POLARIS INDUSTRIES INC PII
May 20, 2015 - 3:17pm EST by
Investor
2015 2016
Price: 140.00 EPS 0 0
Shares Out. (in M): 67 P/E 0 0
Market Cap (in $M): 9,310 P/FCF 0 0
Net Debt (in $M): 218 EBIT 0 0
TEV ($): 9,528 TEV/EBIT 0 0

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  • Manufacturer
  • Leisure
  • recreational vehicles

Description

Summary:

 

PII represents an opportunity to buy a great company with returns on capital in excess of 40% and consistent top-line growth in the double digits.  Some of the nuance around the key debates have changed, but are largely the same arguments that pop-up every year around this time.  At the core of the debate is the sustainability of the aforementioned top-line growth and evidence of its imminent deceleration as demonstrated by growth in channel inventories.  These issues bear monitoring, but their importance is overstated in the context of an industry with such robust growth characteristics.  Said differently, current end-market demand is sufficient to fix the inventory overhang in less than 2 quarters. 

 

Aside from the hyper focus on PII's SxS business, I think there is an underappreciated margin story building.  The company hired a new EVP of Operations last November who is focusing on lean initiatives and driving scale benefits through PII's rapidly expanding manufacturing footprint.  The biggest opportunity might be in PII's motorcycle business, which is currently losing money.  Fixing the paint issues at the Spirit Lake facility and scaling Indian represent near term opportunities.  For context, HOG's motor margins are ~18% leaving PII with a lot of headroom for improvement. 

 

Key issues:

 

Agricultural bust and oil correction will negatively impact PII's core end markets.

 

Response:

The ag thesis has been around for ~18 months now and has yet to show up in the numbers for either PII or any of its competitors.  While some dealer checks in the corn belt have validated the thesis by acknowledging that they've seen a slowdown, none are concerned on an outright basis and have noted incremental offsets to the positive.  With respect to oil, it would only affect 2 states, TX and PA and is already beginning to recover.  Contacts note that the ratio of new to trade in buyers is the same today as it was 5 years ago, which when combined with continued HSD-LDD percentage retail growth suggest that category saturation is still a ways off.  In terms of what's possible, the North American ATV market peaked at 650k units while global SxS sales were 413k last year and one could argue that the TAM for SxSs is larger than ATVs. 

 

FX led promotionality, particularly by the Japanese players will eat into PII's ~60% market share in SxSs.

 

Response:

It's clear from speaking to dealers that the competitive environment is heating up.  Management has acknowledged as much, but noted that it's primarily at the low-end (a notion supported by DOO CN).  Commentary from HOG has added fuel to this fire, but it's worth noting that their problems appear to be industry specific to motorcycles.  One key distinction between ORVs and motorcycles is that the ORV industry is still growing at a healthy clip while motorcycle industry units have been barely positive for the last 5 quarters.  The point being that ORVs don't represent the same zero sum type environment that we're seeing in motorcycles.  PII's stock can still work if their ORV business grows at a mid-single digit rate vs. the industry at high-single digits, thus losing share.  To a certain extent this is inevitable as their share is unlikely to stay around its current ~60% forever.  As long as the share loss is promotionally led (as opposed to a product misstep) and they're still growing I don't see reason for concern. 

 

It's also important to understand the relative differences in the manufacturing bases in each industry.  Of particular note is the fact that ORV manufacturing by the Japanese brands by and large occurs in the United States as compared to in Japan for motorcycles.  It's therefore more difficult to use the Yen as a competitive weapon in ORVs than it is in motorcycles. 

