By Jaime M. Katz, CFA
Morningstar's recreational vehicle coverage list includes two companies with sustainable competitive advantages and dominant market share positions: Polaris Industries (NYSE:PII) and Harley-Davidson (NYSE:HOG). Their strong brands, which command pricing power, and a large and intact distribution channel have built their advantageous positions. Entry into the manufacturing of off-road vehicles, motorcycles, or snowmobiles would require strong brand equity, superior technological innovation, and significant capital to set up a manufacturing facility. For existing rivals, a threat to Harley's and Polaris' leading share positions would likely come from the introduction of a compelling, innovative product in a new category (like Polaris' introduction of side-by-sides a few years ago in off-road vehicles). Either way, we believe we would have sufficient lead time to see a meaningful threat develop before having to reassess the moat status on either of these leading recreational vehicle firms.
We've Upgraded Harley-Davidson's Moat Trend to Stable From Negative Following a Review of Brand Opportunities Beyond Core Customer and Longer-Term Pricing Power Trends
While we originally thought Harley would face tenuous headwinds as its core consumer became a smaller proportion of the total population and could be challenged to penetrate new markets with its traditionally heavy displacement bikes, we now realize that we may have underestimated the universal appeal of Harley's brand. Our previous negative moat trend rating was based on concerns that the company would find it difficult to penetrate new audiences outside its core customer (Caucasian men older than 35) with its traditionally heavy displacement bikes. However, recent customer segment data suggests that the Harley brand may carry more broad appeal than we initially believed. During the past four years, the firm has made significant inroads into key outreach categories (African Americans, Hispanics, women, young adults), which now comprise 30% of all new domestic bike sales.
The company has already achieved the number one market share position in its outreach segments, but we believe significant strides in volume sales could still be made here. Although the populations of men and women are growing at practically the same rate, Hispanics and African Americans are growing significantly faster than the core consumer base, offsetting the slow decline in the Caucasian segment, and we contend that Harley should be able to continuously gain greater penetration with these expanding demographic groups.
We still think Harley has pricing power as the company commands a premium price because of a strong brand identity.
We expect that the company will be successful in carrying its pricing power into outreach markets, and that it will not need to discount to entice new consumers to try the brand. More important, we believe the company will offer targeted promotions, but will not lower MSRPs in order to protect Harley's premium brand image. We verified bike pricing strength by assessing both prerecession and postrecession periods, and noted that similar touring models had experienced rising prices, with special-edition products offered at materially higher prices than other touring models prior to the recession. This indicated to us that while the increases may be light in some years, the company can still raise pricing over an economic cycle.
Additionally, Harley's average pricing across most categories remains at a premium to its competitors. The superior pricing power tells us two important things. First, the brand is still well received--prices higher than the nearest competitors would be unsustainable if the company brand was weakening, unit volume growth was slowing, or market share was shrinking. Second, Harley is not sacrificing price to entice new customer segments to engage with the product, which is key in continuing to generate compelling operating margins in outreach segments. We sought the models that were being marketed to women on Harley's and their competitors' websites, and were pleased to find that the pricing on an outreach segment's models crossed multiple price ranges, rather than focusing on only low-end price models to entice new users. Longer-term, we believe this illustrates that margins will not be sacrificed for volume.
Moreover, Harley's pricing power continues to be key in driving both revenue and gross margin expansion. Over the past three years, Harley has been able to maintain or increase prices as the domestic consumer has begun to recover from the last economic downturn. As the economy continues to strengthen, we expect Harley's pricing power to continue to grow. Leading into a period where outreach customers are becoming a larger part of the overall domestic sales mix, this pricing power could set gross margin growth on a much faster trajectory than we currently anticipate as unit volume picks up speed.
Harley's ability to maintain pricing as it increases its international penetration (international now accounts for 35% of consolidated sales, up from 19% in 2005) also contributes to our updated stable moat trend rating.
