Polaris Industries, Inc. Q3 2009 Earnings Call Transcript

| About: Polaris Industries (PII)

Polaris Industries, Inc. (NYSE:PII)

Q3 2009 Earnings Call

October 15, 2009 10:00 am ET

Executives

Richard Edwards – Investor Relations

Scott W. Wine – Chief Executive Officer

Bennett J. Morgan – President and Chief Operating Officer

Michael W. Malone – Chief Financial Officer

Analysts

Greg [Inaudible]

James Hardiman

Tim [Conder]

Bob Evans

Edward Aaron

[Alexander Fodor]

Operator

Good morning. My name is [Tanika] and I will be your conference operator today. At this time I would like to welcome everyone to the Polaris third quarter earnings result conference call. (Operator Instructions)

I would now like to turn the call over to Mr. Edwards. You may begin.

Richard Edwards

Thank you Tanika, and good morning and thank you for joining us for our third quarter 2009 earnings conference call. As in the 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 these factors may be found in Polaris’ 2008 annual report and in the 2008 Form 10-K, which are on file with the SEC.

Now we’ll turn it over to Scott. Scott?

Scott W. Wine

Thanks Richard. Good morning everyone and thank you for joining us.

It was almost exactly a year ago I was conducting my first earnings call for Polaris. At that time we reported record sales and earnings per share for the third quarter of 2008 and also discussed a very uncertain economic outlook. We’ve been through a great deal in the past 12 months and this team has accomplished quite a lot. I’m proud of the fact that once again we exceeded our expectations for the recently ended third quarter.

Net income of $31.2 million for the quarter equates to earnings per share of $0.94, both down 17% from the prior year period. Sales for the quarter were $436.2 million, down 25% from the third quarter of 2008. Retail demand remained weak across almost all regions and markets, although we continue to see trends moving in the right direction, especially for our industry leading side-by-side products.

We do not ever plan to get comfortable with large sales declines, but I do like the way we’ve managed through this downturn. Volume was again lower in all product lines, but overall we cut production and shipments more than the retail sales decline, which enabled us to bring down dealer inventory and also gain share in our largest product line, the off-road vehicle division.

Our smallest business unit, Victory Motorcycles, had another difficult quarter with revenue down 56% on a slightly smaller drop in retail sales. We made significant changes and progress in the Victory business during the quarter and managed to achieve a small share gain in September, providing better traction going into the fourth quarter.

Outside the U.S. we saw sales and shipments in Canada outperform the U.S. market for the sixth quarter in a row. Europe was down only slightly less than the 28% drop we saw in North America. We continue to benefit from positive pricing and mix from our strong product line up, but took a small hit from currency which we expect to turn around and be favorable in the fourth quarter.

We made solid progress with our gross margin expansion efforts in the quarter. Despite a 25% top line sales decrease, we improved gross margins by 160 basis points, enabling us to deliver $31.2 million in net income, a 17% decline. One of my major initiatives to insure that our gross margin improvements actually drive an increase in our bottom line. We demonstrated our ability to do that in the third quarter as our control of expenses and all other aspects of the P&L drove a 60 basis point net margin improvement from the same period a year ago.

Our teams have developed tools and processes to insure our margin expansion is sustainable. And we expect to have another strong performance in the fourth quarter. Lower product and commodity cost and better pricing will continue and we expect to have currency turn from a headwind to a tailwind to finish the year.

I like to use the quarter to look at retail sales to dispel any thoughts that this will be a V-shaped recovery. While we have seen improvements in all product lines except Victory in the third quarter, the 17% decline in North American retail sales was a stark reminder that this remains a difficult time for consumers. We are operating under the premise that we must make growth happen and we continue to find ways to outperform the market.

With solid programs in place and a very strong model year ’10 line-up we did see demand improve as the third quarter progressed. Side-by-side continues to lead the way with retail sales down mid-single digit percent in the quarter and even a smaller drop in September. While still down significantly, core ATV’s had their smallest percentage retail drop since the spring of 2008.

As we progress into the fourth quarter we’ll benefit from easier comparables, but it is worth noting that retail sales grew 3% in October of last year so we really only have two months of easier comps. Our expectation is that North American retail sales will be down about 10% in the fourth quarter.

One reason we have confidence in our fourth quarter outlook is due to the strong reception of our expansive model year 2010 product launches. This summer we unveiled more than 25 new models across our product lines. Our order solicitation has slightly exceeded our expectations and provided welcome momentum as we work to close out a challenging year.

The interest in and orders for our new Electric Ranger exceeded expectations and we remain excited about the potential for that product and that technology. We gained access to another 30% of the side-by-side market with the launch of the value oriented Ranger 400. And the Victory team was not about to be outdone and impressed our dealers, customers and industry press with two exciting new touring bikes. Innovation remains a strength and a competitive advantage for Polaris.

Partly because of our strong new product lineup and certainly because we continue to assist our dealers in reducing inventory, we are seeing surprising strength and stability from our dealer network. Our Max Velocity Program rollout continues to go well, which helped drive dealer inventory down 18% in the quarter. Our joint venture relationship with GE via Polaris acceptance continues to provide access to wholesale credit for our dealers, which is certainly an advantage in the industry.

