sustainable going into 10. How should we directionally think about that?

Scott Wine

What I talked about before is that when we finished last year at net income margins at 6% and we think we've got long term potential to drive a couple hundred basis points in the bottom line and actually driving net income margin expansion. Part of that is going to come from gross margin expansion and then I'll let Mike talk about, we're not going to give 2010 guidance right now, but Mike, you want to provide anymore color on our ability to drive that?

Michael Malone

As I said in the prepared comments, we've been working this for quite awhile. What we're seeing significant benefits in cost reductions activities that are going to play into model year 2010 product which obviously continues into calendar 2010. So we would expect that that can be helpful.

We expect hopefully the currencies will be less harmful next year than they've been this year. We'll see. Who knows about that? It's hard to impossible for me anyway to predict what's going to happen there.

The commodity cost situation, we're planning on escalating. It's at historical lows right now. We don't think that that can continue forever, so our plans right now are that we're going to have to deal with an escalating commodity cost structure going forward.

So everything moves around and puts and takes, but at this point in time, Scott's right, we're not going to give guidance for gross margin for 2010, but I see no reason why we can't continue our trend of the last couple of years of expanding gross margins going forward.

Timothy Conder – Wells Fargo

Along that line, have you hedged out for the model year, looking at currencies and then also the commodities?

Michael Malone

We've actually been pretty active in that. The currencies as I said have been unfavorable from a year ago, but they've actually moved a little bit more favorable than they were a quarter or two ago. So we've leaned forward and hedged a fair amount as those moved more positive. So right now we're hedged 80% of our exposure for the balance of the year on the Canadian dollar. It's quite punitive to last year still, but a little bit better than what our earlier expectations were.

The Yen, we're hedged only about 30% for the balance of the year. We started to hedge the Australian dollar and we're hedged about half right now of the balance of the year on the Australian dollar.

On the commodities, we've also seen this favorability and have leaned forward with things like aluminum for instance where we've hedged quite a bit actually into 2010 of our aluminum exposure. Diesel fuel is another one that we've seen come down significantly from a year ago so we've hedge exposures on the diesel fuel as well throughout the balance of 2009. So we're trying to use opportunistic timing here to lock in where we can, some favorability.

Timothy Conder – Wells Fargo

Could you give us a little more color again or just go over again the change you did in the dealer hold back during the quarter?

Scott Wine

The idea there was, as you know our hold back is paid out to the dealers twice a year, in the first quarter and the third quarter. What we did was, we made an early payment in the second quarter of what normally gets paid in the third quarter to assist the dealers with improving their cash flow.

We recognize they're under a lot of pressure with the market environment the way it is and so we thought is was appropriate to kind of do a one time assistance to pay out early.


Your next question comes from Craig Kennison – Robert Baird.

Craig Kennison – Robert Baird

How are you thinking about the policy changes that you're seeing out of Washington relative to health care or cap in trade or potentially surcharge taxes on some of your customers? Is that something that may strategically affect you in any way?

Scott Wine

We actually thought we were having a decent call until now. Are you trying to end it on a really bad note?

On a serious note, it's very, very unhelpful. We're going through our strategic planning process now and part of the dampening down of our longer term outlook for demand that we don't create. We're confident in our ability to create demand, but for tailwinds coming back from an economic pickup, we are very concerned.

We work closely with NAM on what's going to happen with the employee free trade act, which is a terrible name. The tax implications of the health care policy is horrible. It's very, very concerning.


Your next question comes from Joseph Hvorka – Raymond James.

Joseph Hvorka – Raymond James

On your cost controls so far and operating expenses through the year and specifically in the quarter, your deepest cuts were in R&D which given that you're such a product driven company, why so deep and does this mean anything for products one year, two years, three years down the road?

Bennett Morgan

I actually, thought in my formal remarks we talked about that. I think based on what you've seen in model year '08 and model year '09 and what you're seeing in '10, we're not off the gas one bit. One of the benefits of this operational excellence initiatives and all the speed that we're getting and the stabilization of our platforms, we're just way more efficient in what we're doing in engineering. So we're getting new products to market much, much quicker.

So in essence, we're getting more for less or the same for less. So as I look at our product portfolio, what's in the pipeline, it feels good. There's not reductions. As much as we're trying to cut every penny, we're a product driven company and that's the last place we'll cut investment.

So I would tell you that's really a benefit of efficiencies on operational excellence and our speed more so than we've cut our appetite in R&D.

Scott Wine

That also applied not only to the R&D spend on the P&L but that also applies to the new product tooling investments that we'll make in Capex. Those investments are also coming down significantly year over year, but as Bennett said, we're not cutting to the bone there from a new product innovation perspective. We're just getting much more efficient with the operational excellence initiatives.

Joseph Hvorka – Raymond James

If I look at the declines there versus selling and marketing and G&A, would it be fair to say there's more fat there? You've got almost a 20% decline versus an 8% decline in G&A or 12% decline in selling and marketing? Was there just more room for improvement?

Scott Wine

There's some timing. I wouldn't necessarily say there's more room. It's timing related. Things tend to be a little lumpy quarter to quarter.

Joseph Hvorka – Raymond James

This is a six month number. It was down 25% in the quarter. Is down 20% kind of the number we should look at for the full year then or no?

Scott Wine

In that range.

Joseph Hvorka – Raymond James

You made a comment about the side by side inventory being up on a year over year basis but down versus the first quarter. Seasonally we should see a decline from 1Q to 2Q, right, or am I thinking of core ATV's?

Bennett Morgan

I think in general what we've seen historically is that you don't generally see a seasonal decline from Q1 to Q2. It's generally fairly flat. So we're encouraged by that trend and again, based on what you've seen what we've done with our shipments, that's in large part what's driving both of those sequential declines.

Joseph Hvorka – Raymond James

I think you commented that the side by side industry looks like the rate of sales decline was a bit larger in the second quarter for the industry. Is that also true for your product?

Scott Wine

No. Actually we saw sequential improvement in side by side sales from the second quarter versus the first quarter on a percentage basis for Polaris products. And again, as I said on the industry data, we all have to be pretty careful on that. We're trying to share information with you but in all honesty, it's not MIC level data or from a month to month basis, so we're getting directional feedback and that's why we tend to be a little bit broader in that range.

To me the first quarter, the second quarter, we didn't see a dramatic differences in behavior that I would call from an industry standpoint.

Joseph Hvorka – Raymond James

Or that the declines were similar?

Scott Wine


I want to thank everybody. That's all the time we have this morning. We look forward to seeing many of you next week at our dealer meeting and the rest of you, we'll also talk to you again in our third quarter call. So thanks again for participating.

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