Polaris Industries: TAP Acquisition Timing Is Questionable

| About: Polaris Industries (PII)

Summary

Polaris Industries announced the acquisition of TAP, creating both financial and strategic benefits.

I like the rationale of the deal but question the timing given the challenges which the company faces at this moment in time.

Despite the concerns regarding the timing of the deal, I believe that Polaris will emerge stronger out of the current turmoil.

A recovery in earnings and valuation multiples could easily warrant a +$100 valuation in a relative short period of time, if profit pressures alleviate.

Polaris Industries (PII) announced a fairly sizable acquisition, by far the largest in its history. Polaris will acquire Transamerican Auto Parts (NYSE:TAP), obtaining a leading position in the market for Jeep and truck aftermarket accessories. The deal creates strategic benefits in terms of operating in adjacent markets, diversification of revenue streams, while the financial rationale is sound on the back of tax and cost synergies.

The timing of the deal raises some questions however as Polaris is facing big headwinds at the moment in terms of soft demand and rising costs on the back of product quality issues and recall costs. That being said, Polaris has the potential to overcome these issues, in part on the back of its strong balance sheet.

A potential recovery in terms of the core and contribution of TAP would really boost the potential earnings power in the coming years. Given the non-demanding multiple at which Polaris trades, valuation multiple inflation (to normalized levels), could result in significant upside potential from current levels.

Making A Move In Tough Times

Polaris announced that it will acquire Transamerican Auto Parts. The company is spending $665 million to acquire the private company which manufactures, distributes and installs off-road Jeep and truck accessories. Typical products sold include suspensions, bumpers, sidesteps, tires, and accessories.

Important to realize is that the purchase prices includes future tax benefits with a net present value of $115 million. Adjusted for these benefits, the effective purchase price comes in at around $550 million. Based on that price Polaris says it is paying 9 times EBITDA, suggesting an EBITDA contribution of roughly $61 million.

TAP generates $740 million in sales, as the effective purchase price is equivalent to 0.75 times annual revenues. Important to realize is the rapid growth rate of the company, as sales have grown at an average rate of 15% per annum over the past four years. TAP holds a leading position in a $10 billion market which is still highly fragmented, allowing for potential bolt-on move additions in the future.

With the deal Polaris is gaining a leading position in a growth market. TAPs products in the four wheel drive markets are adjacent to the off-road segment of Polaris, allowing for cross selling opportunities and potentially resulting in manufacturing synergies as well. Besides combined engineering and sales efforts , the new Polaris will become more diversified as well.

Meaningful synergies are anticipated through 2020 on the back of $20 million in cost synergies and unspecified revenue synergies. Including the cost synergy estimate and tax benefits, the effective EBITDA multiple being paid for the assets drops towards 6.8 times.

The Timing Is Awkward

The timing of this deal is very interesting as Polaris is facing some real issues in terms of sales growth amidst lackluster demand, as well as quality and warranty issues. The good news is that TAP will be largely run as an independent business, thereby not putting a burden on the organization given these issues.

While diversification is to be applauded, a move like this will eat up time from the executive management team as well. According to the deal presentation, leverage will increase towards 2 times EBITDA. Given the solid state of the balance sheet at the end of the second quarter, and the purchase price of TAP, this statement suggests that Polaris has been active in recent weeks to buy back its own stock at depressed levels.

The company has made some smaller acquisitions in the past, but the purchase of TAP is by far the largest deal. As mentioned before, TAP will become a largely independent organization, not taking up a great deal of time from management, alleviating integration risks.

The multiples look fair as well. Polaris will add $740 million in sales and $61 million in EBITDA once the deal closes. Including synergies, this expected EBITDA contribution might rise towards $81 million by 2020. Based on the 0.75 times sales multiple, the 9 times EBITDA multiple, and 7 times multiple if we factor in synergies, the valuation looks relatively appealing.

Note that Polaris posted EBITDA margins of 17-18% in the good year of 2014-2015, and 16% on a trailing basis. TAP is less profitable even while it has similar gross margins. EBITDA margins just surpass 8% of sales at the moment as margins could improve towards 11% following a realization of the projected synergies.

In either way the valuation multiples look reasonable. Polaris has traded at an average EBITDA multiple of 9-10 times over the past decade. The purchase of TAP, taking place at 7-9 times EBITDA, looks appealing in this light, especially as Polaris has access to cheap financing given the strong balance sheet of the company.

Pro-Forma Impact

Polaris is facing a storm in its core business which is anticipated to post revenues of $4.4 billion this year. Including the $740 million in sales from TAP and factoring in a modest recovery in the core business, a $5.5 billion revenue number looks attainable by 2017/2018.

The question is what margins can look like. Operating margins have risen from 10% towards 15% of sales before the recent troubles started. I believe that a return to growth and resolving of the quality issues should result in operating margins of 15% for the core business which could see sales recover towards $4.8 billion.

Based on a $81 million EBITDA contribution from TAP and using a 3-4% sales assumption for depreciation & amortization expenses, I expect an EBIT contribution of $60 million from the acquisition. That suggests that operating margins come in at 8% of sales, including the realization of synergies. That suggests that pro-forma operating profits could recover towards $750-$800 million on a pro-forma basis, under normalized conditions.

If we reserve $50 million in interest costs on a gross debt load of little over a billion, and assume a 30-35% tax rate, a $475-$500 million after tax profit number looks realistic. That would be equivalent to $7.50 per share, suggesting that shares currently trade around merely 10 times earnings.

The good news is the strong growth performance of TAP, having a real potential to positively impact the growth profile of the overall business. This is certainly the case if TAP can sustain the momentum seen in the past years.

Final Thoughts

The $7.50 pro-forma earnings per share number, assuming the purchase of TAP and recovery of the core, could easily yield a +$100 valuation even amidst non-demanding valuation multiples.

The deal makes sense as it results in diversification, Polaris finally uses its very strong balance sheet, as synergies create real financial accretion as well. That being said, the road to a +$100 scenario is still challenging given the troubles in the core of business, as described in a previous article, as Polaris sees a decline in demand following a harsh external environment. At the same time, it has to deal with some severe quality issues as well.

Competition, a strong dollar, weakness in energy related markets and quality issues have been hurting both sales and profits. The $7.50 earnings per share number is therefore not realistic in the short term. Polaris is now guiding for earnings of $6.00-$6.30 per share for this year excluding the anticipated contribution of TAP, while it excludes large recall related costs as well. The costs of recalls, lost sales and customer compensation is seen around $2.60 per share, as Polaris sees GAAP earnings at $3.30-$3.80 per share in 2016.

The current turmoil will last into the remainder of 2016 and probably into the first half of 2017 as well. If the warranty issues get resolved, energy markets stabilize and recover, and comparables become easier, there is plenty of upside. A $7.50 earnings per share number is attainable if the core recovers and TAP starts contributing.

With shares trading at just 10 times projected earnings in a recovery, after having been cut in half since the high of 2015, the risk-reward is clearly appealing. If earnings recover, it might be likely to see valuation multiples recover as well, allowing for a $100-$125 valuation in a relative short period of time.

Disclosure: I am/we are long PII.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long PII. May increase or reduce position at any point in time.