Is It Time To Give Up On Polaris?

| About: Polaris Industries (PII)

Summary

Polaris is a leader in the powersports category.

Continued recalls have hammered the company, but efforts in quality control hope to put an end to the issues.

Polaris has strong brands and is a good value play if it can move through the recent issues.

Polaris Industries (NYSE:PII) is a leader in powersports with many iconic brands. Continued recalls and poor performance have crushed the share price, which has been held nearly 50% down from the all-time highs achieved in late 2014. The future remains uncertain, but moves into higher-margin businesses and focus on quality control should help the company move past the recent issues.

2016 marked a significant decline in operating results on the YOY comparison. Revenues were down 4.3%, operating profit was cut in half, and net profit was down ~53%. On the quarter, adjusted earnings were down 31% YOY, but the company saw a sales increase with the close of the Transamerican Auto Parts (TAP) acquisition.

Core sales were mostly flat on the quarter, with motorcycle sales down 35% on an artificially inflated comp from the previous year on the clearing of the paint backlog. The Slingshot faced difficulties due to the most recent recall, which has become more and more the norm for the company.

Recent recalls have included a September 2016 recall of two off-road models for fire issues, encompassing ~13K vehicles. In May 2015, the RZR 900 had issues with pinched fuel lines. In 2014, the Ranger had crash hazard issues and 16,500 were recalled. It has become more and more difficult to think about how Polaris will perform when it has come through all of the recall issues, and more about whether it will be able to come out the other side with its brand strength intact.

Management stated that the company is ~70% through with the 900-1,000 cc RZR recalls and over 80% complete with the RZR Turbo recalls. Polaris claims to be, and needs to be, dedicated to improving safety and quality in its products to stem the tide of these repeated recalls. The recent hiring of a head of quality has led to the improvement of post-sales surveillance, which has lowered the response time to an incident in the field more quickly. Additionally, it seems that Polaris feels good about where it is at with coming through the thermal issues that plagued it in the recent past. It remains to be seen if the company can start playing strong defense going forward. Better quality control in the design and manufacture of the vehicles is a must or else the Polaris brand name will become associated with shoddy products and recalls.

Polaris has also recently decided to exit the Victory motorcycle brand. Low margins and mounting losses in combination with strong performance from Indian have led the company to decide to wind down the brand. Polaris CEO Scott Wine on the most recent earnings call:

Our recent announcement to exit the Victory brand was undeniably the right strategic and financial decision but that clarity did not lessen the blow felt by our many loyal and passionate customers. We share their pain at the same visceral level but with cumulative losses exceeding $100 million in growing we could not continue to invest in the brand.

I view the 18 years of blood, sweat and tears we poured in the Victory of the investment and education required to successfully bring the legendary Indian motorcycle brand back to industry prominence.

With the acquisition of TAP, Polaris is closing out a low-margin business and moving into a high-margin one. With the outstanding performance of the Indian Motorcycle brand, it makes sense that management wants to focus on the core brand, especially considering the larger move into apparel and accessories.

For the full-year 2017, sales are expected to be up from 10% to 13%. This includes the inclusion of TAP, and the wind down of the Victory brand and ~$30M in forex headwinds. Organic sales are expected to be mostly flat from -1% to +1%. EPS is expected to be up 22-29% on the year, which would be back to the level in 2012, but not 2013-2015. This includes a $0.25-0.30 EPS bump from TAP, which is now expected to deliver ~$20M in cost synergies.

Looking at the individual segments, ORV/snowmobiles are expected to be down low single digits due to a weak market and promotional costs. As Victory is wound down, motorcycle sales are expected to be down low double digits. However, Indian Slingshot is projected to be up low-double-digit percent on the year. Global Adjacent Markets is expected to see low-single-digit growth from strong operating conditions. The new aftermarket reporting segment is obviously going to be up significantly as TAP's sales are added.

Margins took a hit in the last quarter due to promotional spending and warranty costs. This is reflected in the operating performance of the company and the significant hit to earnings. The cost improvement initiatives helped to offset the headwinds by 150 basis points, but margin contraction is not ever a good sign. Polaris has forecast a 180 basis point expansion in margin on the full year as warranty headwinds abate (barring another recall) and cost cutting continues. If it is able to deliver on this, and profitability improves, I would expect to see a strong recovery in the share price for the company.

Polaris has sacrificed some wiggle room on the balance sheet with the TAP acquisition. This put the debt to total capital ratio up to 57%, with ~$1.1B in long-term debt at this time. Most of the debt has a maturity date in 2021, with a small portion coming due next year. Polaris has had strong free cash flow generation over time, and if it is able to bounce back from the recent issues, it should continue to generate plenty of cash. I have no near-term issues with the debt load so long as Polaris is able to bounce back to the strong level of profitability it achieved prior to its recent issues. The company improved its manufacturing footprint with the opening of the Alabama plant, which should help distribution costs and servicing the growth of Indian.

Source: Company Filing

Chart PII Free Cash Flow (TTM) data by YCharts

As I discussed above, Polaris has generated strong free cash flow over time. Additionally, the dividend has grown every year for 22 consecutive years. The growth has been great, with a hiccup this last year for obvious reasons. Forecasting the future dividend growth rate is very much so based on how long it takes the company to return to its previous strength. I would expect the near-to-mid term to be less than the long-term average due to debt servicing costs and increased focus on investments for growth. Over the long term, however, I see Polaris continuing to grow the dividend at a strong rate.

This graph shows the operating results well over the last few years. If you look at the bottom in early 2016 coming off of the last peak in mid-2015, that is when I became interested in purchasing shares. I wrote my first article on the company in July of 2016, and expected a relatively swift recovery. However, continued problems have pushed out the recovery time frame. With the compressed earnings at the moment, I don't believe that the current P/E ratio is indicative of the value to be had in Polaris at this time.

The earnings estimate graph does a better job in this case of showcasing the value proposition in Polaris shares today. I will say that maintaining a 20-21X P/E ratio may not necessarily happen considering the damage Polaris could have suffered to its brand name. However, even a contraction to ~16X yields a 10% annualized total return based on estimates. This is all predicated on the company managing to come through its issues, and quality control keeping it out of similar issues going forward. I was much more bullish on the company last year, and continued issues plaguing results have made it harder to see a quick rebound in results. However, I still feel that the long-term strengths of the company are there, and that Polaris will continue to drive strong results with its brands into the future. Potential investors should just be aware that there is definitely no guarantee that the issues are all in the rear view for the company.

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Financial statistics were sourced from Morningstar, with the charts and tables created by the author, unless otherwise stated. This article is for informational purposes only and represents the author's own opinions. It is not a formal recommendation to buy or sell any stock, as the author is not a registered investment advisor. Please do your own due diligence and/or consult a financial professional prior to making investment decisions. All investments carry risk, including loss of principal.

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.

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Tagged: , Recreational Vehicles, Earnings
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