We have seen a decline in the number of repossessions throughout the year and still expect to maintain dealer terminations below 5%, which is in line with our historical annual turnover.

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 J. Morgan

Thanks Scott. We’ll start with off-road vehicles. Our off-road vehicle business performed to our expectations in the third quarter, with wholesale sales down 30% off of stout third quarter ’08 comparables. ORV markets appear to have stabilized. We have not seen signs of significant improvement in the markets yet.

North American ATV industry retail sales are down high-20’s percent year-to-date and while we don’t have clear industry data for side-by-sides we believe it is down mid-teens percent year-to-date. We have sequential improvement from both the industry and Polaris in the third quarter versus the previous quarters.

Polaris continues to gain solid amounts of market share in both ATVs and in particular side-by-sides. With our strong Ranger and Razor lineups we saw our side-by-side retail sales improve to down mid-single digits in the third quarter. Our model year ’10 July dealer meeting was a resounding success in our home state of Minnesota as we entertained our dealers at our Wyoming Worldwide Product Development Center. We once again are the most aggressive OEM in introducing innovative new products for both side-by-sides and ATVs.

Our entire Ranger lineup received more horsepower and we introduced an all new mid-size Ranger 400 at a value price of $7,999 which has received fantastic reviews. In addition we introduced our first off-road low emission vehicle, the electric powered Ranger EV which Scott mentioned. In ATVs we introduced a full lineup of value priced products for most key ATV segments, as well as expanding our award winning Sportsman XP chassis in the two all new two up touring models.

ATV dealer inventories are down over 30% in North America versus a year ago at this time and down double digits percent versus just 90 days ago. With the strong new model lineup and the managed dealer inventories, orders from dealers exceeded our expectations for both ATVs and side-by-side products at the show and we are well positioned for the upcoming quarters from both a business and competitive standpoint.

Our military business had a strong quarter with sales up well over 50%. More importantly, we secured a number of future orders with a growing number of new customers including a large order for Ranger Cruise for the National Guard.

Snowmobiles. Third quarter wholesale sales were down 13% and as we expected Polaris and the industry have gotten off to a slow start for the season. Early season industry retail sales are down double digits with Polaris down more. This was expected with the lower snow check sales and the planned late fall shipment of the award winning new Polaris Rush Snowmobile.

Consumer attendance has increased at the fall shows and there is a ton of excitement. In particular, for the new Rush model which was recently named Snowmobile of the Year by Snow Blower Magazine, the industry’s largest publication.

Less than 10% of the season’s retail has occurred so the next 120 days as they do every year will be the critical retail months for the industry and Polaris. Dealer inventory levels for the industry and Polaris are in solid shape and based on these factors we remain cautiously optimistic about the upcoming snowmobile season.

On-road vehicles and Victory Motorcycles. The overall motorcycle industry and Victory continued to disappoint in the third quarter. Total North American motorcycle industry retail sales improved versus the second quarter, but were still down mid-30s percent. In the segments Victory competes in, heavyweight cruiser and touring segments, the industry performed slightly better. Victory retail sales declined a little bit more than the industry and we lost a little bit of share in the third quarter due primarily to competitive discounting activity.

Third quarter sales to dealers declined 56% as we continued to aggressively reduce shipments to assist dealers in reducing inventories. Dealer inventories continue to come down. They’re down 22% from a year ago but remain higher than we and our dealers would prefer. We are not satisfied with our progress on the retail and inventory fronts. And we have made additional investments, including increased promotions, personnel additions, product lineup streamlining, adding new value priced model options and international market expansion to insure that we are more competitive in this challenging motorcycle environment.

The summer dealing meeting was a significant success for Victory as all of our new model year ’10 cross country and cross road touring bikes received rave reviews from the press, our dealers and consumers. We expect these new models will greatly increase our reach in the large and the lucrative touring segment and drive market share expansion in the upcoming quarters.

Model year ’10 Victory orders slightly exceeded expectations, which is encouraging. But we will continue to actively monitor retail sales to insure that we maintain appropriate inventory levels in the field.

During the third quarter we began our first shipments and actually had our first retail transactions in our newest adjacency, our low emission electric vehicle for Master Planned Communities. We are currently in five communities with a plan to be established in nine communities by year end. The early consumer traffic and response has exceeded our expectations and we continue to learn more about this new market. Our dealer business model is based on a variant of our MVP program and early dealer feedback has been positive.

Parts, garments and accessories. PG&A had a decent quarter with sales declining by 11% which once again outperformed our overall Polaris business. Gross margins expanded impressively and we are seeing outstanding productivity gains from our Vermilion operation despite the lower volume environment. Innovation remains strong with over 200 new accessory products introduced for model year ’10. Third quarter program orders from dealers exceeded our expectations and our daily order volume appears to have stabilized and is showing modest directional improvement.

International. International sales were down 24% in the third quarter, a modest improvement versus the first half of the year. As in North America we are seeing markets stabilize, with some beginning to show modest signs of directional improvement. The overall European off-road vehicle market continues to be down mid-20s percent with Polaris gaining a nice amount of market share thanks to our innovative products and our strong distribution. Victory has achieved 5% market share position in the UK heavyweight cruiser market and we are poised for an excellent start in Germany based on our dealer additions and our pre-sold model year ’10 product retail sales.

