Summary

By all indications the current valuation of Polaris Industries (NYSE:PII) provides an excellent opportunity for long term investors to take a stake. The company continues to lead the North American power sports market, and is well positioned to exploit growth channels within and outside the side by side vehicle category. The company has a massive moat built on its extensive dealer network, product design, manufacturing capabilities, brand, and install base. Product recalls, which have burdenned the company thus far, will likely be transitory, as the company has made the necessary investments in R&D and quality control to minimize future occurrence of product quality issues.

Background

About 63 years ago the company that we know today as Polaris Industries (NYSE:PII) was incorporated as a machine shop in Roseau, Minnesota. The company has come a long way from a group of explorers making snowmobiles as a hobby, to where they hold the number 1 market share in North American powersports. Polaris manufactures a wide assortment of side-by-side vehicles, all-terrain vehicles (ATVs), snowmobiles, motorcycles, and other small vehicles. They also manufacture and retail the parts, garments, and accessories (PG&A) that transform the image of an ordinary guy into a "rough cut" alpha male.

Track Record of Top Quality Performance

Things have not always been super at the company as there was a period during the 2000s when the company lost some of its shine. However, with the hiring of Scott Wine as CEO in 2008, profitability took a positive turn, and so did the stock price. Over the 9 year period from 2007 to 2015, the company grew revenues by a CAGR of 11%, operating income by 18%, and adjusted earning per share by 19.2% (reduced by income from financial services), while return on tangible capital averaged 45% (See Form 10-k). From 2008 to early 2015 the stock price increased sevenfold to US$150 per share. Data from industry reports indicate that today the company holds the number 1 market share in the off-road vehicle category, number 2 in snowmobiles, and is quickly stealing market share in the heavy duty motorcycle category (more on this later). The company has also amassed a suite of complementary businesses in the small commercial vehicle market, enough to pose a credible threat to current incumbents.

So what went wrong?

In our opinion, the years of market leading growth and profitability overshadowed a growing weakness in the company's operations. Caught-up in growing the business and designing great products, management, we believe, under invested in quality control, an error that was gradually unmasked as the company grew. Consequently, in the midst of its capacity expansion, Polaris had a number of product recalls. According to a press release in FY-15 the company said "recalling model year 2015 Polaris RZR 900 and 1000 vehicles due to reports of pinched fuel tank vent lines". Again through a press release in FY-16, Polaris said "[the] company is voluntarily recalling certain RZR 900 and 1000 off-road vehicles manufactured since model year 2013 due to reports of thermal-related incidents, including fire". This happened several times throughout the year and again in Q1 of FY-17. These recalls affected the company's results immensely. After a relatively mediocre performance in FY-15, the company then posted a 4.3% decline in revenues in FY-16, with adjusted EPS (Earning Per Share) and operating income declining by 48.4% and 52.2% respectively. Q1 of FY-17 was similarly dismal, with revenues (excluding the revenues from the TAP acquisition) flat relative to Q1 of FY-16, operating income down some 72%, and EPS a loss of 5 cents relative to a profit 0.71 cents in Q1 of FY-16 (Form 10-Q).

Time to invest, with all this terrible news

For the moment lets ignore the company's A+ management team, wide moat, attractive valuation, strong balance sheet, and discuss its quality control. Yes, recent results look terrible, but as long term investors, we are more concerned about management's response aren't we? Looking behind the numbers, the product recall statement Q1 of FY-17 also states:

...recalling certain model year 2015 RANGER 900s due to faulty fasteners on a heat shield, ..., as well as certain model year 2017 Sportsman ATVs due to a potentially faulty electronic power steering unit. Both recalls were prompted by data from the Company's enhanced post-sales surveillance capabilities, which gives Polaris the ability to rapidly identify product quality or safety issues in fielded vehicles. .. So, we've talked about increasing our safety and quality organization. So, we have hired and put in place a significant organization to make sure that we've got everything from post-sales surveillance to monitoring manufacturing and supplier quality set up and established.

In our view, this is symptomatic of management's laser-focus on limiting potential damages to the brand. It doesn't end there, the content of the last conference call also indicates that the company has upped investments in quality control at the manufacturing and post-sale level of the value chain, and has generated immediate results.

