Strong Pipeline Blazes Trail for ATV Maker Polaris

For  Polaris (PII), the past decade has been filled with new product launches, new category expansions, creative partner relationships, and stringent financial discipline. We don't expect any of these positive trends to stop or weaken, and we anticipate that the persistent spending on research and development and focus on delivering best-in-class product will help maintain Polaris' leadership position in powersports. This ability to consistently turn out preferred products at competitive prices, thanks to excellent manufacturing efficiencies, recently led us to raise our Morningstar Economic Moat Rating to wide from narrow. Polaris has delivered healthy returns on invested capital historically--an average of 41% over the past five years--which we believe will improve over the next decade; we forecast ROICs will rise to 45% over the next 10 years. We think the company's economic moat is predicated on its brand strength, but low-cost production supports and strengthens the moat. Having competitive manufacturing facilities in strategic locations gives the company the ability to remain an efficient and low-cost competitor. Despite its tremendous growth in recent years, we still see promise in periods ahead thanks to a strong product pipeline and acquisition potential.

We have long opined that Polaris' economic moat has been a function of its innovative and groundbreaking research, leading to best-in-class product offerings, and we have even greater conviction after viewing the 2015 model year lineup. Polaris routinely spends around 4% of its revenue base on research and development (about $140 million in 2013), versus 3% for Arctic Cat and 5% for BRP (DOO). Because of its scale, we think peers would have to invest at a much faster rate than Polaris to develop the same quantity of compelling products. Though we expect that some categories will start to become more saturated than in the past because of increased product selection by competitors (particularly in off-road, where peers continue to chase Polaris' best-in-class products and attempt to close the gap), Polaris continues to create new categories for itself by entering entirely new territories both organically and through acquisitions. Recent examples include the launch of the updated Indian brand and the introduction of the Slingshot product.

We believe the new opportunities Polaris has created or acquired give insight into the culture of the business and its potential for top- and bottom-line growth. The company has projected growth through new markets and acquisitions of $2 billion in recent presentations, on top of our forecast for $4.4 billion in revenue in 2014. The product pipeline and potential additional acquisition targets (there are a number of fragmented manufacturers overseas in categories like small vehicles) set the company up for longer-term success.

Three Drivers of Profit Growth
We see three areas that stand out as key profit growth drivers over the next five years: on-road (particularly Indian and Slingshot), off-road (especially in the value arena), and Lean manufacturing. We don't want to discount the relevance of the other categories, and we view segments like parts, garments, and accessories as critical to building brand equity, helping reach customers at an additional touch point. We expect that the PG&A segment will be increasingly accretive to operating margins (we estimate PG&A margins to be higher than the company average of 15%) as the SMART (Stocking, Merchandising, and Retail Transformation) replenishment initiative is implemented. Closeness to the customer has long been discussed by many consumer companies, including Polaris' nearest motorcycle competitor, Harley-Davidson (HOG), which refers to its product research as "consumer-led." Polaris recently noted that 86% of consumers will pay more for a better experience, and the probability of selling to an existing customer is 60%-70% (versus 5%-20% for a prospect), which speaks to the company's focus on customer service.

This is the first time we recall Polaris calling out a specific focus on customer service excellence, although consumer closeness was previously implied through the implementation of other inventory management programs that help place the right product in the channel at the right time. We would expect that the focus on a reliable customer experience and differentiated treatment should create an entrenched customer base of lifetime repeat buyers who are sure to revisit Polaris branded products for replacement or new category demands.

Slingshot Leads to New Customer Base
Though all product categories tend to have annual updates, the on-road segment had significant changes for the 2015 model year with the launch of the Slingshot and the expanded lineup for Indian. The Slingshot, categorized as a motorcycle for legal purposes and priced at either $19,999 or $23,999, depending on the model, is set to attract an entirely new audience. We don't expect this product to take meaningful sales away from either Victory or Indian, as it targets affluent thrill-seeking males and other powersports owners who are familiar with the Polaris brand and looking for a new experience--and the Slingshot doesn't seem to replicate anything like the motorcycle experience at first blush.

The Slingshot is coming to retail over the next few months, and Polaris has forecast the distribution channel to reach 350 dealers in North America; we think this could take some time as it has more than 350 dealers committed, but none ready to retail as of the end of July. It expects overseas distribution beginning in 2015. Management indicated that the Slingshot could be a $300 million-$500 million revenue opportunity over the next three to five years, which would imply 18,000 units sold globally on an annual basis if we use the midpoint of the current price points offered and the midpoint of the forecast revenue range. Our updated forecast calls for motorcycle revenue of $757 million in 2018, with the category growing at a double-digit clip annually, which could be light if the Slingshot has success at the high end of its forecast range. Our current earnings per share forecast for 2018, which includes Slingshot success in the middle of the expected range ($1.03 in 2018 earnings), is $12.01.

This upswing in on-road revenue will make the on-road segment more important to Polaris over time. It represented 6% of total sales in 2013 and is forecast to grow to 11% in 2018. The on-road category should also be bolstered by the continued expansion of the distribution channel for Indian. With 125 dealers expected to be retailing by 2014 year-end and the potential for more than 300 locations to be selling product over the next three to four years (and more than 70 locations internationally), we think Indian brand revenue could expand faster than we currently anticipate, depending on how fast the dealer base grows and the willingness of dealers to pay the up-front costs to distribute the brand. We think that Indian, positioned as an iconic American brand, could steal heavyweight share from Harley over the next decade, as the quality of Polaris' manufacturing and the included add-ons offer an upgraded bike at a competitive price.

