Arctic Cat (NASDAQ:ACAT) is an established producer of outdoor recreational vehicles encompassing snowmobiles, all-terrain vehicles (NYSE:ATV) and utility task vehicles (UTV), as well as related accessories and garments. We believe the future for this company is promising as it is constantly improving and developing its product line to appeal to its customers. We reiterate our BUY recommendation with $65 price target as we believe the company offers competitive products and is locking in customers by developing its brand awareness.
The three products offered by the company are snowmobiles, ATVs and UTVs. In terms of revenue, snowmobiles accounted for 39% whereas ATVs and UTVs accounted for 45% of total revenue for 2013. The remaining 16% was revenue from parts, garments and accessories. We have identified a key catalyst for each segment of revenue that is key to the future success of the company.
First, we look at the snowmobile segment that is also the most common product associated with the brand. Currently, ACAT maintains a 20% market share of snowmobiles, behind its competitors Polaris and BRP. The latter commands close to half of the market through its Ski Doo product line that is a well-established name in the snowmobile segment. The question then becomes what ACAT is doing to improve its market share over its competitors. The answer is product differentiation. According to a study done by the International Snowmobile Manufacturers Association, 80% of snowmobiles are used for recreational purposes and 20% for work related tasks. Arctic Cat is targeting both categories. The XF1100 Turbo Sno Pro was voted the best snowmobile of 2013 and regarded as the most powerful among snowmobiles. Another model was voted Best Personal Sport Touring. It seems Arctic Cat is doing a great job targeting the snowmobile enthusiasts by offering superior performance. As for the utility category, the Bearcat Z1 XT Groomed Special was voted 2012 Best Utility snowmobile. We believe the company is building a competitive advantage that will result in a larger market share for this segment in the near future.
ACAT is committed to improving its products. For the year 2013, $20.6 million was spent on research and development, which represents a 16% increase from the previous year and 38% more from 2012. The company is focused on reducing cost of production by manufacturing certain parts in house. ACAT is currently experimenting with an in house manufactured engine for certain 2014 models. The additional spending on research and development decreased operating margins for FY 2013. Nevertheless, if the proprietary engines are welcomed with positive customer feedback, then the company will be able to reduce the cost of snowmobiles sold and improve profit margins for this segment in the long run.
The next catalyst moving forward is brand recognition. Can the company lock in customers that are loyal to its brand? If so, how? Snowmobiles are an integral part of the Winter X Games, a nationally televised sporting event that involves athletes competing in different types of events. The Arctic Cat snowmobiles have taken center stage in numerous event racing competitions. Athletes using snowmobiles produced by ACAT have won in 65 of 80 final races at the last 2 Winter X Games. This helps build brand awareness among enthusiasts that in turn leads to higher snowmobile sales and accessories. Building a loyal customer base will result in increased market share.
Moving on to ATVs, we believe the company is a middle of the pack player in this segment. The market for ATVs is highly competitive, with Arctic Cat enjoying only a 7% market share, the second smallest share among the major competitors. There are a multitude of ATVs for customers to choose from, in different shapes and sizes that makes it difficult for ACAT to differentiate its product. But, it's not entirely bad news. UTVs (utility task vehicles) are becoming a more popular option to ATVs, as data provided by Power Products Marketing shows that 10% of annual ATV sales are lost to UTVs. A UTV is an off road vehicle controlled by steering wheel and pedals, as opposed to handle bars for ATVs and sits at least two persons side by side.
For the year 2012, ATV sales grew by 1.5% to 225K, whereas UTV sales were 228K, up 20% year over year. The popularity of the UTV has increased in recent years. ACAT revenue from ATV and UTVs jumped 32% for 2013 and, although the company does not breakdown the sales of the two vehicles, we believe most of the increase is due to sales of UTVs. We also believe ACAT holds an advantage in the market for UTVs. The 3 most popular models in this category are made by Polaris, Can-am and Arctic Cat. From our previous article: "The company's development of the Wildcat side-by-side has also been a huge catalyst and will continue to be. The company is set to launch its Wildcat Four in FY14, which will feature four seats instead of two, as well as a Wildcat X, which is a high horsepower version of the previous model. The company has really benefited from its growth in side-by-side. They had not had a strong foothold in this area for some time due to patents from Polaris, but the company has been able to successfully develop some winning new models". ACAT is expanding its product line in this up and coming market segment that will play a larger role in terms of revenue in the years to come.
Turning to accessories, this segment accounts for 16% of total revenue, but 25% in terms of gross profit. This segment offers better gross margins of 35% compared to 21% for the snowmobile and ATV category. The main revenue sources for this segment are product parts and accessories that account for 60% and 24%, respectively. The UTV is highly customizable and the company is offering more and more accessories for this line. As the company sells more UTVs, the sale of accessories will follow suit and due to smaller cost of goods associated with accessories, overall gross margins will improve as a result.
Turning to valuations, we see company P/E value is 17.2 and forward P/E is 14.3 as future earnings are expected to increase. This is correlated with a PEG value of 0.86 that suggests the company is undervalued relative to its growth potential. ACAT scores well in terms of profitability as well. Return on equity is 26.76 due mainly to solid asset turnover. The current ratio is an optimal 2.18 showing a healthy balance between current assets and liabilities. The company currently has no long term debt as it uses cash flow to generate growth. ACAT also offers dividends with a 0.74% yield.
The largest competitor is Polaris (NYSE:PII) with a market cap of $8.5 billion, almost 12 times larger than Arctic Cat. Polaris has better gross margins of 29% compared to 23% for ACAT. Return on equity is much higher as well for Polaris, sitting at 49%. However, ROE has decreased every year for the last 5 years for PII, whereas the same ratio has improved every year since 2008 for ACAT. It seems the giant of recreational vehicles is losing some ground to ACAT, which manages to grow at a steady pace. The high pe and future pe values of 26.14 and 20 respectively for PII also suggest that ACAT is a better value for investors as it offers more room to grow.
Lastly, we would like to look at some potential short comings. One main concern may be the ATV market. As we have mentioned, this particular segment is highly competitive. ATVs still represent a significant part of revenue and losing more ground could affect the Arctic Cat brand. Overall market trends may not be in line with company expectations. The Consumer Confidence Index for September 2013 fell from the previous month. Because the products sold by ACAT are recreational, sales are dependent on the average customer's disposable income capabilities. Another drawback may come from the proprietary engine manufactured for the 2014 snowmobile lineup. If the engines are inferior to those of competitors, the brand will be affected and further lose market share.
Nevertheless, snowmobiles will play a big part in the upcoming months as winter settles in. Sales for the latest quarter were up 27% in the off-season, driven by volume. As the snowmobile season begins, we can expect to see volume spike from October until March of next year. Following March, we expect the sale of UTVs to pick up in most part due to the Wildcat model as it is becoming a popular choice among consumers.
After analyzing the key catalysts for ACAT, we reiterate our BUY recommendation for the company as we believe it is currently undervalued. We believe the company is building its brand through competitive products and will continue to grow its market presence in the upcoming years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: 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 David Ristau, 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.