The A+ Team

In case you are not already convinced that management deserves an A+, let's look at the company's history. Under its velocity improvement program (VIP), management has been focused on lean manufacturing techniques to drive efficiency across the business. Over the period FY-07 to FY-15, operating profit margins increased from 10% of revenues to 15%, with the potential for further increases as management continues to generate savings from its VIP initiative. Polaris has made thoughtful acquisitions, that leverage its core competences, that are a great strategic fit, at conservative prices, and typically with cash on hand. The acquisition of Transamerican Auto Parts was done with cash at an implied EV/EBITDA of 9.0X, and transamerican Autoparts generated EBITDA growth of 17% CAGR over the previous 3 years. TAP is a manufacturer and distributor of off-road Jeep and truck accessories, and so TAP is a great strategic fit with Polaris' PG&A business unit and manufacturing strength. Notwithstanding the highly competitive motor sports industry, management has consistently generated return of tangible capital in excess of 38%, while maintaining a conservative balance sheet.

The company has maintained debt-to-capital ratios of around 38% over the preceding 9 years, but has increased this ratio to 59% post the TAP acquisition. Nevertheless, Debt service coverage ratio stands at 2.2X, while EBITDA interest coverage stands at 5.1X. We expect these ratios to improve as the full EBITDA contribution of the Transamerican Autoparts (TAP) acquisition takes effect in FY-17 (Form 10-K, Analyst reports).

Wide Moat

Augment a reputation for superior quality and innovation, with a large install base, and a community of recreational riders, and you have a sticky customer base. For the past 10 years, Polaris has led the off road vehicle (ORV) industry in product design and manufacturing quality- a point emphasized by Scott Wine in the Q1 FY-17 conference call. Polaris pioneered the side by side vehicle market, and has introduced the most modern technological features the industry has seen. Reviews from Dirt Trax TV and other customer surveys indicate that Polaris' ORVs stand head and shoulder above the competition on ride quality, features, engine power, build quality, handling, and ergonomics. Polaris' unmatched manufacturing and design capabilities are also evident in rider impressions of Indian motorcycles, which have been better than Harley Davidson's. Participants of motorcycle.com, and the Bike Show have highlighted the Indian Scout 60 as a clear leader in ride quality, design, engine power, and durability.

In our view, Polaris' extensive dealer network is difficult to replicate by those outside the industry, and very few inside the industry can match its size. The structure of its dealer network (its size and incentive scheme) gives the company enormous leverage to implement industry leading customer experience. It also provides a channel for the company to cross sell items from its PG&A business, items that often carry higher margins. As outlined in the company's 10-K, products are sold through 1,800 independent dealers in North America, and 1,700 independent international dealers. The dealers are also incentivised to sell Polaris products, a point reinforced by Scott Wine in the Q1 FY-17 conference call when he said:

What we're finding is if you factor in the overall dollars that most of our multi-line dealers make, they're still making the vast majority of their money from Polaris", in response to a question on dealer profitability

Our calculations indicate that, although not operating at the lowest unit cost (economic cost/unit of ATVs, Side-by-Sides, Motorcycles, Snowmobiles & Watercrafts; filings of Kawasaki, Honda, Suzuki, Polaris, Yamaha, BRP, Artic Cat, BMW, Harley Davidson, & Volkswagen Group) in the powersports industry, the company has had one of the lowest cost among those who compete on quality. It certainly has the lowest cost among European and North American manufacturers, but its cost is above that of the Japanese manufacturers. Overtime we expect the company to continue cost improvements under its VIP initiative and perhaps approach that of the Japanese. Polaris however, does not compete on price, instead they aspire to provide innovative and high quality products as defined by ride quality, features, power, ergonomics, and handling. They also leverage their extensive dealer network and large install base to provide an engaging rider experience. Japanese vehicles simply do not have the brand equity to match this level of differentiation, and so most Japanese brands compete on price.

Attractive Valuation

Insiders are buying like crazy, what do they know? To buy any company with a strong moat at an EV/EBITDA of 7.0X is a deal, let alone Polaris. The closest comparable companies trade between 7.1X and 10.1X, with a median of 8.7X. At the high end of the spectrum is BRP Inc. (OTC:BRPIF) trading at 10.0X. Harley Davidson (NYSE:HOG) and Thor Industries (NYSE:THO) are at 7.1X and 7.4X respectively. Harley Davidson and Polaris have had similar return on capital, and credit ratios. In recent times, both companies have had similar sluggish growth, albeit for different reasons. Polaris's revenues have been declining primarily because of product recall issues, while Harley Davidson's because of competition and a slower retail environment. Thor Industries has had lower margins, and lower return on capital, but a better credit profile than Polaris. Thor industries also has had higher growth, but the growth is primarily inorganic. BRP Inc. has had lower margins, lower return on capital, lower credit ratios, but similar organic growth as Polaris pre-recall.