Operational excellence. Our focus on quality, cost and speed continue to pay big dividends. Inventories at both the factory level and dealer levels continue to be significantly lower than a year ago, both down 18%. Our cost position continues to improve significantly as we see the rewards of our value engineering, low cost country sourcing efforts and benefits from favorable commodity costs. Together, these activities drove gross margin improvement of 160 basis points in the third quarter. We expect to continue and accelerate this momentum in the fourth quarter.

We increased our MVP roll out to about 50% of our North American dealer retail volume in the third quarter. We’ve been able to manage the additional dealers and handle the more rapid order cycles effectively. MVP dealer orders and retail performance has performed within our range of expectations. And while we and our dealers continue to learn and improve this new business process, we are growing increasingly confident in our ability to execute this model successfully and that it will lead to competitive advantage for Polaris and our dealers in the long term.

MVP should allow both our dealers and Polaris to be more nimble and better positioned to weather the current environment, while being able to more quickly respond to the emerging market opportunities as conditions improve.

Our operational excellence progress has Polaris in a stronger, healthier position than when we entered the recession. It is enhancing our product innovation and is the fuel behind much of our success.

With that I’ll turn it over to Mike Malone, our Chief Financial Officer.

Michael W. Malone

Thanks Bennett, and good morning everyone. As Scott and Bennett mentioned we are very pleased with our third quarter results in this difficult economic environment. Our cost reduction initiatives are producing positive results and the momentum we have drives our expectation of continued benefit going forward. As before, my comments this morning will be related to updating our 2009 guidance with some reference to actual third quarter results to highlight a few specific points.

I’ll begin with financial services. Income from financial services for the third quarter 2009 declined 12%, largely due to a decline in income from retail financing as our sales volumes and penetration rate has declined compared to last year. Income from financial services for the full year 2009 is expected to decline about 20% from the full year last year, which guidance has narrowed from previously issued guidance.

For the third quarter we financed through our retail credit programs, HSBC, GE and Sheffield combined about 35% of Polaris products sold to consumers in the United States, which improved sequentially over the penetration rate we experienced in the first half of the year. The approval rate in the third quarter increased to 52% compared to 46% for the first half of ’09. Sheffield, our newest retail credit provider, continued to gain share of the installment financing provided to our consumers during the third quarter.

During the third quarter the wholesale portfolio related to the floorplan financing for dealers in the United States was approximately $563 million, a decrease of 16% from a year ago third quarter, reflecting the decline in the dollar amount of dealer inventories. This 16% decline is in dollars. The units outstanding in the portfolio in the United States are down 24% compared to last year, due to the mix change to higher priced side-by-side inventory.

Credit losses in the dealer wholesale portfolio remain very reasonable, averaging well less than 1% of the portfolio. During the third quarter we continued to see a modest number of dealer failures, repossessions of inventory and credit losses as expected. But these issues were well within our expectations as Scott mentioned earlier.

The actual gross profit margin percentage generated for the third quarter was 24.1% compared to 22.5% in the third quarter a year ago, a 160 basis point improvement. The primary driver of the improvement in gross margins was a focused attention on taking costs out of our products, both from an engineering perspective and adjusting our manufacturing capacity and cost structures to help minimize the fixed cost absorption impact of the lower production volumes resulting from the lower sales.

The gross margin percentage in the third quarter continued to benefit from commodity and transportation cost decreases, higher selling prices and a positive mix change. These gross margin benefits in the third quarter ’09 were somewhat offset by higher Victory promotional costs and by the negative currency movements in Canada, Europe and Japan compared to last year.

However, in the fourth quarter ’09 currencies are expected to turn positive for sales and gross margins, given the dramatic move in currencies in the fourth quarter of a year ago. Taking into account the year-to-date improvement in gross margins and the benefit of the cost reduction initiatives in place, and changes in currency rates, we now expect the gross profit margin percentage for the full year 2009 to improve in the range of 150 basis points to 180 basis points over what was generated a year ago. This implies a significant improvement in our gross margin percentage for the fourth quarter of ’09, upwards of 230 to 320 basis point improvement. We are confident in these projections, given the success we have experienced in taking costs out of our model year 2010 products, in addition to ongoing benefits from higher selling prices, lower commodity costs and the lower ATV promotional cost environment.

Moving now to our balance sheet and liquidity profile, our debt position finished at $200 million at the end of the third quarter which is $20 million lower than a year ago. We continue to have ample borrowing capacity under our attractively priced, long term $450 million banking arrangement.

As Bennett mentioned, factory inventories at the end of the quarter were $220.8 million, an 18% decrease from a year ago. We expect factory inventory levels to continue to decline during the fourth quarter to below $200 million at year end.

Accounts receivables of $88.1 million at the end of September, 2009 is up 14% from a year ago, entirely due to a delay in the timing of collection of the floorplan receivables from GE in Canada. We now collect those receivables in 30 days rather than just a few days as we did in the past.