We think management could easily convert a similar marketing campaign from its domestic outreach markets to international markets, helping penetrate a broader consumer base abroad, which could boost international sales significantly (we expect international sales to encompass 42% of the firm's consolidated total by the end of our 10-year explicit forecast). Abroad, Harley remains focused on countries like Brazil, India, and China, where it can market to very high-income customers, creating an even more aspirational brand image than Harley has at home. This premium positioning should allow Harley to continue to charge lofty prices for its products in these newer markets, and the ability to assemble bikes in both Brazil and India should help maintain superior profitability, as the company is able to escape excessive tariffs through its CKD facilities. The addition of more than 100 dealers in these younger markets in the five years leading up to 2014 will help propel the marketing message to a naive consumer. The ability to manufacture more custom bikes should appeal to international consumers, as they can choose motorcycles with smaller frames that lend better to the infrastructure in Europe and the smaller-statured consumers in Far East economies.
In our view, the incremental market share Harley could gain from a marketing push in these newer customer and geographic segments would further strengthen the company's wide moat status and help make up for the lost unit volume it has experienced over the past five years. We remind investors that despite the fact that Harley-Davidson continues to steal share in a market that it already dominates, the U.S. remains a market that is materially smaller than it was in the past, even when including international sales, which continue to exhibit steady growth.
We believe Harley has the infrastructure in place to support outreach/international consumer demand for the brand.
Since the end of 2008, Harley has reduced its manufacturing footprint by 38%, consolidating its Wauwatosa and Menomonee Falls facilities and eliminating its East Troy, Wis., and Varese, Italy, locations that produced the Buell and MV Agusta brands (which are no longer produced by Harley). We expect the final 15% reduction in the manufacturing square footage to occur during 2013 as the motorcycle wheel production in Australia gets outsourced and that location's lease expires. The lower overhead cost offered through better utilization at fewer plants will certainly benefit the company's operating profits for years to come, boosting the already better-than-average operating margins that Harley offers. As a result, we forecast that selling, general, and administrative costs as a percent of sales will drop from 20% in 2012 to just 18% by 2014.
In addition, the company's new flex capacity initiative, instated at York in 2013 and expected to kick off at the Kansas City facility in 2014, will help improve Harley's operating line. Besides positioning Harley for a materially better utilization rate at its plants, it offers the company lower labor costs and increased matching of costs and revenue. The cost and revenue matching is expedited through a two-pronged approach. First, it has trimmed its dealer base, which now has around 1,450 dealers, to include only the best-performing distributors (while removing the worst performers), which means units will likely be moving faster through a more consolidated channel, making inventory easier for Harley to manage.
Second, the changes to manufacturing, where any bikes can be produced on a single line, ensures that the company can quickly fulfill dealer requests, better matching supply and demand. We think this keeps Harley dealers engaged as dealers have less aging inventory, which quickly becomes less relevant on their show floors. Having the right manufacturing process available to better match supply and demand should minimize discounting and preserve pricing power while allowing Harley to be the most efficient motorcycle manufacturer (which should help boost ROICs over our 10-year explicit forecast period).
Adjusted ROICs (without goodwill) have averaged 24% over the past five years, and we think that it will increase easily to above 30% in 2015. In our view, the firm will be able to sustain a mid- to high-single-digit top-line growth over the next five years at a minimum, driven by unit demand from outreach and international customers and low single-digit price increases. We project that operating margins will also improve over time, as the company continues to capitalize on its nearly completed restructuring plan, which incorporates a leaner manufacturing profile and improved labor costs (flex capacity utilizes union workers with no benefits). Additionally, as we experience a period of more stable commodity costs, the benefit of price increases should flow straight through to the bottom line.
Valuation of a premium brand remains lofty.
Our $52 per share fair value estimate includes expectations that the company creates compelling products that allow it to pass along steady, minimal price increases to the end user and continues to grow its outreach consumer base. Over the next decade, we forecast that pricing can grow in the low-single digits (with a 2% increase in 2013), while units grow at a midsingle-digit pace. Our forecast includes gross margin expansion to 37% thanks to the restructuring of manufacturing and lower commodity cost pressures. Operating margin expansion of more than 300 basis points could occur over the next decade, which brings Harley within about 100 basis points of peak historical operating margins.
We deem Harley's valuation fair based on the company's opportunities, despite the fact that there aren't any competitors close to catching Harley in its biggest market (with nearly 60% of retail registrations domestically), which offers the company's multiple some stability. Additionally, we could see some near term multiple expansion as lean initiatives that are close to completion could improve operating margins for the company through at least the end of 2014. Longer-term, we think additional operational improvements could be difficult to achieve unless volumes tick up materially. Although the stock is trading above our $52 per share fair value estimate, its trailing twelve month price/earnings multiple remains below its three-year average. We would still wait for a pullback for entry into shares, as shares have risen 21% over the past 12 months, while the market (S&P 500) has increased 22%.
