Ø Sustainable and Attractive Return on Invested Capital
o Exceeded 40% over the past five years
o Brand loyalty and limited price competition should help sustain returns on invested capital over a long time period
Ø Management Team Focused on Delivering Value to Shareholders
o New CEO hired in September in 2008, and he has already taken actions to prepare for recession
o Old CEO was very successful, still has a large stock ownership, and sits on the Board of Directors. He would serve as a great interim CEO, if the new CEO doesn’t work out.
Ø Attractive Valuation
o Current stock price implies a 21% normalized free cash flow yield
o Market is over penalizing the Company for the fact that 2009 will be a horrible free cash flow generation year, and is ignoring the long-term earnings power of the firm
Is Polaris a Good Company?
The Polaris Industries, Inc. (“Polaris” or “PII”) designs, engineers, and manufactures off road vehicles (“ORV”) and snowmobiles, including parts, garments, and accessories, in the United States, Canada, and Europe. It sells its products primarily through independent dealerships. The Company was founded in the early 1950s and is headquartered in Medina, Minnesota.
ORVs (67% of 2008 revenues / #1 market share) are (i) off-road, four-wheel, single person vehicles with balloon style tires designed for off-road use and traversing rough terrain, swamps and marshland (“ATV”) and (ii) side-by-side vehicles (“SXS”) are ORVs that can carry up to six passengers in addition to cargo. ORVs are primarily used for recreation, in sports such as fishing and hunting, and also for utility purposes on farms, ranches, and construction sites. Side-by-side products are rapidly growing in popularity due to the fact that they fit well with the social aspects of hunting and fishing, which caters to an older, and more financially stable demographic. ATVs represented ~45% of Polaris’ 2008 ORV revenues and side-by-sides represented ~55% of 2008 ORV revenues. Prices range from $2k - $12k for new ORVs.
Polaris also produces a full line of snowmobiles (10% of 2008 revenues / #2 market share), consisting of thirty-three models, ranging from youth models, to utility and economy models, to performance and competition models. Snowmobile prices range from $2k - $11k. Snowmobiles are primarily for recreational use.
Both types of products are sold through independent recreational vehicle dealers whose product offering likely includes jet skis, snowmobiles, ORVs, camping/hunting equipment, etc. Polaris is vertically integrated in several key components of its manufacturing process, including: plastic injection molding, stamping, welding, clutch assembly and balancing, painting, cutting and sewing, and manufacture of foam seats. Fuel tanks, tracks, tires and instruments, and certain other component parts are purchased from third party vendors. Raw materials or standard parts are readily available from multiple sources for the components manufactured by Polaris. Due to the seasonality of the Polaris business and certain changes in production cycles, total employment levels vary throughout the year. During 2007, Polaris employed an average of approximately 3,200 people. Approximately 1,250 of its employees are salaried. Polaris’ employees have not been represented by a union since July 1982. The Company’s capital expenditures are primarily related to replacing manufacturing equipment, and some research and development efforts.
Polaris also produces or supplies a variety of replacement parts, garments, and accessories (“PG&A”) (18% of 2008 Revenues). ORV and side-by-side accessories include: winches, bumper/brushguards, plows, racks, mowers, tires, pull-behinds, cabs, cargo box accessories, tracks, and oil. Snowmobile accessories include: covers, traction products, reverse kits, electric starters, tracks, bags, windshields, oil, and lubricants. Polaris also markets a full line of recreational apparel including: helmets, jackets, bibs and pants, leathers, and hats for its snowmobile, ORV, and motorcycle lines. This revenue tends to have higher margins, and is more recurring in nature. 67% of PG&A sales relate to ORVs and 19% to relate to snowmobiles.
Note the Company also has a small motorcycle line called Victory that only represented 5% of 2008 sales, and thus will not be discussed thoroughly in this report.
Over the past 10 years, the Company has earned excellent returns on capital, exceeding 40% every year. Below I will discuss the factors that drive such high returns on invested capital, and why I believe those returns can be preserved over long periods of time. Note that returns are sensitive to economic activity, and can fluctuate based on when inventories held by dealers are sold. In other words, sometimes dealers have too much inventory on hand at year end, which reduces sales and margins in the following year. However, returns on invested capital consistently exceed my 25% threshold.