For the year-to-date period we have made appropriate and more efficient investments in the business through capital expenditures and new product development tooling totaling $35 million, which is 40% lower than a year ago. For the full year ’09 we expect our appetite for capital expenditure spending to be in the range of $50 to $55 million, which is significantly lower than last year. We will continue to invest in tooling for innovative new products and targeted investments in capital projects to reduce our production costs and improve efficiencies to continue to improve our product margins.

We expect depreciation for the full year 2009 to be in the range of $60 to $65 million, unchanged from previous guidance.

Operating cash flow provided by operating activities was $111 million for the third quarter of ’09 and actually increased slightly over the third quarter a year ago. For the nine months year-to-date, we’ve generated $102.5 million of operating cash flow, down 23% from last year. The decreases in net income and the decrease in accrued expenses for the year-to-date period compared to last year are the primary reasons for the decline in our year-to-date operating cash flow. We continue to expect cash flow provided to decrease for the full year 2009, in line with the percentage decline in net income, but well above the net income level in dollar terms.

During the first nine months 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 from our Board of Directors to repurchase, but as I have stated in the most recent past calls, we have taken a different approach this year and are being more conservative in share repurchases for the foreseeable future.

During the third quarter we once again paid a cash dividend of $0.39 per share, which represents a 3% increase over a year ago. And we expect to continue to pay the dividend at that rate for the balance of 2009.

Guidance for the full year 2009 has been raised and narrowed to reflect the actual results generated from the first nine months and our current outlook for the remainder of the year. Total company sales guidance has been narrowed and is now expected to decline 20 to 22% for the full year, with the individual businesses as follows. Off-road vehicles is now narrowed to down 22 to 24%. Snowmobiles have improved to down 12 to 14%. On-road and Victory motorcycles has narrowed to down mid-40% range and PG&A has improved to down 11 to 12%.

Gross margins for the full year are expected to expand in the range of 150 to 180 basis points for the reasons I explained earlier.

Operating expenses are expected to decrease significantly in dollar terms for 2009, down in the mid-teens percent or around $40 million as we continue to aggressively deal with the reality of lower volume environment. Operating expenses will increase as a percentage of sales for the full year 2009 due to the lower sales.

The income tax provision was recorded at a rate of approximately 32.1% of pretax income for the third quarter of ’09, which is higher than last year due to a lower amount of favorable tax events compared to last year. For the full year ’09 our expectation is that the income tax provision rate will be in the range of 33.5 to 34% of pretax income, slightly better than the previously issued guidance.

Earnings per share for the full year 2009 are now expected to be in the range of $2.92 to $2.98 per diluted share, which is a decrease of 15 to 17% compared to the full year last year.

Guidance for the fourth quarter 2009 is as follows. Lower company sales are expected to decrease in the range of 12 to 17% from the fourth quarter of last year, due primarily to an expected continued decline in the total company retail sales in the fourth quarter. Earnings are expected to be in the range of $1.19 to $1.25 per diluted share for the fourth quarter, an increase of 7 to 13% over the fourth quarter a year ago.

In conclusion, we are very pleased with our results given the economic environment and are confident in our ability to finish the year strong. Assuming we achieve our fourth quarter guidance range, the result will be the highest net income and earnings per share quarter in the company’s history, evidence of our ability not only to weather but actually thrive in this current economic storm.

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

Scott W. Wine

All right. Thanks Mike. Overall we had a solid third quarter and as you can tell from our comments we feel good about how we’re positioned to finish the year. Our commitment to staying on strategy while also aggressively reducing costs has put us in a position of strength to prepare for the challenges of 2010.

We are still in the early stages of our official planning for next year, but I will offer a few initial thoughts. As I mentioned earlier, we do not expect a V-shaped recovery and are not planning on any tailwinds from the U.S. or our key international markets. While it is possible that GDP will grow 2 or even 3% next year, we expect consumer demand to remain muted by high unemployment and an overdue period of increased personal savings.

We have proven that we can manage through tough times and still improve our business fundamentals. We are committed to being the best in power sports and will continue in 2010 to invest wisely in our business and products to prepare us for the strong economic growth that will ultimately come.

We will continue to diversify and seek growth outside of North America, as we add more investment to our business in Europe, the Middle East and Africa as well as South America and most recently, China. Our new general manager has been in China for several months now and we are encouraged by his progress to help us establish strong distribution and a foothold in that important and growing market.

We will likely make at least one acquisition in 2010 and are pleased to have Todd Balan on board as our Corporate Development Officer, to insure we execute on only the best opportunities to accelerate growth and profitability and to enhance shareholder value. We will stay on the gas with operational excellence, which will be a key part of our ongoing margin expansion efforts. The opportunities for us to improve quality, cost and speed are real and we are committed to capturing the benefits for all player stakeholders.

2010 will be an important year for our newly formed on-road business, as we drive much needed improvements in our Victory business to help both margins and our top line and accelerate the growth of our new low emission vehicle product line. We anticipate continued growth in our military business and expect our Bobcat relationship to begin generating revenue and profit in the second half of 2010.

In summary, we are preparing for a challenging year but feel confident that we have stayed on strategy and have made progress in 2009 that will enable Polaris to return to the limited top line growth and continued margin expansion in the year ahead. Our primary focus right now is closing out 2009 on a strong and positive note and I am confident in our ability to do that. I look forward to speaking with you again next year to talk about our full year results.