 

Finally, I think it's worth disaggregating the relative trends between ATVs and SxSs.  PII's total ORV retail sales were up mid-single digits in Q1, but that was comprised of relatively flat growth in ATVs and ~7% growth in SxSs.  The point here is that end market demand in the company's bread and butter SxS business remains robust.  It would be more concerning if the opposite were true and their highest margin, core business was no longer growing.  Specific to ATVs, being flat in Q1 is actually a pretty amazing feat given the just how ridiculous the promotional environment was.  This is largely the result of new leadership at ACAT.  We know from their recent release that the new management team is deploying a reset strategy whereby they're clearing the channel of all inventory at any cost.  As such ACAT's Q1 ATV sales were up 40% at retail and their gross margins were actually negative as they took an inventory reduction charge.  This promotional cadence will clearly not go on forever and in my opinion actually represents a share opportunity for PII (more on this below). 

 

The mid teens growth in dealer inventory is clear evidence that PII is stuffing the channel. 

 

Response:

Management has been forthright about this issue and tried to address it head on by disaggregating the components of its growth.  As such, 7 points of the increase comes from new models as 2015 represents the largest product launch in company history, while another 4 points comes from incremental distribution via new dealers coming into the network.  That said, PII has admitted that a few points of the inventory growth was unplanned and the result of weather and promotionally affected sales in Q1. 

 

It's evident from talking to dealers that the new RFM inventory management system lacks flexibility and is forcing them to take on some unwanted ATV inventory (the system has not been deployed for SxSs yet).  While management would never admit to it, this could be an aggressive market share strategy.  Basically we know that ACAT is sucking the channel dry so it behooves PII to replace that floor space and tie up dealer capital in advance of ACAT's new product launch.  In this regard I'm fine with the company using its superior market position to disrupt a competitor. 

 

Similar to the discussion above on the relative performance of ATVs vs. SxSs, it sounds like of the excess inventory that does exist, it's more heavily weighted toward ATVs.  Once again it's encouraging that there doesn't appear to be a major problem in the core profit center of the company.  From a sentiment standpoint dealers seem to acknowledge the inventory build, but are not overly concerned by it.  This is helped by early season checks through mid-May indicating that retail has accelerated to a HSD-LDD% pace in terms of units. 

 

So what if we're wrong and there really is a problem, what's the right way to contextualize the downside?  If we make some basic assumptions about ASPs, we can ballpark some unit numbers for the company’s ORV business.  Given that they give us a split between pricing and unit growth at wholesale as well as retail sell through, we can then make some estimates about how inventories have built over time in channel.  This is clearly an imprecise science, but is sufficient in terms of getting us to a ball park number to see what a channel destocking would look like.  The output of my assumptions suggests that PII wholesaled ~257k ORVs in 2014 and that there are ~4k excess units in the channel at the end of Q1.  If we assume a 4 point spread between sell in and sell through it would take ~1.6 quarters for channel inventory to decline on a y/y basis. 

 

 

Therefore if Q2 retail units come in at a HDS-LDD rate and the company wholesales 5%, the channel would be almost entirely clean in just over one quarter.  We know based on how the company is guiding that's not going to happen, as management has told the Street to expect continued growth in channel inventory, but at a declining rate. 

 

The key understanding from my perspective is that this isn't a problem as long as the industry is still growing.  Given the persistent double digit unit growth of the last several years, that doesn't really seem to be in question outside of a tail risk macro type event. 

 

I think it’s also underappreciated just how achievable PII’s guidance really is.  For ORV’s (+60% of revenues) the company is guiding to mid-single digit growth, while the street is modeling 6.9% growth in this business.  As can be seen below, if we assume that PII’s wholesale unit growth is 0% in the final 3 quarters of 2015 and that they get 4 points from a price/mix benefit (4% is in line with what they’ve achieved the last 3 years), ORV sales will be up 5.5% for the year. 

 

 

To get upside to the Street’s 6.9%, we only need to assume that wholesale units exceed a 1.4% average rate in the next 3 quarters.  As a reminder our preliminary checks suggest retail units through mid-May are showing HSD-LDD growth.  The point here is less about how much upside there could be and more about how little downside there likely is.  Simply said it’s very difficult to fathom the scenario under which wholesale units turn negative in the back part of 2015, which is what needs to happen for PII to miss numbers. 

