Polaris (NYSE:PII) has been on a steep decline for quite some time. After reaching all-time highs in the high $150's in early 2015, their shares trade hands today around $76. They have many strong brands, including the reincarnation of the Indian motorcycle, which has been taking market share from key rival Harley Davidson (NYSE:HOG) consistently. However, several factors have contributed to weakness in overall results for the company, which may present an opportunity for the patient investor.
Fire hazards in the RZR and Ranger ROV units led management to issue recalls for both, the second recall of RZR units this year. Recalls are a part of business, but they have been especially painful for Polaris in 2016. The base warranty and legal costs for the recall activity totaled $65M, taking over a 50% chunk out of the company's net income for the quarter. This doesn't include lost business due to delayed launches of new models while verifying their integrity, or margin hits due to increased promotional activity. Recall activity is expected to be mostly complete by year-end, at which point Polaris will get to work on repairing its image and restoring lost profitability.
The overall industry was down high-single digits, which combined with recalls and lost shipments led to Q3 sales plummeting 19% YOY. These sales numbers have led to a narrowing of full year 2016 EPS guidance of $3.40 -$3.60, which represents a 41% decline YOY. The average selling prices of their ORV's was down around 8% for the quarter, due to increases in promotional activity. This was management's response to the recalls, which sacrificed margins to attempt to maintain market share through this tough time. Polaris remains the leader, but has likely lost share regardless of promotional activity. The hope, going forward, is that Polaris will have done enough work and research into the issues they have been having to have fully fixed the problem. Scott Wine, Polaris CEO, addressed these changes in their earnings call:
But what we've done is gone through an extensive - I mean, extensive effort to understand any thermal risks on our RZRs and other vehicles. And part of the issue, the reason we didn't see it in 2013 and 2014 is that we didn't have the processes and tools to get the information from the field as quickly as we could and manage the information flow. And ultimately, it took us a while to recognize the trends. And ultimately, these are very complex issues. I mean, we have had some of the best engineering experts in the industry, including the automotive industry to help us review these situations. In some cases, it will take us many months to ultimately define the root cause and we went as aggressively as we could once we understood the risks, and it just took us a while to figure it out. As I said in my remarks, we've embodied all of that knowledge now into both our processes and our products going forward and we feel extremely confident in our ability to manage the thing, the thermal risks of our vehicles going forward.
With the numbers presented above, it's hard to find many bright spots. However, there are a few. Polaris still managed to take market share in their motorcycle segment. Their motorcycles continue to outperform the overall industry, which likely means they are taking share from Harley-Davidson. Overall revenue actually declined 3% YOY, but this is only due to the Slingshot backlog of orders being pushed to market in Q3 2015 for its new launch. This continued strength in the motorcycle segment should help them weather the difficult times they are facing in ORV's in the near-term.
Source: Investor Presentation
The recent acquisition of Transamerican Auto Parts will expand Polaris' footprint in the PG&A category. This will lead to creating a new reporting segment starting next year combining Transamerican with their existing PG&A sales. The acquisition will likely close in the fourth quarter, as early as this month. Earnings will be accretive in the range of $0.25 to $0.30, likely starting next year.
Transamerican will be adding 75 retail stores, 6 distribution centers, and ~1700 employees to the Polaris team, and should represent relatively low integration risks. However, the timing of this acquisition seems very strange. Although the pains Polaris is going through haven't made them unprofitable, it doesn't seem like they are in a place to be looking at acquisitions. However, I suppose that this show management's conviction that earnings will turn around soon. If they saw an opportunity in Transamerican, then I applaud their boldness in pushing ahead with the acquisition. This is something that investors will be able to know much better with hindsight, likely with a year of earnings under its belt at the end of 2017.
That being said, Transamerican has grown its sales by 15% in the last 3 years, and their combination with Polaris should leverage an extended distribution network to improve that growth. I would expect that Polaris will see a solid bump in their PG&A from pushing products into the Transamerican retail outlets, as well.
Polaris is a dividend contender, having hiked it every year for the last 21 years. I don't see the recent issues causing them to break that streak by freezing or cutting their dividend. Even with earnings at their likely bottom this year at the low range of $3.40, their payout ratio is still only 64.7%. This will obviously go down significantly if their earnings recover to levels seen even last year. Their debt is at a manageable level, even after their acquisition of Transamerican. Overall, Polaris is not in any significant financial hardship and their cash flows remain healthy.
Source: Investor Presentation
Source: FAST Graphs
If earnings were not likely to recover, Polaris would be overvalued today. However, some of the recovery expected next year is already reflected in the stock price, since it is trading today for a P/E multiple of ~21-22X expected full-year 2016 earnings. However, 2015 peak earnings were about double that, which would lead to a close to 11X P/E. If Polaris is able to recover within a year or 2 to their EPS number last year (which had its own difficulties due to a warm winter), then I believe the company is trading cheaply today. There are several things that would have to happen in order for that to occur, with alot of the onus resting on management. Recovery of the RZR brand, integration of the Transamerican acquisition, and the continued push of Indian to take market share are all key drivers of Polaris profitability going forward.
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Financial statistics were sourced from Morningstar, with the charts and tables created by the author, unless otherwise stated. This article is for informational purposes only and represents the author's own opinions. It is not a formal recommendation to buy or sell any stock. Please do your own due diligence and/or consult a financial professional prior to making investment decisions.
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.