With that, I’ll turn it over to Tanika to open up the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Greg [Inaudible].

Greg [Inaudible]

First just with respect to retail sales, I think that you mentioned it was going to be down around 10% in the fourth quarter. Did I hear you right on that one?

Scott W. Wine

Yes. That’s about right.

Greg [Inaudible]

And I’m just wondering, did you notice any change throughout in terms of trend throughout the quarter? And also if I’m not mistaken I think compares get easier in November because that’s when I believe trends fell off for you last year.

Scott W. Wine

Yes, that’s exactly right. It did. In most of our product lines we did see improvements in September. Could be the end of programs and just regular seasonality but September was better than the previous months in the quarter. October as I said was still up 3% last year, so you’re right, Greg, it was November where we started to see a real decline. So we have a little bit easier comparables in November and December.

Greg [Inaudible]

And also just in terms of financing you know maybe a little bit more color on that. The last 60 days I believe things have kind of eased up for you and kind of would you expect it to maybe ease up a little bit or what are you kind of seeing out there?

Michael W. Malone

Well, I assume you’re talking retail financing, Greg?

Greg [Inaudible]

Yes.

Michael W. Malone

Yes. Yes. As the metrics showed in the speech and on the charts, the metrics are a little better in the third quarter than earlier in the year, both from an approval rate and a penetration rate perspective. It’s still tough out there. You know the credit score requirements are higher. Certainly the down payment requirements are higher than they were a year ago. This business is probably not going back to where it was you know a year or two ago. That’s the reality of this situation. But our providers and our dealers are working their way through it and you know we’re relatively pleased with the stability that we’ve seen in our retail credit business. And customers that have decent credit can still find credit to purchase our products, which is our ultimate goal.

Greg [Inaudible]

And then finally just on inventory levels, obviously down pretty substantially at the retail level, your dealer level. You know with retail sales starting to stabilize you know when would you expect them to start kind of adding to their inventories?

Bennett J. Morgan

Greg, this is Bennett. I would tell you based on what we’ve seen from you know what’s going on in the markets, we expect to continue to work inventories down additionally in the fourth quarter. And I would expect that we will continue to make efforts through the MVP program to take inventories down even further in 2010. I think you know a lot of the more heavy lifting has been done over the last couple of years, but we would expect to continue to drive inventory levels down for both frankly the dealer as well as us in the upcoming quarters.

Greg [Inaudible]

And in terms of your competitors, you know in terms of their inventory level at the retail level, how would you characterize that?

Bennett J. Morgan

You know we don’t get perfect visibility to that, Greg, but I would tell you based on at least what we think the Japanese have done they’ve made progress on their inventory levels in the first nine months of the year. I think they cut back production maybe more aggressively than we even anticipated and inventory levels are coming down out there. So you know again it’s a tough environment out there for the dealers but I’m encouraged by that, frankly. I think that the competitors have made more progress, at least most of them made more progress than I might have anticipated three months ago.

Operator

Your next question comes from James Hardiman.

James Hardiman

A couple of questions for you guys. Just first I think you said year-to-date core ATVs are down high 20s. What was that number in the third quarter for the industry and for you guys?

Scott W. Wine

We were down low 20s and the industry, we were better than the industry. Like I said we’ve seen difficult core ATV retail numbers for quite some time, so it was the best quarter in five quarters in terms of less bad year-over-year declines. But we were down the low 20s.

James Hardiman

And on the side-by-sides obviously you sort of know what you were. I think you said you were down mid-singles and that’s meaningfully better than the industry as well, even though you don’t have the other industry numbers you think you’re gaining share on side-by-sides as well.

Scott W. Wine

Yes. We’re still fairly confident of that.

James Hardiman

And then in terms of MVP you’ve said that you’ve rolled that out to 50% of your dealer base, or at least dealers represent 50% of your sales. Where should we expect that number to get to over the next couple of quarters? And are there any sort of metrics you can share or at least you know qualitatively share how the inventory management is going, you know MVP versus non-MVP dealers at this point?

Bennett J. Morgan

James, this is Bennett. I think from a standpoint of expectations you guys should have going forward on MVP, I mean we’re trying to be aggressive about this. It is about 50% of our volume currently. Based on how it’s going so far, not a commitment but our expectation would be you know no later than sometime in 2010 we would expand that more broadly, perhaps as much up to 70, 80% of our volume. You know again we continue to learn on this so there is some scale that is advantageous to run this program for our dealers.

From a metrics or some qualitative standpoint, you know as I said the orders and the retail activity is meeting our expectations right now. I can’t remember where I was.

Scott W. Wine

The other part of his question was the inventory levels on the MVP versus non-MVP.

Bennett J. Morgan

What we’re seeing as you would expect is inventory levels in the MVP dealers are lower than our non-MVP dealers. And just based on the model I think you should continue to expect that. So as we expand MVP that will tend to drive lower levels of dealer inventory levels, because that’s almost what that models based on.

Scott W. Wine

You know one point we ought to just address. We’ve heard some noise. We had a couple of dealers that didn’t have product that they thought they’d want and we ought to dispel that that’s directly related to MVP. You know I guess it’s just the type of thing that we could find in our business overall. And overall I think the team has done a really good job of rolling this out and you know as Bennett said you should expect good things from the program going forward.

