Here's Why Polaris Belongs In Your Portfolio

Summary

• Demand for Polaris’s products served as the biggest catalyst for top line gains over the past five years.
• Polaris possesses an employee stock ownership plan with employees collectively owning 6% of the company.
• Polaris exercises financial prudence in expense control, debt and capital expenditures.

It's important for long-term investors to develop a guide for doing their investment research. Over the years I have developed questions to guide me in my thinking when researching the publicly traded universe. Right now let's talk about Polaris Industries (NYSE: NYSE:PII).

1.) What does the company do?

When you buy shares in a company you effectively become part owner of that company. Therefore, it's important for an investor to understand what a company sells. Polaris essentially sells a variety of small motorized vehicles such as ATVs, motorcycles, snowmobiles, and off-road utility vehicles. Some of the names you may recognize include Slingshot, Victory, Indian and RZR.

2.) What do the fundamentals look like?

Investors should also look for companies that grow revenue and free cash flow over the long-term, retaining some of that cash for reinvestment back into the business and for economic hard times. Excellent revenue and free cash flow growth serve as catalysts for superior long-term gains. Polaris possesses excellent fundamentals. The company expanded revenue, net income and free cash flow 157%, 241% and 45%, respectively, over the past five years (see chart below).

PII Revenue (NYSE:TTM) data by YCharts

It's safe to say that volume served as the greatest contributor to Polaris's top line gains, followed by price increases and product mixes. Good volume increases point to healthy demand for a product. Prudent cost controls contributed to gains in net income and free cash flow. Operating margins improved consecutively since 2008. Moreover, Polaris isn't afraid to scale back on capital expenditures during lean times.

So far this year, Polaris continues to perform well. Its year-to-date revenue and net income increased 13% and 7%, respectively, year-over-year. However, its year-to-date free cash flow declined 96% year-over-year, stemming largely from the timing of payments on accounts payable.

Polaris possesses an ok balance sheet. In the most recent quarter, the company had $119 million in cash and equivalents equating to 13% of stockholder's equity. I prefer to see companies with cash equating to 20% of stockholder's equity or greater to get them through tough times and allowing them to self-finance innovation.

I don't like debt. It creates interest costs that choke out profitability and free cash flow. I like to see companies with long-term debt amounting to 50% or less of stockholder's equity. Currently, Polaris possesses long-term debt amounting to 41% of stockholder's equity. This represents an increase from the end of the year when long-term debt resided at 23% of stockholder's equity.

The company still possesses a reasonable margin of safety in terms of interest coverage. Polaris' year-to-date operating income exceeds interest expense by 53 times. The rule of thumb for safety lies at five times or more.

Polaris does pay a dividend. I like to see companies pay out less than 50% of their free cash flow in dividends each year. Last year, Polaris paid out a prudent 39% of its free cash flow in dividends. Currently, the company pays its shareholders $2.12 per share per year translating into an annual yield of 1.5%.

3.) How much management-employee ownership is there?

Investors should always look for businesses where the managers and/or employees own a lot of stock in the company. Managers with a great deal of stock in the company will take better care to maximize company profits, which will enhance share price and their personal wealth along with the wealth of shareholders. According Polaris' latest proxy, no executive owns more than 1% of the company's stock.

Interestingly, the company has an employee stock ownership plan, which represents 6% of Polaris stock holdings in aggregate. Employees that own stock in the company they work for have a sense of ownership and pride in the company. This provides them the extra incentive to go the extra mile to take care of the final consumer.

4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?

Every year a company employs external auditors to audit financial statements and evaluate whether it maintains adequate financial controls. At the conclusion of the audit, you want to see a letter from auditors with the language "unqualified" or "fairly presents", which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see "qualified" or "adverse" in the auditing letter's language then deeper issues in a company's financial statements may exist. Results of its last audit indicate that Polaris maintained adequate internal controls, and auditors gave its financial statements an unqualified opinion.

5.) What types of risk does it have?

It's always important for investors to weigh the various risks such as exposure to political risk in parts of the world where war is the norm, competitive positioning, and market price risk. Polaris operates across the globe. Europe makes up 64% of Polaris' international sales, but it also operates in places like Latin America, Asia, Australia and Africa. Some of these places come with some significant political risk.

Polaris does compete with some serious players with deeper pockets such as Harley Davidson (NYSE: HOG), Honda (NYSE: HMC), and Deere & Co. (NYSE: DE), all of which generate more free cash flow than Polaris (see chart below).

PII Free Cash Flow (TTM) data by YCharts

Polaris's stock recently went through a correction. Currently, the company trades at a P/E ratio of 20 vs. 19 for the S&P 500 as a whole, according to Morningstar. This makes it slightly overvalued vs. the market as a whole.

6.) What does its forward analysis look like?

Look for the company to continue expanding its Indian motorcycle footprint. In fact, the company expanded sales in all of its vehicle and related merchandise segments so far in FY 2015. The only downside for this company right now would stem from a slowdown in the economy and increased competition from companies like Honda. Considering Polaris' financial prudence and ability to innovate this company definitely warrants a spot in your portfolio.

Analyst’s Disclosure: I/we 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.

Comments

[flyingmariner]

Thanks William,
Nearly bought PII today but will wait a bit longer.
Appreciate the report.

[William Bias]

Thanks for reading flyingmariner.

William

[stu_s]

Thanks for this piece, William. If I did my numbers right, inventory turns fell to 4.75X in 2Q15 from 6X in 2Q14, a big drop. In combination with your analysis, I come to the opposite conclusion as you.

[William Bias]

Hi stu_s

Thanks for reading. Always good to hear from you.

William