Polaris Inc.: Take The Money And Run

Summary

• I think the case of Polaris Inc. is interesting because it demonstrates the fact that a challenged company can be a great investment if the price is right.
• The problem in this case is that the stock is now much too expensive relative to the fundamentals here, and for that reason I recommend selling now.
• I think the company has the resources to (barely) cover obligations over the next few years. 2023 will be a challenge.

Since publishing my bullish piece on Polaris Inc. (NYSE:PII) just over two months ago, the shares are up an eye watering 89% against an 18% for the S&P 500. I think I need to look in on this name again for two reasons. First, the risks inherent in a stock are much different when it's trading at $89 than when it is trading at $47. Second, the company has released financials since I wrote about them, so I thought I'd check in on the name. Also, I should update investors on the options trade I recommended in my previous article. I'll come right to the point. I think the market previously overreacted on the downside and is now overreacting on the upside. For this reason, I am taking the money and running, and I recommend that other investors do the same.

I think the case of Polaris is interesting for two reasons. First, writing about it allows me to engage in the financial bloggers' favorite pastime of cherry picking successes and then bragging about them. Second, and far more importantly, it reveals something about the risks associated with what I call "narrative investing." The idea here is that very plausible sounding stories can get us into trouble. To use Polaris as an example, when I wrote a bullish piece about the company at the height (depth?) of market despondency, everyone "just knew" that a stock like Polaris was doomed to languish for years. It's not as if the people who disagreed with my first article were stupid. They had very sound, well reasoned arguments for avoiding the name. In my opinion, it's just that those plausible sounding stories weren't sufficiently anchored in the data. I think we can learn a few things from this experience. First, I've revealed yet another odious personal trait, namely a tendency toward braggartism. Second, we investors need to go past plausible sounding stories and start to rely more heavily on data and valuations. Sometimes a troubled company can be a great investment if the stock has "gotten ahead of itself" on the downside.

Financial Update

I wrote extensively about the financial history here in my last article on the name, so I won't repeat the earlier, long-term analysis. In this financial update, I'll focus in on the most recent period relative to the same period a year ago. I'll also make some observations about dividend sustainability.

The first quarter of 2020 was not kind relative to the same period a year ago. In particular, revenue was down ~6% from the same period in 2019, and operating income, and net income fell off the proverbial shelf. Specifically, operating income was 93% lower, and net income was just under 112% lower. The company did manage to lower cost of goods sold by ~$31 million, but the $90 million drop in revenue more than swamped this improvement. In addition, selling and marketing expenses were about $20 million higher in the first quarter of 2020 relative to the same period a year ago. It seems that the company wasn't able to quickly respond to a loss of demand. While I think this is only one data point, and thus not necessarily indicative of an ongoing trend, it is worrying. In coming quarters I'll be quite keen to review the company's ability to react to changes in demand.

Dividend Sustainability

I think the dividend that a stock pays out offers some sort of "floor" on prices, and so I think it's prudent to pay particular attention to whether the dividend is sustainable or whether it's likely to be cut. In order to try to estimate the strength or weakness of a given dividend, I'm going to compare the size and timing of the company's upcoming obligations with the resources it has available. The greater the coverage, the better obviously.

I've compiled the upcoming obligations in the following table for your enjoyment and edification. Please note that the company offered no guidance about future capital expenditure, and so I've made the following assumptions about it. First, the $188 million figure this year is derived by simply multiplying the most recent quarterly CAPEX investment of $47 million by four. The $240 million figure for 2021 forward is derived from the mean of the last two years of capital expenditure. Obviously this is less precise science and more exercise to gauge the approximate size of the upcoming cash outflows.

Source: Latest 10-K, Investor presentations

Against these obligations, the company has about $424 million in cash on hand. Note that the entirety of this cash increase came from added debt. This suggests to me that the company can meet its short-term obligations, but the firm will increasingly be dependent on outside sources of capital for the next three years, culminating in a $1.331 billion outflow in 2023. I've recently seen worse coverage, but I've certainly seen far, far better coverage than this. Given the above, I would be willing to buy this stock at current levels as long as it was trading at a significant discount to the overall market. I'll explore that question next.

Source: Company filings

The Stock

I think the case of Polaris demonstrates that a reasonably challenged company can be a great investment at the right price. By "right" in this context, I mean "cheap." Thankfully, I'm not cheap in any other aspect of my life, as I'm more than willing to invest in high quality oil paints, canvases and various, uh, "stimulants." When it comes to stocks, though, I see no benefit to overpaying because in my opinion, cheap stocks offer the chance at better returns with lower risk. I determine whether a stock is cheap or not in a host of ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of stock price to some measure of economic value, like earnings, free cash flow and the like. The lower the ratio, generally the better. In my previous article, I made much of (droned on about?) the fact that the P/E had sunk to just over 10 times. Now, only two months later, the P/E has effectively doubled, per the following.

Data by YCharts

In addition to looking at the ratio of price to some measure of economic value, I like to understand what the market is currently assuming about a given company's future. In order to do that, I turn to the methodology described by Professor Stephen Penman in his book "Accounting for Value." In this work, Penman walks an investor through how they can isolate the "g" (growth) variable in a standard finance formula to work out what the market must be assuming about a given company's future. Previously, the market was forecasting that Polaris would be bankrupt over the next 8 years, which was a massively pessimistic assessment in my view. At the moment, the sentiment seems to be that Polaris will grow at a long-term (i.e. "perpetual") growth rate of about 5.5%. I consider this to be the mirror image of what we saw only two months ago. The sentiment has swung from excessive pessimism to excessive optimism in my view. Given the above, I can't recommend buying at current levels.

Options Update

In my previous article, I recommended selling the January 2021 Polaris puts with a strike of $45. At the time, these were bid-asked at $7.40-$9.10. I sold 10 of these and, somewhat surprisingly, I wasn't exercised in spite of the fact that they were in the money for a short time after I recommended the trade. They are currently bid-asked at $1.30-$1.55, and I'll be closing out the trade at a decent profit. I think these short puts offer even more vindication of the risk adjusted profit potential for short put options.

I normally recommend a short put that represents a decent combination of reasonable premium and reasonable strike price. I can't recommend one at the moment on this stock, though, as I think premia for reasonable strike prices aren't worth it. If the shares drop in price, I will certainly revisit this trade.

Conclusion

I think the case of Polaris Inc. demonstrates the fact that markets can overreact in both directions. Earlier, I think the market was excessively pessimistic about this company's future in the teeth of a pandemic. It has now flipped direction, and has moved to being excessively optimistic in my view. It's quite possible that the recent share price appreciation was a function of a massive uptick in stock buybacks. Whatever the reason for the switch, I'll be taking profits in my shares and short puts and will revisit the company if valuations return to what I saw a few months back. I think the company's coverage of future obligations is barely adequate relative to other companies I've recently looked at, and I think that sooner or later that will weigh on the shares. Given that investors have access to a host of different investment options, there's little reason to buy a very imperfect company that's priced like a relatively safe company. I'm "taking the money and running" here, and I recommend other investors do the same.

Analyst’s 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.

Although I'm currently long, I'll be selling this stock and buying back the puts on this stock over the next week.