James Hardiman

And then just one last question on the snowmobile segment, you mentioned that it’s off to a little bit of a slow start. Is that basically through September and has any of the unseasonably cold weather, some of the snowfall that we’ve been getting the last couple of weeks, I know it’s a little bit early but does it seem like that’s helping? And you know do you have any thoughts on sort of where, obviously your guess is as good as anybody’s in terms of where snowfall is going to be this year and how that might impact your business?

Scott W. Wine

I’m not going to touch the snowfall prediction with a ten foot pole.

James Hardiman

Fair enough.

Scott W. Wine

If it was I’d be smarter and I wouldn’t be sitting here. I don’t think that the weather probably in the Snow Belt, it might get people thinking about it. It’s way too early to see any kind of appreciable increase in retail activity. I think that there’s some positive signs as I said in the remarks that we’re encouraged by. The interest at the shows has actually been up year-over-year which is fantastic and a real pleasant surprise. And so the state of the snowmobile enthusiast is strong. But you know it’s only 7% of the seasonality is gone and so again as I said, James, we’re just going to have to wait and see. With this economy and what’s going on, we’re cautiously optimistic but it’ll come down to weather and when the snow falls. We feel good where we are right now though.

Operator

Your next question comes from Tim [Conder].

Tim [Conder]

Scott you used the plural form of the word acquisition. Can you elaborate on that? And again it would appear that Mike, Scott, whoever, Bennett that wants to take this part that you’re letting the cash build in anticipation of at least one if not multiple acquisitions in 2010.

Scott W. Wine

Tim, we’ll have to review the transcript to see who heard and what was said. I think it was at least one was the way it was referred to. You know we, and I’ve said for a year now that we think it’s an important part of our longer term growth strategy. You know we like what we see in terms of acquisition possibilities aligned with our strategy. We’ll continue to be disciplined. You know the fact that we generate a lot of cash and aren’t buying back shares, obviously it’s going to build up on the balance sheet. And our commitment is to continue to maintain a very shareholder friendly capital allocation model. And you know if that means a small acquisition that’s going to add to the business performance over time, we’ll do that.

But I don’t think you should read anything into my comments or our cash position to change what we’ve been saying all along about acquisitions.

Tim [Conder]

And in relation to your comments on China and then the additional expansion in the EU, any type of quantification, directional commentary that you can give us as far as how you’re thinking about that in driving the top line in 2010 versus let’s just call it your existing organic businesses elsewhere?

Bennett J. Morgan

I wouldn’t anticipate you know meaningful impact on top line sales in China in 2010. We’re very encouraged by the potential in that market. Interestingly a lot of the ATV manufacturers there are starting to lobby the Chinese government for you know access to trails to kind of create the market there, which will ultimately play to our advantage as they’ve lost opportunities to sell into the U.S. market. So you know we believe we’ll sign up a strong distribution partner here in the next few months and you know we think we’ll have the opportunity for retail sales in China in 2010, but we don’t expect it to be a number. It will grow over time but not meaningful next year.

Europe, you know we’ve got a strong team and a strong business in Europe. They’ve had a difficult year as we have here you know, but we do think with their industry leading share position and where we’re positioned that we can do good things in Europe and have a long way to grow and expand across the Europe, Middle East and Africa region.

Tim [Conder]

You said distributor in China so I guess maybe just talk about that, your broad thoughts, where you’re looking to expand. If you kind of put into the buckets the EU, Asia, Latin America, your thoughts over ’10 and ’11, where you’re looking to expand via distributors versus actual dealers.

Bennett J. Morgan

I meant to say distribution not distributors. And you know obviously in China we just don’t have the patience quite honestly to go over there and organically set up a factory and set up distribution. So we’ll try to do that with very selective partners and you know somebody that can help us get established in the marketplace there.

Michael W. Malone

Tim, this is Mike. I think the right way to look at this is that you know we have an established business in Europe, we have a pretty good market share position there, number one market share position. But it’s actually quite a bit lower on a percentage basis than it is here in North America, so we think that there’s significant growth that we can get with the strength of our team and our operation in Europe. And that in the near term should help our top line sales growth very well.

Other markets like Asia and India and Brazil, we sell almost like zero today. And our desire there is to learn and grow over time, but that’s not going to happen next week or next quarter or probably not even next year. Those are investments we’re making for the long term to allow our international business to grow significantly over time, and we just don’t expect that to materialize in significant dollar terms in sales in the short term.

Tim [Conder]

But again there you’re evaluating whether more of a distributor versus a dealer direct type of model as you roll out those expansions in roughly Latin America.

Michael W. Malone

Yes. We’re learning, okay? So we’re in the markets, we’re talking to companies, manufacturers, distributors in the markets, learning and we’ll figure out how we’re going to do that going forward.

Operator

Your next question comes from Bob Evans.

Bob Evans

First again, clarification on something that was said earlier on on the retail sales, do we dump 10% did you say? Was that for core ATVs?

Bennett J. Morgan

No. We said we expect the entire North American retail to be down about 10% in the fourth quarter, Bob.

Bob Evans

But you’re saying ATVs not side-by-side and everything else.