Growing Brand Equity and Design Patent Provide the Foundation for Polaris Industries' Narrow Economic Moat
Polaris is the leading powersports manufacturer based on number of units produced. More than 60 years ago, Polaris started to build its reputation and brand by producing snowmobiles, but in the decades since, the company has wisely expanded into all-terrain vehicles, motorcycles, small vehicles, and for a short period, personal watercraft, building a recreational and utilitarian vehicle powerhouse. Holding leading market share positions two of the three categories in which it operates has ensured the company's brand remains relevant and helps us remain confident regarding Polaris' favorable growth prospects.
Design patents offer a unique intangible asset in the powersports industry. With what appears to be the best product in the off-road vehicle market ( side-by-sides), we think it will be hard for competitors to catch Polaris. We note that the company has patents that will protect specific aspects of its side-by-side design for close to the next 20 years, which has made it difficult for competitors to produce a compelling side-by-side product in response to Polaris' current product line. Specifically, the assembly is protected, which includes a transmission placed strategically under the rear of the vehicle, keeping the center of gravity for the engine low. In addition, Polaris design permits for the fuel tank to be under the seating surface of the passenger side, which improves the balance when only the driver is present in the vehicle. Also, the battery is located under the driver seat, which also improves balance.
Overall, the placement of these (and numerous other) parts provides a better center of gravity and thus an improved riding experience. Competitors need to put these parts in alternate positions under their vehicles, making the end product significantly less stable and thus less desired. We estimate that side-by-sides comprise about two thirds of the off-road vehicle category, or approximately 40% of the total company revenue. For trail models (approximately 50 inches in width) we believe competitors will find it very difficult to replicate the experience, while we note that these concerns are somewhat easier to get around in larger models offered by competitors.
Distribution channel is vital in accomplishing growth in retail sales. Although Polaris has an established base of more than 1,600 dealers, the distribution channel is relatively weaker than Harley's as Polaris dealers are not dedicated (it shares dealers with competitors of other recreational vehicles). Despite this, we believe the distributors it is engaged with are loyal to the firm as they move the most powersports unit volume through the channel--Polaris captures more than 25% of the market share in both snowmobiles and off-road vehicles. Additionally, creative dealer programs, like Maximum Velocity Program, or MVP, and Retail Flow Management, or RFM (where dealers order fewer units more frequently), ensures units are delivered through the channel faster than in the past and allows dealers to obtain the right inventory when they need it, which subsequently better matches supply and demand. This ultimately helps the dealer's profit margin, which we believe keeps the distributors satisfied. The strength of the dealer channel and the brand, along with best in class manufacturing (discussed below) are key reasons we think Polaris' narrow economic moat will remain intact for the foreseeable future.
Although part of Polaris' brand equity comes from snowmobiles, both on-road and off-road vehicles have turned this established company into a growth business through vision and innovation, particularly over the last decade. These newer segments are what the company will lean on to maintain and improve its moat position, as snowmobile industry demand remains depressed vs. historical levels, despite unit sales ticking up over the past two years. However, while the market at home is languishing, we think Polaris can still grow the snowmobile segment through international expansion. In total, only 31% of snowmobile units are sold outside North America, and we believe the company can both steal share and increase unit volumes as it increases its visibility overseas through some of the distributors it's gained from recent acquisitions. We forecast snowmobile segment sales to grow in the low-single-digit range over the next decade and to surpass $300 million in 2015.
Since snowmobile sales are highly dependent on weather, Polaris' other segments, on-road and off-road vehicles, help smooth seasonal volatility in sales and build brand loyalty across additional consumer categories. Polaris has used its strong reputation for innovation beyond snowmobiles and into its other segments. We see this clearly in off-road vehicles, currently the most important segment for Polaris, representing nearly two thirds of total sales (and we expect it to remain so for at least the next decade). In 2012, the company was number one in off-road vehicles domestically, experiencing growing market share in both side-by-sides and all-terrain vehicles. A widely recognized brand, topnotch innovation, and smart patenting will help keep Polaris ahead of its competitors.
