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While currently fairly priced given developments in the business to date, Polaris Industries Inc (NYSE:PII) still has more to offer to shareholders. Management has a lot of unfinished business to attend to, which if dealt with will lead to incremental cashflows to the business. Incremental cash flows will come from further cost optmizations in the Global Adjacent Markets Business, sustained growth in the off road vehicles (ORV) business segment, and more penetration of the heavy duty motorcycle segment, and cost/quality optimizations.
It has been almost six months since our first report on Scott Wine and his team at Polaris Industries Inc., and almost a year since we took a position in the company. Wow, time does go by quickly doesn't it? Today, we are sitting on unrealized percentage gains in the high-fifties, but we have no intentions to sell. Why? We think Scott Wine and his team have a lot more work to do to get the business back on track. From our vantage point, we see the potential to further improve earnings power through 4 levers namely, greater penetration in the international (ORV) market, greater penetration in the North American motorcycle category, more revenue synergies from the Transamerican Autoparts (TAP) acquisition, and continued cost and quality optimization. These levers certainly have the potential to optimize earnings in the near term. In the long run, we think that Polaris and other incumbents in the power sports industry, can build momentum through innovations in marketing and product development.
Before we delve into the value enhancing levers, let us take a step back and take a "bird's eye view" of the Q3 of FY-17 financial results. According to data provided by the company, Q3 revenues increased 25%, while revenues in the 9-months ending in Q3 increased 21%, relative to the same respective periods a year earlier. Core Generally Accepted Accounting Principles (United States) operating income (operating income LESS income from financial services) increased 158.6% in Q3, but was down 6.7% in the 9-months ending in Q3, relative to the same respective periods a year earlier. Normalized for non-recurring expenses (management's guidance for one-time costs associated with the wind-down of the victory product line, manufacturing re-alignment, and the write-up of inventory associated with the TAP acquisition), core operating income increased 198.7% in Q3, and 34.2% in the 9-month period ending in Q3, relative to the same respective periods a year earlier. Earnings per share on a Generally Accepted Accounting Principles (United States) basis was 1.28 per diluted share in Q3-- adjusted for non-recurring expenses-- was 1.46 per diluted share, up 192% relative to Q3 in FY-16.
In our view, the underlying economic drivers of the results are improving global ORV industry demand coupled with Polaris' strong competitive position in the side-by-side market, improving demand conditions in Europe, and the TAP acquisition. Polaris management estimates that the ORV industry grew in the 5% to 10% range in Q3 of FY-17 -- an estimate consistent with our own calculations that we imputed from other industry players. Data provided by Polaris also indicate that in Q3 of FY-17 ORV segment sales grew 13% in North America, versus the 5% to 10% industry average, which in our opinion reflects Polaris' market leading product lines, and a partial recovery of market share due to improved brand perception. The part garments and accessories (PG&A) business segment benefited in Q3, from the TAP acquisition that contributed US$191Mn to segment revenues (84% segment contribution in the quarter). On a pro-forma basis, the (PG&A) business grew 6%, and excluding TAP sales the (PG&A) segment grew organically by 13%. The global adjacent markets segment benefited from improved economic conditions in Europe, as the 17% year-to-date growth in revenues reflect strong Aixam and Goupil Sales.
While we love to see businesses that we own take advantage of macroeconomic tailwinds, as value investors we also want to see the business return to optimal profitability in the shortest possible time. With that said, we are narrowing our focus on areas that are value enhancing irrespective of the stage of the business cycle. Sales of ORV and snowmobile are below trend, and are much closer to those seen in Q3-13.
Currently, Polaris earns roughly 14% of total sales from markets outside of North America. Management already had plans to increase that to 33% by 2020, on a targeted revenue base of US$8Bn. After product quality issues surfaced the targets appeared stretched and subsequently, management have communicated that the "vision and strategy remains unchanged, but we are reviewing financial goals given recent performance". On the Q3 conference call Scott Wine mentioned that the new financial targets will be made public in January 2018. We believe that this is a key growth driver for the business going forward, and we expect particular focus on the market potential for side-by-side unit growth in the Agriculture and the Oil & Gas sectors internationally.
Large agriculture equipment manufacturers such as Dree & Co, Kubota, and Caterpillar are focused primarily on heavy machinery, with small tangential units that handle lower cc vehicles. In our view, Polaris with primary expertise in manufacturing low cc vehicles could take a small share of the US$368Bn global market, which is expected to grow at 10.2% CAGR over the next decade. North American power sports represents close to 65% of the global power sports industry, with the US alone accounting for more than 50%. Polaris Industries is already the market leader on a global level, but there are opportunities to "grow the pie". Most of the demand for off-road vehicles in North America are for leisure, with the average customer aged 45 to 55, and earning in excess of US$90K per year. If we assume that the customer profile for ORVs is consistent across the world, we can be sure that growing the "pie" in leisure is dependent on a rising middle class outside of America. Certainly, customers in the Asia Pacific and Latin American region seem the right fit long term, given rising income per capita, and their increasing taste for high quality products. This may require time however, given that supporting infrastructure around this type of leisure is not yet fully ingrained into the culture. In the interim, the global agriculture and oil & gas industries represent an enormous opportunity to expand market share, and perhaps could be the driver of activity for a protracted time.