Bennett J. Morgan

No. If you take the cumulative Polaris business.

Bob Evans

Okay.

Bennett J. Morgan

We expect overall retail, so that’s everything in our portfolio, North America and you know we can’t predict what’s going to happen, and especially with the difficult comparables throughout the quarter. But we expect it to be down about 10% in the fourth quarter.

Michael W. Malone

So that’s relative to the minus 17% in Q3 and the minus 22% in Q2 of this year.

Bob Evans

So sequentially the trend is showing nice improvement. And you had made the comments about you’re not looking for a V-shaped recovery but how should we take that in terms of are you expecting a recovery and can you just give us a little bit more color as you maybe, you know obviously you can’t find a crystal ball but give us some sense of what you’re thinking?

Scott W. Wine

I would call it a poorly written U. I mean it’s going to be a very, very slow to the curve I believe, Bob. You know we’ve started the early cycles of planning next year and if you factor in the weak GDP growth and the fact that consumers are going to have to rebuild their personal balance sheets, consumer demand’s going to remain low. So we’ll get back to organic growth. That’s kind of what we projected next year. You know we’ll get limited growth. But you know we just don’t see a strong return to demand in 2010.

Bob Evans

I think there was a comment of continued margin improvement. Can you give us some sense of maybe thoughts on margin trends?

Bennett J. Morgan

I think that’s about all we’re going to say. It’s going to get better.

Bob Evans

And then I believe a comment was made, PG&A margins were up nicely this quarter. Can you give us color as to why?

Bennett J. Morgan

Yes, Bob. This is Bennett. Some of it is mix with the markets the way it is. You know our parts piece of the portfolio, PG&A is probably the most stable part in line. It doesn’t go up as much. It doesn’t go down. And that’s the highest margin piece of the PG&A piece. And that’s really good execution by the team and some innovative new products. I mean they’ve increased margins essentially in every one of the pieces in parts and garments and accessories. They’re doing a nice job on reducing costs and bringing innovative products that have higher margins. So I’m thrilled with how that team is performing on the margin standpoint.

Bob Evans

And that’s a trend that we should see continue in the future?

Bennett J. Morgan

We’d like to believe that.

Operator

Your next question comes from Edward Aaron.

Edward Aaron

So I know you’re not ready to talk about next year in a whole lot of detail but I was hoping you could maybe share some thoughts just about mix in 2010. It’s more of a wholesale shipment question than a retail sales question and the reason I bring it up is you know side-by-side trends at retailers are still much better than core ATVs but you know you’ve under shipped retail by such a greater magnitude than core ATVs this year that I wonder if the mix you know will continue to shift in your wholesale shipments toward side-by-sides in 2010, unlike it did in 2009.

Scott W. Wine

Ed, I wouldn’t expect that to change. Remember the reason we under shipped much more on core ATVs was because we started with a much higher inventory level than we did on side-by-sides. So you know I think the positive mix is likely to maintain. As you heard Bennett talk about, we introduced some very strong new models in the side-by-side range and you know we expect that to be helpful in the fourth quarter and then throughout next year.

Edward Aaron

And last quarter I think you might have shared some side-by-side inventory trend with us. I might have missed it this quarter, but if not can I ask you for some similar commentary as what you made last quarter?

Bennett J. Morgan

Yes. And this is Bennett. We didn’t put it in the remarks because it just generally isn’t an issue. Inventories are essentially about flat there and again I would characterize the dealer inventory levels as very, very healthy. We actually in a couple of key products and side-by-sides we’re actually in shortage positions which is you know never fun to have, but those are good kind of problems you like to have.

Edward Aaron

And then lastly just on the promotional environment, is it fair to say do you think that in aggregate it’s somewhat less promotional than perhaps it was? I know you cited Victory as a negative for gross margins on promotions, but if I look at the accrual on your balance sheet which was down and some of just the anecdotes of the year from the channel it seems a bit more benign than you know what we’ve seen recently.

Bennett J. Morgan

Yes, and this is Bennett again. I think on the ORV side you know the competitive environment remains I think what I would characterize as aggressive. We did see it stabilize in the third quarter. We continued to see efficiencies in our portfolio because of kind of the operational excellence model we have. You know our inventory levels are in general lower. Our age of our products is newer. You know we have a lot more innovative new products and that’s certainly helping drive some short term and then longer term more promotional efficiencies. You know in Victory and the motorcycle industry you just saw the numbers, so they just have been weak across the industry. And people and particularly dealers have had to step up to try to move non-current products.

So you know for that reason, that’s why you’ve seen us make some adjustments there is to be more aggressive because again we just want to manage those inventory levels as effective as we can.

Operator

Your next question comes from Tim [Conder].

Tim [Conder]

Bennett one question, where do you guys stand on your engine mix, internal versus external? And then I guess in relation to that from Mike, Mike a traditional question I’ve asked you along the way here, how do you look on currency hedges looking into 2010?

Bennett J. Morgan

This is Bennett. On the engine mix it’s fairly similar to what we’ve quoted you in the past. It’s fairly close you know on a percent of revenue, right around 50-50. You know that’s something again longer term we would continue to like to grow that you know into our control in our portfolio.

Tim [Conder]

Okay.