The ORV market is characterized by limited price competition from the following major companies, (i) Polaris, (ii) Honda, (iii) Yamaha, (iv) Kawasaki, (v) Suzuki, (vi) Arctic Cat and (vii) Bombardier. The market has relatively low barriers to entry with three companies entering the market in the past 10 years, but gaining market share is difficult for new entrants due to strong end user brand loyalty. Based on conversations with end users and dealers, end-users rarely switch brand loyalties, and identify themselves with their brand of ORV or snowmobile. For example, one dealer interviewed said “I own a John Deere dealership and a Polaris dealership, and there is even more brand loyalty to Polaris than John Deere”. Another dealer said, “How can you tell a guy wearing Polaris gear from head-to-toe, to switch brands?” Further, there are little actual (although large perceived) differences between competitive products, so end users are normally not faced with the dilemma of buying a more technologically advanced product instead of their typical brand. Further, the major brands historically increased prices in unison, resulting in minimal price differences between major brands. This lack of pricing differentiation makes sense given the low likelihood of an end user switching brands for a few hundred dollar savings, especially when purchases are financed, and thus results in negligible monthly payment differences.
The Snowmobile market is characterized by limited competition from the following four major companies, (i) Polaris, (ii) Yamaha, (iii) Bombardier, and (iv) Arctic Cat. The market has had no material new entrants since 1983. Like ORVs, end users rarely switch brand loyalties, and they identify themselves with their brand name. There are little actual (although large perceived) differences between competitive products, and prices increase in unison.
Risks to Cash Flows
The fact that these vehicles are typically financed (although by relatively strong credits based on their demographics), has caused investors to have significant concerns about Polaris’ sales in 2009, as credit standards have tightened significantly. Approval rates for end users only declined from 53% for full year 2008 to 51% in Q4 2008, which is still higher than 46% in 2007. However, with interest rates offered increasing and financing terms becoming less attractive, many end users have opted not to use Polaris financing (31% in Q4 2008 versus 39% in full year 2008 and 38% in 2007) and many have simply deferred their purchase of the ORV.
These deferred purchases, and an overall reduction in consumer spending in 2009, is the largest risk to the Company’s cash flows in 2009, as ORVs and snowmobiles are highly discretionary purchases. The Company is projecting that sales will be down 15 – 23% in 2009, and based on conversations with dealers, I believe it could be even worse with sales down 25 – 30% (similar to declines seen in ORV market in the late 1980’s), especially given excess dealer inventory. While next year will be challenging, demand will return to historical levels when the economy and credit standards return to normal levels. When valuing cyclical businesses like this one, it is important to realistically assess the downside in this environment to develop a good estimate of normalized free cash flows. After studying the industry’s history, pouring through the financial statements, and talking to dealers, end-users, competitors, and the management team, I believe I have a realistic sense for cash flows in 2009 and normalized free cash flow.
Does Polaris have a Good Management Team?
The Polaris management team is lead by Scott Wine. He has been Chief Executive Officer since September 2008. Scott served as President of a similar sized business prior to joining Polaris. Since Scott became CEO, he has taken difficult actions to prepare the Company for operating in a severe recession, including terminating 450 or ~15% of the workforce.
Scott replaced Thomas Tiller who retired in 2008 after nine years of serving as President. Thomas grew earnings at a ~5% compounded annual growth during his tenure and was an excellent steward of shareholder capital. Thomas still sits on the Board of Directors and owns $5.7MM of the common stock, which gives me comfort that if Scott is not the good choice I think he will be, Thomas can serve at least as interim CEO until another CEO is hired.
The Company has a stock ownership guideline that requires officers to hold at least 3x their salary in Polaris common stock, with the CEO required to have 5x his salary in Polaris common stock. This policy helps ensure the management team is aligned with the Company’s shareholders. Scott has been purchasing shares since his employment began in September.
Can Polaris be Bought at a Cheap Price?
After examining the past 10 years and recession level free cash flow, I believe that normalized pre-tax equity free cash flow is ~$133MM. At Friday’s closing per share price of $18.41, Polaris’ market capitalization is ~$622MM, which means the stock has a 21% pre-tax equity free cash flow yield. If Polaris trades at a 10% pre-tax equity free cash flow yield, which would be appropriate for this high quality, but economically sensitive business, the stock will rise to ~$39 without any earnings growth, making it a compelling buy at $18.41. Further, the Company has an 8.5% dividend yield at $18.41 per share, which I find very attractive. One quick note on buying equities in cyclical (but not commodity like) industries: an investor should separate the business from the stock. Just because the business is going to perform poorly in 2009, doesn’t mean that the business isn’t a good long-term buy. In fact, it is this short-term cash flow decline that is creating the buying opportunity. Absent a material change in the Company’s long-term earnings power, I am happy to buy a stock at a cheap price because earnings will be at a cyclical low in the coming year. Investing opportunities like these lend themselves to investors with long time horizons that can wait out the current economic challenges.
As always, please feel free to contact with any questions, or if you would like to discuss my research further.
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© Matthew Darrah, 2009.