 

 

Budding Margin Opportunity:

 

The company is becoming increasingly vocal about a burgeoning margin opportunity that is not yet adequately reflected in the Street’s numbers.  In November the company hired Ken Pucel from Boston Scientific to fill its newly formed EVP of Operations, Engineering, and Lean.  While specifics are still on the come, we have some clues about what the size of the opportunity might look like.  In recent investor meetings the CEO Scott Wine has suggested that lean initiatives could lead to 3-5 points of gross margin improvement.  As mentioned earlier, we also know that the motorcycle business is currently being run at a loss—likely 20 points below HOG’s margins by our estimates.  The Motorcycle business alone could represent 3 points of EBIT margin opportunity as it scales over the next several years.  This says nothing about the rest of the manufacturing footprint, which to date has been solely focused on meeting demand as opposed to having been optimized for scale efficiencies.

 

 

To this end, it’s possible that we could get an update to long-term guidance at the analyst day in July.  Raising the long-term profitability targets above the current 10% net margins should act as another catalyst for the stock. 

 

Valuation:

 

Bear Case: $116 or ~17% downside.  It basically assumes 2.5% growth in ORV’s (below the MSD guide) and consensus for the other segments.  Beyond that if 80% of the opex is fixed, I get to a 2015 EPS of $7.13:

 

 

Base Case: $171 or ~22% upside.  I’m modestly above street numbers, primarily driven by ORVs and Motorcycles in conjunction with slightly better margins: 

 

 

 

Upside Case: $198 or ~42% upside.  Assuming $8B in revenues for 2020, in line with management’s guidance, implying a 10.1% CAGR off the 2014 base.  I then sensitize those scenarios with a buyback and margin expansion assumptions.  The EPS CAGRs over those periods are 16.5% and 18% respectively. 

 

 

In terms of buyback, I’m modeling $5-600m annually, which is well within the company’s capacity even with continued increases in their dividend.  While this is likely in excess of what management will actually do, it compensates for tuck in acquisitions that I’m not modeling and as we know from the last several years, this is an acquisitive management team. 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Opportunity to buy best in class powersports operator as shares are pressured by transient concerns over channel inventory levels.  

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    Description

    Summary:

     

    PII represents an opportunity to buy a great company with returns on capital in excess of 40% and consistent top-line growth in the double digits.  Some of the nuance around the key debates have changed, but are largely the same arguments that pop-up every year around this time.  At the core of the debate is the sustainability of the aforementioned top-line growth and evidence of its imminent deceleration as demonstrated by growth in channel inventories.  These issues bear monitoring, but their importance is overstated in the context of an industry with such robust growth characteristics.  Said differently, current end-market demand is sufficient to fix the inventory overhang in less than 2 quarters. 

     

    Aside from the hyper focus on PII's SxS business, I think there is an underappreciated margin story building.  The company hired a new EVP of Operations last November who is focusing on lean initiatives and driving scale benefits through PII's rapidly expanding manufacturing footprint.  The biggest opportunity might be in PII's motorcycle business, which is currently losing money.  Fixing the paint issues at the Spirit Lake facility and scaling Indian represent near term opportunities.  For context, HOG's motor margins are ~18% leaving PII with a lot of headroom for improvement. 

     

    Key issues:

     

    Agricultural bust and oil correction will negatively impact PII's core end markets.

     

    Response:

    The ag thesis has been around for ~18 months now and has yet to show up in the numbers for either PII or any of its competitors.  While some dealer checks in the corn belt have validated the thesis by acknowledging that they've seen a slowdown, none are concerned on an outright basis and have noted incremental offsets to the positive.  With respect to oil, it would only affect 2 states, TX and PA and is already beginning to recover.  Contacts note that the ratio of new to trade in buyers is the same today as it was 5 years ago, which when combined with continued HSD-LDD percentage retail growth suggest that category saturation is still a ways off.  In terms of what's possible, the North American ATV market peaked at 650k units while global SxS sales were 413k last year and one could argue that the TAM for SxSs is larger than ATVs. 

