Polaris' Profits Headed North

Polaris PII is one of the longest-operating brands in powersports. We believe that its brands, innovative products, and lean manufacturing yield the firm a wide economic moat and that it stands to capitalize on its research and development, high quality (which has admittedly taken a few steps back in recent periods), operational excellence, and acquisition strategy. However, Polaris' brands do not benefit from switching costs, which makes it hard to capture incremental share in the off-road segment; peers are innovating faster than in the past, jeopardizing the company's ability to easily take price, particularly on the heel of recent recalls.

Polaris has sacrificed some near-term financial flexibility by financing most of its recent acquisition of TAP, which could lead to crimped free cash flow gains as operational excellence and lean initiative benefits are offset by higher debt-service costs. The firm's manufacturing footprint should finally be the right size, with Alabama open and the consolidation of some smaller facilities, yielding distribution savings and improved capacity utilization. We anticipate the resumption of top-line growth in 2017 bolstered by the TAP addition, despite pricing pressures persisting in the off-road vehicle segment. With Polaris plagued by ORV recalls and delayed shipments for model year 2017, we think it will take some time for the firm to rebuild brand goodwill and pricing power in the ORV segment, which will weigh on segment growth potential. We plan to watch market share trends unfold, and we think if share erodes persistently, it could signal that the firm's competitive edge is deteriorating. For reference, the ORV/snowmobile segment represented 74% of total sales in 2016 (versus 84% in 2014).

We see growth ahead coming from motorcycles, global adjacent markets, and the recent entry into the truck afterparts market. We think acquisition opportunities remain across global adjacent markets, which can build incremental demand. International expansion remains promising and could drive revenue upside, particularly as Polaris increases its global operating presence with a wider physical presence and partnerships with peers in India and China.

Brand Strength Results in Wide Moat
We believe Polaris has established a wide economic moat, delivering healthy returns on invested capital that have averaged more than 50% in the past five years. Nonexistent switching costs could weigh on pricing power intermittently. However, we believe innovative product offerings and growth of adjacent categories through acquisitions (as well as organically) have positioned the business to continue to capture increasing volume and profits as it reaches new end users. Our main concern now is that recent hiccups in the quality of innovation along with an increasingly competitive environment could be putting Polaris' wide moat at risk. We plan to watch the company's ability to protect market share and restore brand goodwill in the ORV segment over the near term to determine whether brand equity has been temporarily or permanently impaired by recent recalls. In our opinion, Polaris is taking the right steps to protect its wide moat, hiring a head of quality and reassessing its manufacturing processes and product output to prevent further product mishaps.

More than 60 years ago, Polaris started to build its reputation and brand by producing snowmobiles. In the decades since, the company has expanded into all-terrain vehicles, motorcycles, people movers, and for a short period, personal watercraft, building a recreational and utilitarian vehicle powerhouse. Holding leading market share positions in all of the categories in which it operates (the company is number one in ATVs, utility side-by-sides, recreational SBS, quadricycles in Europe, and ultralight tactical vehicles for military and number two in snowmobiles and domestic motorcycles) has ensured the company's brand remains relevant. We believe that when consumers replace or think about purchasing products in the snowmobile and off-road categories, they tend to want the best products with the newest technology, which is what Polaris provides, yielding stability in pricing and positive brand perception.

We believe the volume of product that the firm manufactures and ships leads to meaningful cost leverage, as Polaris sold $4.5 billion in goods in 2016 versus a projected $588 million for Arctic Cat (March 2017 year-end, recently acquired by Textron TXT ) and CAD 4.1 billion for BRP DOO (January 2017 year-end). We think the company's cost leverage can continue to improve as the expansion of its brand presence overseas leads to further unit volume growth. While the relaunch of Indian motorcycles in 2013 and the continued evolution of on- and off-road products (Slingshot and Ace launched in 2014) should drive domestic demand, small vehicles could experience robust growth overseas. Over the past few years, management has pieced together a significant stake in the global small-vehicle business, which included the acquisitions of GEM, Taylor-Dunn, and Aixam Mega, along with its joint-venture product launch of the Multix with Eicher in India. We still believe there are opportunities to increase exposure in small-vehicle sales (now known as global adjacent markets) over time through a series of further acquisitions, which could provide material growth in international markets. With new manufacturing facilities abroad, we could see operating efficiencies achieved with the appropriate acquisitions, and with a distribution network already intact overseas, we think acquired sales could rise quickly. This could boost Polaris' scale faster, helping the business capture further operating efficiencies and possibly boosting operating margins higher than we currently anticipate, as lean manufacturing has remained a key theme over recent years. As the company rights the ship domestically, however, some of these transactions could be put on hold for now.

We think the company's economic moat is predicated on its brand strength, but low-cost production supports and strengthens its moat rating. Having competitive manufacturing facilities in strategic locations gives the company the ability to remain an efficient and low-cost competitor. In 2012, the company opened its first factory in Mexico, aiding distribution in the Southwest and engaging labor at competitive rates. After that, the firm added extra capacity in Milford, Iowa (adjacencies and capacity, but now being consolidated given waning demand), more space at Spirit Lake, Iowa, expanded room at Roseau for the lean manufacturing transformation, the Aixam plant for people movers, a new facility for production in Poland, an acquired facility in South Dakota, and a new plant in Alabama. In addition, new vehicle production in India through the joint venture with Eicher will provide Polaris with quick distribution to the Far East and possibly a better tariff situation, increasing the company's visibility and footprint significantly.

Concerns Include Economy and Weather
Polaris faces a number of risks. Motorcycles, snowmobiles, and ATVs are all big-ticket items, and a slowdown in the global economy could hamper the replacement and adoption rates of these recreational products. Another domestic downturn could also affect financing rates at the dealer and retail levels. In 2016, consumers financed 33% of the vehicles sold in the United States through Performance Finance, Sheffield, or Synchrony, and changes in lending standards could prove problematic. Polaris faces integration risk, particularly as it has become more acquisitive, and liability risk, as it self-insures against product liability claims. Weather is the biggest factor Polaris cannot control; sales of snowmobiles are correlated with the amount of snowfall generated in any given season, making segment volume more volatile than the others. Persistent recalls also weigh on the firm's ability to maintain its brand equity. We assume U.S. corporate tax reform will benefit Polaris starting in 2018; deviation from our targets could lead performance to stray from our valuation. Finally, foreign exchange exposure could prove unpredictable as the firm grows internationally, making sales uncertain.

We remain concerned that the powersports industry has numerous key players that can compete on price to take share from Polaris. In ATVs, competitors like Honda HMC and Deere DE are formidable players, while Indian has to compete with motorcycle manufacturing giants Honda and Harley-Davidson HOG . All of the aforementioned brands have huge franchises and financial resources, which could cause the environment to become promotional. Although Polaris has held its ground against these incumbents, competitive winds got the best of the company in 2004 when it sold its personal watercraft business, and the concern remains that it could happen again (we think this was a factor in the Victory motorcycles wind-down decision).

Polaris is poised to produce strong cumulative free cash flow over the next five years worth more than $2 billion; thus, there should be no concern repaying debt as it comes due. The company maintains flexibility in its capital structure through stock repurchases and dividends. We don't expect Polaris to aggressively repurchase shares in 2017, given its recent purchase of TAP, but anticipate it will continue to fund its annual dividend of $2.32 per share.