Polaris Industries also have a long runway ahead for its heavy-duty motorcycle product offerings. Recent market share gains for the Indian brand is commendable, but after the victory brand was put into wind up mode in 2017, it is likely that some of the market share gains in the Indian brand are former victory customers. Corporate level gains in market share could therefore be minimal thus far. The heavy-duty motor cycle segment is challenging even in a business as usual scenario, given the strength of the Harley Davidson brand, who is also the market leader with over 51.3% market share. The challenges are further exacerbated by macroeconomic headwinds in North America--the largest market--some of which are secular and some temporary. Given Harley Davidson's economic model, and the degree of leverage in their business, we expect them to put up a fight to maintain market share. We feel good nonetheless, because management has taken the decision to compete with a brand that can claim a deeper connection with American heritage than Harley Davidson can. Consumer reviews also show that riders are throughly in love with the bikes, a fact that will manifest in the financials when the marketing machinery goes full steam. In time, this market segment can be transformed into a duopoly.
The Slingshot has been having a tough ride since reports of product quality issues. In Q3, unit sales were down double digits. Since the product quality issues surfaced the motorcycle business have been volatile, which have been causing some concern among investors. In our view, the slingshot is a great product that serves a unique niche in a market with little or no direct competitors. Product quality issues will deter any customer from purchasing any product, and so we think it is up to management to implement procedures to minimize the recurrence of further quality issues. This is an area we think management must focus on in order to get the business running optimally, and to maintain a brand perception of high quality.
Looking at the business of both TAP and Polaris Industries, we think there are revenue synergies to be had. This is not to say that we are relying only on revenue synergies to assess the company, as serial deal maker John Malone would say "revenue synergies are very hard to justify". We think that the TAP deal is value accretive "off the bat" without synergies. According to data provided by management, TAP was purchased at an EV/EBITDA multiple of 9.0X, which is not particularly high in an absolute sense, and may even be cheap given the business is estimated to have an EBITDA margin of 10.5%, and to have grown EBITDA by 17% CAGR over the preceding 3 years. Notice we are a bit hesitant to speak definitively, as we do not have enough data to cyclically adjust the growth in EBITDA, and so the 3-year CAGR might reflect cyclical tailwinds. Even so, year-to-date pro-forma growth in revenues has been reported at around 6%, which higher than US nominal GDP growth, with 1 Quarter remaining, seasonal demand, and scale advantages to consider. Polaris also ahead of target on estimated cost synergies of US$20Mn, which we think is already conservative given where TAP's SG&A margin was relative to corporate average. After adjusting for cost synergies, we get an EBITDA multiple of 6-8X which would be cheap by anyone's standards.
Why are we confident about revenues synergies? The size of the addressable market of US$10Bn leaves a lot of room to grow, even if it is through bolt-on acquisitions. In addition, the customer profile of both companies are similar. In fact, how does one get an ORV to the dirt track? It must be carried on-road by either truck or a jeep, or some sort of 4-wheeled drive vehicle, so why not "pimp your 4-wheeled ride" with some TAP products while you are at it. With 75 retail outlets, and 6 distribution centers, their customer reach is tiny in comparison to Polaris network of 1,800 independent dealers in North America, and 1,700 independent international dealers. Undoubtedly, to get to the point of getting revenue synergies, management will have to make changes to the supply chain, sales teams, distribution networks, negotiate with dealers, change the current footprint of installation centers etc etc. A lot of work to do, but that is what their business is about isn't it.
Quality has been a major problem for Polaris Industries since Q4 of FY-15, but we feel that the Polaris brand has not been permanently impaired, and that the ball is in management's court as relates to improving brand perception. We feel good about management's comments on the Q1 of FY-17 conference call:
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.
On the other hand, we do not feel good about the number product recalls that have occurred subsequent to that statement, some of which are for 2017 and 2018 model-year products. With warranty accruals just shy of US$200Mn (4.3% of revenues) in FY-16, and management underestimating the amount for accruals for FY-17, we would like to see more emphasis placed in this area.
Polaris also has enormous opportunities to drive value in the business over time, through cost improvements. Management deserves high points for identifying, without the involvement of shareholder activists, areas where margins can be improved substantially. The company managed to get US$150Mn in FY-16 under their VIP program, and has projected to get somewhere north of US$150Mn in FY-17. According to management, some of the areas where cost savings have been solicited include, factory inventory, logistics, manufacturing, and materials handling. Year-to-date Polaris has spent close to US$10Mn for manufacturing re-alignment in their Global Adjacent business segment. In our view, this business segment has the greatest potential for cash flow improvement from cost savings, as this segment is an amalgam of acquired businesses that use similar production technologies, and that have not been fully integrated as yet. With continued focus on lean initiatives, quality, consolidation of factory space, and streamlining of production processes, this business unit has a lot more "juice to squeeze out".
In summary, the Polaris management team has a lot of work ahead to deliver additional value for shareholders. We believe that the current valuation is fairly reasonable in consideration of what the team has done thus far, but is yet to include additional value enhancing initiatives to come. Given the track record of Polaris under CEO Scott Wine, we feel fairly comfortable assuming these initiatives will get done. In January 2018, we hope to get additional information about the future plans of the company, and may revise our thesis then.