Michael W. Malone

Tim, I would have been disappointed if I had gotten off the call without the currency question so I’m pleased. Seriously though we have done more currency hedging lately given the strength of the currencies most recently. We have hedged us a relatively high portion of our exposure for the first half of 2010, upwards of 50% for the Canadian dollar. We’ve also hedged you know between a third and half of our exposure for the Australian dollar and the Norwegian and Swedish currencies as well. So our view is that we’d like to take some of that positive movement and lock it in, so we’ve done probably a little bit more aggressive hedging on currencies than we typically do.

On the yen, that’s unfavorable currently to us and as of today we have no hedges on the yen for 2010.

Tim [Conder]

And Mike you’ve said those percentages that you were citing, was that of your expected exposure only in the first half or for the full year just to clarify that?

Michael W. Malone

Yes. You’re correct. The expected and estimated expected exposure for the first half of 2010.

Tim [Conder]

So really you don’t have much or anything in the back half of the year at this point?

Michael W. Malone

Correct.

Operator

Your next question comes from [Alexander Fodor].

[Alexander Fodor]

Just curious, the third quarter, can you talk a little about sequential improvement? Is there some way you can quantify it? Just overall demand of your sales.

Scott W. Wine

Yes. You know if you can get online and we do have a chart in the deck that we used that talks about where retail sales have trended for the last five quarters. So if you think about going back to the third quarter of 2008, it was down 12. This is for the overall.

[Alexander Fodor]

I’m sorry to interrupt but I meant the question sort of inter-quarter not you know quarters-to-quarters.

Scott W. Wine

Within the quarter we saw it get better and as we’ve seen throughout the year it’s kind of not only been through other quarters but with the rare exceptions this year we’ve seen it get better month over month. September was a better month than July and August.

[Alexander Fodor]

In terms of the fourth quarter and the full year, I know you give gross margin outlooks, where does the operating margin fall for the year and the fourth quarter?

Michael W. Malone

It will expand. I mean obvious [audio impairment]. With the guidance we’ve issued on the gross margin line and the EPS guidance we’ve issued, if you work your way down the model you know it’s going to expand significantly. But I guess I’m not going to give any more.

[Alexander Fodor]

I mean I get a fourth quarter as something like over 13%. Does that make sense?

Michael W. Malone

Yes. I’m not going to do the math for you.

[Alexander Fodor]

Well, just looking at what sort of you know the run rate coming out of the full year ’09 could be like you know under 10, 9.5. Is the fourth quarter typically from a seasonal perspective a higher margin quarter versus the other three?

Michael W. Malone

Typically the second half of the year is significantly higher sales, higher profitability than the first half of the year. Oftentimes it kind of bounces around between third and fourth quarter, which one is better, based on you know the timing of our new products and when its produced and when they’re shipped and retail sales patterns and those kind of things. So you know sometimes its third quarter, sometimes its fourth quarter that’s better. But the seasonality works with the second half of the year is always significantly better than the first half.

[Alexander Fodor]

And so is the third quarter, you know because I’m just trying to think of next year what’s sort of a normalized operating margin assuming sort of you know comparable sales for this year, no sales growth. Given all the improvements that you’ve made, what’s really an annual run rate?

Scott W. Wine

Well, you know we’re not giving guidance for 2010 yet so I’m not.

[Alexander Fodor]

I’m just trying to get a sense of what’s you know what’s more permanent. So if this year looks like it’ll be below 10 but obviously it’s progressed throughout the year, I’m just kind of wondering if you know we’re at 12% for the year, you know just we’re at a 12% run rate, just what the run rate would be.

Scott W. Wine

It would be wrong to extrapolate our fourth quarter or third quarter results for the full year. And I think what my comments were that we were going to have margin expansion in 2010 and that’s probably the extent of what we’re going to communicate today.

Richard Edwards

Okay. We’ve got time for one more question, Tanika.

Operator

Your last question comes from Bob Evans.

Bob Evans

My question is inventory related as it relates to MVP. I think you said you expect to be at $200 million or lower by the end of the year. Right?

Scott W. Wine

Yes.

Bob Evans

Can you give us any sense of how low you think you can drive it, given kind of more fully implementing MVP? And you know maybe as a percentage of sales or I’m just trying to get some sense of a target of where you think you could drive it.

Bennett J. Morgan

Bob, I want to be careful with that one. We’re trying to be reasonably per script by saying we believe that we’ll drive inventory levels to the low $200 in the fourth quarter. We feel very confident that we’ll be able to do that. You know as I’ve made the remarks on MVP, we’re learning and we’re lowering the water level for ourselves and our dealers. And as we lower the water level on inventory we learn. And we’ve gotten a lot faster with what we’ve done in our operations and with our supply chain, so we’re able to react to the more frequent ordering and the shifts in demand much, much more effectively. But that’s an unknown for us. We believe we’ll be able to drive it lower but I’m not going to quantify that at this point because we’re just not far enough down the learning curve right now to make any bold claims on that.

Scott W. Wine

All right. Thank you all.

Richard Edwards

Thanks everyone. That’s all the time we have this morning. We’ll look forward to speaking to you again next quarter. Thanks again. Bye.

Operator

This concludes today’s conference call. You may now disconnect.

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