     

    FX led promotionality, particularly by the Japanese players will eat into PII's ~60% market share in SxSs.

     

    Response:

    It's clear from speaking to dealers that the competitive environment is heating up.  Management has acknowledged as much, but noted that it's primarily at the low-end (a notion supported by DOO CN).  Commentary from HOG has added fuel to this fire, but it's worth noting that their problems appear to be industry specific to motorcycles.  One key distinction between ORVs and motorcycles is that the ORV industry is still growing at a healthy clip while motorcycle industry units have been barely positive for the last 5 quarters.  The point being that ORVs don't represent the same zero sum type environment that we're seeing in motorcycles.  PII's stock can still work if their ORV business grows at a mid-single digit rate vs. the industry at high-single digits, thus losing share.  To a certain extent this is inevitable as their share is unlikely to stay around its current ~60% forever.  As long as the share loss is promotionally led (as opposed to a product misstep) and they're still growing I don't see reason for concern. 

     

    It's also important to understand the relative differences in the manufacturing bases in each industry.  Of particular note is the fact that ORV manufacturing by the Japanese brands by and large occurs in the United States as compared to in Japan for motorcycles.  It's therefore more difficult to use the Yen as a competitive weapon in ORVs than it is in motorcycles. 

     

    Finally, I think it's worth disaggregating the relative trends between ATVs and SxSs.  PII's total ORV retail sales were up mid-single digits in Q1, but that was comprised of relatively flat growth in ATVs and ~7% growth in SxSs.  The point here is that end market demand in the company's bread and butter SxS business remains robust.  It would be more concerning if the opposite were true and their highest margin, core business was no longer growing.  Specific to ATVs, being flat in Q1 is actually a pretty amazing feat given the just how ridiculous the promotional environment was.  This is largely the result of new leadership at ACAT.  We know from their recent release that the new management team is deploying a reset strategy whereby they're clearing the channel of all inventory at any cost.  As such ACAT's Q1 ATV sales were up 40% at retail and their gross margins were actually negative as they took an inventory reduction charge.  This promotional cadence will clearly not go on forever and in my opinion actually represents a share opportunity for PII (more on this below). 

     

    The mid teens growth in dealer inventory is clear evidence that PII is stuffing the channel. 

     

    Response:

    Management has been forthright about this issue and tried to address it head on by disaggregating the components of its growth.  As such, 7 points of the increase comes from new models as 2015 represents the largest product launch in company history, while another 4 points comes from incremental distribution via new dealers coming into the network.  That said, PII has admitted that a few points of the inventory growth was unplanned and the result of weather and promotionally affected sales in Q1. 

     

    It's evident from talking to dealers that the new RFM inventory management system lacks flexibility and is forcing them to take on some unwanted ATV inventory (the system has not been deployed for SxSs yet).  While management would never admit to it, this could be an aggressive market share strategy.  Basically we know that ACAT is sucking the channel dry so it behooves PII to replace that floor space and tie up dealer capital in advance of ACAT's new product launch.  In this regard I'm fine with the company using its superior market position to disrupt a competitor. 

     

    Similar to the discussion above on the relative performance of ATVs vs. SxSs, it sounds like of the excess inventory that does exist, it's more heavily weighted toward ATVs.  Once again it's encouraging that there doesn't appear to be a major problem in the core profit center of the company.  From a sentiment standpoint dealers seem to acknowledge the inventory build, but are not overly concerned by it.  This is helped by early season checks through mid-May indicating that retail has accelerated to a HSD-LDD% pace in terms of units. 