Comparable Companies

In our view, an EV/EBITDA of between 8.0X to 15.0X with base case of 11.0X is appropriate for Polaris, which is consistent with that implied by our discounted cash flow (DCF) model. That would give us a price range of approximately US$ 100.0 to US$ 200.0 per share, with a base case of US$ 141.0 per share. The premium valuation is driven by higher medium term expected growth, and expectations of return to industry leading margins, return on capital, and credit risk. Our DCF model gives us a price range of US$ 96.0 to US$ 200 per share, with base case of US$ 147.0 per share. The current trading range of US$ 80 to US$ 92 per share provides a massive upside to the patient investor, with a large margin of safety on the downside.

Our DCF model is based on the following assumptions:

Base Case:
  • Weighted average cost of capital of 9.2%
  • 10-Year Free Cash Flow CAGR of 6.3%
  • Terminal year free cash flow growth of 3.1%
  • EBITDA Margin averaging 18.0%
Optimistic:
  • Weighted average cost of capital of 9.2%
  • 10-Year Free Cash Flow CAGR of 7.4%
  • Terminal year free cash flow growth of 3.1%
  • EBITDA Margin averaging 19.1%
Conservative:
  • Weighted average cost of capital of 9.2%
  • 10-Year Free Cash Flow CAGR of 4.5%
  • Terminal year free cash flow growth of 2.8%
  • EBITDA margin averaging 15.0%

Polaris can achieve higher long term growth than the 2% growth implied by its current EBITDA multiple, given its position in the industry, innovation track record, and the suite of products available. We believe that within the next 10 years, Polaris is positioned to generate revenue growth between 4% and 8%, against the backdrop of a 10% CAGR over the last 10 years. Customer reviews show that, despite increased competition, Polaris continues to make the best off road vehicles (ORV) on the market. This unmatched vehicle quality can drive high single digit growth in the Europe, Middle East & Africa and the Asia Pacific regions, where there is a ready addressable market. A 345,000 sqft manufacturing facility was built in Poland in FY-14, which positions the company to execute within the next 3 years. Management has grown the ORV business by 11.0% CAGR over the last 15 years, and so a mid single digit growth rate is certainly realistic.

Polaris continues to grab market share in the North American cruiser and touring motorcycle category, a category currently dominated by Harley Davidson. As explained earlier, riders continue to rank the Indian motorcycle above similar Harley Davidson motorcycles on design, ride quality, power, and handling. There has also been a growing community of Indian riders glued by the rich tradition of the Indian brand. The strength of the Indian brand, and the competitive price tag of the bikes, positions Polaris to continue stealing market share. The motorcycle division has grown by a 34% CAGR over the least 15 years. With product innovations such as the slingshot, and a narrower focus on the Indian brand, the company should able to gain momentum. The CAGR business grew by a CAGR of 10% through acquisitions and organic growth over the last 10 years. In the preceding 4 years, the global adjacent markets business unit has grown by 8% CAGR organically, on top of growth from acquisitions. We see no reason why this trend will discontinue in the medium term, given the size of the addressable markets and management's execution record.

We expect the company return to credit ratios that are better than industry average, as product recall issues dissipate. Ongoing improvements in cost as well as a normalization of product quality are also expected to put EBITDA margins above the 18% range, and return on capital above 40%.

Investment Risks

Our forecasts are subject to the following risks which could lead to actual valuation being less than anticipated.

  • Polaris manufactures the majority of its products in lower cost countries, and therefore a tax imports into the USA (its largest market) could reduce the after-tax cash flow of the business, and hence lower our valuation.
  • The company face competition from Japanese companies that currently have a cost advantage. A rapid reduction in the quality gap between Japanese and Polaris vehicles could lead to higher promotions, R&D, and lower pricing. This would lead to reduction in profitability, and the after tax free cash flow of the business.
  • The value assigned to Polaris is driven immensely by growth, and though the company's history and market opportunities gives us a high degree of confidence in the projections, there is still a certain degree of execution risk.

Last Words

After getting hit by several rounds of product recalls, Polaris Industries saw its stock price of declined. Management's reponse was appropriate as they have quickly implemented the necessary infrastructure to minimise further product quality issues. This gives us a level of confidence in the company's ability to return to profitable growth. Additionallly, the data indicate that management has been doing well at keeping ahead of the competition and delivering top tier shareholder returns for the last decade +. The company enjoys market leading return on ivested capital, and has expanded its market share in key product segments. We expect this level of performance to continue.