Current patents allow the company to design side-by-sides with certain parts strategically under the chassis, ensuring that Polaris' side-by-sides offer the most stable ride. While the side-by-side business has garnered a lot of buzz in recent years, the traditional utilitarian side of the business still represents about one third of total ORV sales, which we think bodes well for the company. Replacement of utilitarian products should be more consistent and frequent than replacement of products that are primarily for leisure, supporting stable growth; we think off-road vehicle segment sales will surpass $3 billion in 2015 with help from newer categories like military and Bobcat-branded products.
On-road vehicles (which represented only 7% of total sales in 2012) is the segment that could have the most growth potential and surprise to the upside over the next few years. Historically, this segment consisted solely of Victory motorcycles, a brand that represented less than 5% of sales in the domestic heavyweight market. Over the past few years, management has pieced together a more significant stake in the area including acquisitions in GEM, Goupil, Aixam, and the historied Indian motorcycles brand. All four of these brands address needs or wants that the company previously had no exposure to and, more important, offer a distribution network abroad, which was fairly rudimentary prior to these acquisitions.
Although strong brand equity and patented designs allow Polaris to maintain its dominant position, having competitive manufacturing facilities in strategic locations gives the company the ability to remain an efficient and low-cost competitor, helping solidify the firm's narrow economic moat. Last year the company opened its first factory in Monterrey, Mexico, aiding distribution in the Southwest and engaging labor at competitive rates.
Polaris also has an extra 380,000 square feet coming on line in Milford, Iowa (adjacencies and capacity); more space at Spirit Lake, Iowa, for liquid paint; expanded room at Roseau, the acquired Aixam plant for small vehicles; and an entirely new facility for production in Poland to cater to European ATV demand (set to be completed in the second half of 2014). In addition, new vehicle production in India through the company's joint venture with Eicher will provide Polaris with quick distribution to the Far East (and possibly a better tariff position), increasing the company's visibility and footprint significantly. While we would expect a nearly 60-year-old company to have to reduce capacity, it seemed imperative that Polaris increase capacity to match the growing demand for expanded product lines so that it could maintain and grow its already impressive market share, helping strengthen the company's narrow moat.
All of these factors combined protect Polaris' competitive advantage and ensure its sustainability over the long term. We think the enviable position it holds in the production of recreational vehicles will easily persist for at least the next decade.
Adjusted ROICs have averaged 32% over the past five years, which we deem impressive through a trough of an economic cycle. In our opinion, Polaris can earn ROICs that are well above 30% after adjusting for excess cash and goodwill, which is significantly higher than its nearest competitor, Arctic Cat. Our forecast incorporates low-double-digit top-line growth over the next five years at a minimum, supported by growth in adjacencies, new acquisitions, and continued organic growth in existing product lines. As unit volumes increase, operating margins should expand in tandem, helping overall profitability metrics improve and keeping ROICs on a positive trajectory.
Polaris remains the company with more promising growth prospects out of the two companies.
Since April we have held our $95 per share fair value estimate, which expects revenue to continue to grow at a 12% compound annual growth rate over the next five years through acquisitions, innovation, and international expansion. Our forecast includes revenue growth of off-road vehicles at a low-double-digit rate, while snowmobile sales rise at a midsingle-digit pace and on-road grows even faster, at a midteen rate, thanks to recent acquisitions in the segment during the period. We expect that more stable pricing through the distribution channel will help improve gross margins due to the implementation of programs like MVP and RFM, which permit a more frequent dealer ordering pattern, preventing stale inventory on showroom floors. This should flow through the income statement, helping grow both net income margins and earnings per share over the next five years.
We admit there could be concern over whether Polaris is pursuing too many opportunities at once with the number of acquisitions it has pursued, stretching leadership talent thin, but there has been no indication thus far that this is the case. In fact, we think most of the company's acquisitions were accomplished at reasonable prices, likely generating positive ROICs for the business quickly. Polaris remains a leader in both snowmobiles and off-road vehicles, and we believe competitors would be hard-pressed to replicate the quality and innovation that the company has implemented in its product line. Although shares approximate their three-year trailing 12-month price/earnings ratio, the stock trades around our $95 per share fair value estimate, and current year earnings per share are expected to grow 15%-18% (up from the original management outlook for earnings growth of 10%-15%), which we view positively.