     

    So what if we're wrong and there really is a problem, what's the right way to contextualize the downside?  If we make some basic assumptions about ASPs, we can ballpark some unit numbers for the company’s ORV business.  Given that they give us a split between pricing and unit growth at wholesale as well as retail sell through, we can then make some estimates about how inventories have built over time in channel.  This is clearly an imprecise science, but is sufficient in terms of getting us to a ball park number to see what a channel destocking would look like.  The output of my assumptions suggests that PII wholesaled ~257k ORVs in 2014 and that there are ~4k excess units in the channel at the end of Q1.  If we assume a 4 point spread between sell in and sell through it would take ~1.6 quarters for channel inventory to decline on a y/y basis. 

     

     

    Therefore if Q2 retail units come in at a HDS-LDD rate and the company wholesales 5%, the channel would be almost entirely clean in just over one quarter.  We know based on how the company is guiding that's not going to happen, as management has told the Street to expect continued growth in channel inventory, but at a declining rate. 

     

    The key understanding from my perspective is that this isn't a problem as long as the industry is still growing.  Given the persistent double digit unit growth of the last several years, that doesn't really seem to be in question outside of a tail risk macro type event. 

     

    I think it’s also underappreciated just how achievable PII’s guidance really is.  For ORV’s (+60% of revenues) the company is guiding to mid-single digit growth, while the street is modeling 6.9% growth in this business.  As can be seen below, if we assume that PII’s wholesale unit growth is 0% in the final 3 quarters of 2015 and that they get 4 points from a price/mix benefit (4% is in line with what they’ve achieved the last 3 years), ORV sales will be up 5.5% for the year. 

     

     

    To get upside to the Street’s 6.9%, we only need to assume that wholesale units exceed a 1.4% average rate in the next 3 quarters.  As a reminder our preliminary checks suggest retail units through mid-May are showing HSD-LDD growth.  The point here is less about how much upside there could be and more about how little downside there likely is.  Simply said it’s very difficult to fathom the scenario under which wholesale units turn negative in the back part of 2015, which is what needs to happen for PII to miss numbers. 

     

     

    Budding Margin Opportunity:

     

    The company is becoming increasingly vocal about a burgeoning margin opportunity that is not yet adequately reflected in the Street’s numbers.  In November the company hired Ken Pucel from Boston Scientific to fill its newly formed EVP of Operations, Engineering, and Lean.  While specifics are still on the come, we have some clues about what the size of the opportunity might look like.  In recent investor meetings the CEO Scott Wine has suggested that lean initiatives could lead to 3-5 points of gross margin improvement.  As mentioned earlier, we also know that the motorcycle business is currently being run at a loss—likely 20 points below HOG’s margins by our estimates.  The Motorcycle business alone could represent 3 points of EBIT margin opportunity as it scales over the next several years.  This says nothing about the rest of the manufacturing footprint, which to date has been solely focused on meeting demand as opposed to having been optimized for scale efficiencies.

     

     

    To this end, it’s possible that we could get an update to long-term guidance at the analyst day in July.  Raising the long-term profitability targets above the current 10% net margins should act as another catalyst for the stock. 

     

    Valuation:

     

    Bear Case: $116 or ~17% downside.  It basically assumes 2.5% growth in ORV’s (below the MSD guide) and consensus for the other segments.  Beyond that if 80% of the opex is fixed, I get to a 2015 EPS of $7.13:

     

     

    Base Case: $171 or ~22% upside.  I’m modestly above street numbers, primarily driven by ORVs and Motorcycles in conjunction with slightly better margins: 

     

     

     

    Upside Case: $198 or ~42% upside.  Assuming $8B in revenues for 2020, in line with management’s guidance, implying a 10.1% CAGR off the 2014 base.  I then sensitize those scenarios with a buyback and margin expansion assumptions.  The EPS CAGRs over those periods are 16.5% and 18% respectively. 

     

     

    In terms of buyback, I’m modeling $5-600m annually, which is well within the company’s capacity even with continued increases in their dividend.  While this is likely in excess of what management will actually do, it compensates for tuck in acquisitions that I’m not modeling and as we know from the last several years, this is an acquisitive management team. 

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Opportunity to buy best in class powersports operator as shares are pressured by transient concerns over channel inventory levels.  

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