The winter season has been tough on Arctic Cat (ACAT). The most recent quarterly earnings missed on analyst expectations, leading to a 20% drop in share price. We have been optimistic on Arctic Cat for some time, and will continue to be. The outcome of the Yamaha partnership has led to shortcomings in terms of sale numbers. However, we see the long term benefits coming from this relationship outweighing the recent woes and maintain our positive outlook on Arctic Cat.
With the winter season in full swing, many expected ACAT to report solid snowmobile sales. Turns out, sales in the segment decreased by 4% on a year over year basis. While other product sales were positive, declining snowmobile revenue was a major hit for the company, as snowmobiles are the staple of Arctic Cat.
In early 2013, Arctic Cat announced a partnership with Yamaha Motor Corp. (OTCQX:YAMCY), to collaborate on a new lineup of snowmobiles. ACAT would provide the chassis and Yamaha would supply the engines. Yamaha went on to launch a new lineup, named SR Viper. The new Yamaha lineup would be built by Arctic Cat in its Minnesota facility. Arctic Cat gained better performance for its Pro Cross lineup. The new Viper lineup is essentially the same snowmobile as the ZR lineup of its partner.
Fast forward one year later, and it looks like the partnership ended up benefiting Yamaha more than Arctic Cat. The reduction revenue was blamed on the lower sales price of Yamaha snowmobiles. Yamaha offers customers a lower average price for its lineup. Prices for the Arctic Cat ZR series can go as high as $15,649, whereas the most expensive SR Viper is $13,899. The strong performance of the new snowmobiles also shows on Yamaha's financial statements. Sales of power products, which includes snowmobiles, increased 22.3% yoy, as of December 2013. This growth is tremendous, given that sales in this category for the last 3 years grew by 1% on average per year. So far, Yamaha was the one that benefited most from the partnership.
As far as Arctic Cat benefits, here is where we see the positive aspect of the partnership. Below is the breakdown of company sales for ACAT by geographical exposure:
Sales By Geography
Total Net Sales
Data taken from ACAT 2013 10-K filing
All 3 major geographical segments have historically enjoyed healthy growth. However, for the 9 months ended December 2013, sales generated from Europe dropped 10% year over year. Throughout most of last year, management has been hinting at weaker international demand, due to unfavorable economic conditions throughout Europe. This where Yamaha could boost sales for ACAT.
We have identified a key reason why international sales are lagging. Arctic Cat offers ATVs and Side by Sides directly to the European market, but no snowmobiles. Even as far as ATVs go, only a limited number of models are offered, compared to the US market. The lack of snowmobiles puts ACAT at a disadvantage, as sales are lower during the winter season. The only winter product offered is a modified ATV called Army, with tank-like treads. Arctic Cat has an extensive chain of dealers spread throughout most of Europe. However, limiting itself to selling only wheel based recreational vehicles constrains international revenue potential.
Here is where the partnership with Yamaha can come into play. Yamaha has a strong European presence in terms of snowmobiles. In fact, the new Viper lineup is a critical part of European sales, accounting for 9 of the current 18 models offered for sale. This is how Arctic Cat can indirectly get exposure to snowmobile sales in Europe, from sales of Viper models.
Snowmobiling in Europe and Russia is a $5 billion combined industry. Gaining exposure to this crucial market is a positive step towards growing international revenue contributions. Moreover, snowmobiling is a growing sport, and offers a growing market. Assuming a recovering European overall economy, we can expect this market to play an important role for top line growth in the next 5 years.
The main downside of indirect exposure is that the Arctic Cat brand is not being developed, which limits the image of Arctic Cat among recreational vehicle enthusiasts. As far as margins go, sales of Yamaha snowmobiles offer lower gross margins, which was a big concern in the latest earnings report. Gross profit margin dropped from 23.3% to 17.8%, which resulted in the overall guidance for the year to decrease.
Overall, the partnership with Yamaha can help both companies in the long run. The benefits of increasing volume and market share for snowmobiles will outweigh the short term impact on margins. While this season of snowmobiles is nearing the end, we look towards next year for developments between the two brands. The international exposure is an added benefit to the domestic opportunities in terms of volume sold. As far as the next season's outlook, ATV sales will become the central focus of the company, where we believe it holds a steady market position, both domestically and internationally. ACAT has a good product in the side by side category as well, which is growing in popularity among enthusiasts.
In our model, we maintain a bullish approach to sales. We believe a 7% growth rate for revenue is within reach for the next 5 years. Arctic Cat has plenty of room to grow, as it currently only holds 20% of the snowmobile market and 7% of the ATV market. The company was a late entrant to the ATV market, which gives it a disadvantage over its larger peers like Honda (HMC) and Polaris (PII), which own the largest market share. However, the market for side by sides is relatively new, with 15%-25% growth expected in 2014. Arctic Cat is perfectly positioned to take advantage as the market continues to grow.
In terms of margins, the Yamaha partnership may have a lasting impact on gross margins, due to lower sales prices. A growing mix of side-by-side sales could improve gross profit, as these vehicles offer better margins than ATVs. As for operating margins, the 9% margin in 2013 was the highest Arctic Cat had in the last 10 years. For 2014, the margin is expected to drop around 7%-8%. In our model we assumed operating margin to hold steady in the mid to high single digit range.
We can expect capital spending to see modest growth in the next years, as ACAT looks to expand its exposure both domestically and internationally. We assumed a residual growth rate of 4% due to the small size and potential growth of the company. As far as taxes, we assumed a 32% rate. Using these figures we have computed a price target of $61 for the next 12 months.
We continue to like the Arctic Cat name. We believe its market presence has plenty of room to grow, both domestically and internationally. The Yamaha partnership can help snowmobile sales in the long run and serves as proof that Arctic Cat offers leading and competitive technology to the market. We may see this partnership bring about further mutual benefits and collaboration moving forward.
Additional disclosure: Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by Adrian Moraru, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.