​

We believe Polaris' pricing strategy is competitive by design, tempting consumers to make the switch to the Indian brand (or at least try it), which could lead to both higher pricing and more repeat purchasers longer term. The recent launch of the Indian Scout, priced at $10,999, is set to entice new customers who don't want or can't afford to make a significant financial commitment to the brand yet. We suspect that once riders ascertain that the Polaris-manufactured Indian bikes have left their troubled past behind, they will be likely to trade up to higher-price models.

Outreach Products Key to Luring New Off-Road Customers
Not only has on-road added a low-price product to entice new riders to try out the brand, but off-road has stepped up to more heavily market Polaris' multiple low-price offerings. We think new models included in the off-road segment could help capture new and younger users. Off-road revenue represents almost two thirds of Polaris' total sales base, and updates to both the technology and the breadth of the product offerings will allow Polaris to maintain its leadership position in powersports (currently one in three sales in the powersports arena is in a Polaris product).

Industry sales are currently split between value- and premium-priced products, with 63% going to value, a segment Polaris has not targeted aggressively in previous periods. In our opinion, this outreach segment represents those who haven't historically been able to afford high-price Polaris products, and we believe that once these consumers purchase entry-level products, they will eventually trade up to Polaris' premium products. Polaris indicated that the $9,000-$12,000 market represents a 60,000-unit opportunity, and we think the company will capture a portion of that potential. If the company can grow to capture one in three sales in the market, as it has in the overall powersports market, this would imply about a 20,000-unit potential in the $9,000-$12,000 space. At a $10,000 price point, 20,000 units implies $200 million in revenue. Polaris has gone above and beyond in the low-price category by launching products like the Sportsman ETX ($5,899) and the Ranger ETX ($8,699), potentially expanding its position in the market by offering more products at lower price points and with more sophistication than its peers, giving consumers more bang for their buck. In August, Polaris had 19 models under $12,000, while Arctic Cat had 14 and Can-Am only 7. Polaris is not alone in manufacturing low-price-point off-road vehicles, however, and we believe both Arctic Cat and BRP offer similar products and competitive price points, which will force all of the companies to continue to innovate, in order to offer the best product at the best price.

We can't disregard that consumers at the low end of the market could still be suffering from the 2008 economic slowdown, affecting their willingness to spend; however, we think Polaris' products are coming to market with the best technology at competitive prices, positioning the firm to be the obvious choice as consumer confidence continues to tick up and off-road product purchases become more likely.

Outreach hasn't been limited to entry-level demographics. Perhaps by chance, the recently launched Sportsman Ace has provided Polaris with another outreach product, with nearly 25% purchased by female owners (versus only 12% in previous Sportsman models). We suspect this is due to the size and handling of the model, whose smaller frame could seem less intimidating and easier to control.

In the traditionally male-dominated powersports category, we think engaging women is critical, as they represent a growing portion of the workforce and their increasing wages bring extra discretionary income--and we would like to see Polaris capitalize on an opportunity to engage a wider audience of powersports enthusiasts. As research and design and manufacturing capabilities increase, we see Polaris increasingly catering to new segments by launching entry-level products, helping reach outside the company's traditional audience to achieve its maximum earnings potential.

Operational Prowess Underlies Best-in-Class Products
Underlying the success and acceptance of product launches in recent years have been the company's operational excellence and focus on Lean initiatives, which have allowed Polaris to produce the best technology (and more horsepower, in many cases) at very competitive price points. Management's perpetual focus on improving the cost structure is something we highly respect, and we note that many competitors have lightly assessed their efficiency, utilization, and costs during periods of strong demand. The conversion from push to pull manufacturing has helped this process evolve as demand has grown. The continued improvement in processes and procedures provides Polaris with world-class safety performance (low injury incidence, according to the company), lower warranty costs, and better factory utilization, which ultimately drive higher operating margin performance.

Expansion of manufacturing capacity has been extremely methodical over the past decade, and just as the company is beginning to bump up to production limitations, more space is coming on line in Poland and India. We think the company operating at high utilization during robust demand periods positions Polaris for still decent utilization rates even in the event of a global economic slowdown and lower demand. However, we understand that operating near capacity limits could pose some concern over the next year or two if domestic demand ratchets up materially in an unpredictable way, and it may cause the business to chase demand and possibly miss out on some near-term sales. Changes to the Milford, Iowa, and Monterrey, Mexico, facilities should allay these concerns for the next few years at a minimum, as Monterrey is slated to increase production volume 50% year over year (this facility was opened incorporating Lean techniques just three years ago and is still becoming more efficient).

We believe the focus on operational excellence and best-in-class product offerings is what has made Polaris a success. We don't doubt that the ability to lead innovation and create products that resonate with consumers will continue as the company gets bigger and better at what it does and allocates a significant amount of resources to leading-edge technology and differentiated products. With close peers like Arctic Cat and BRP having much smaller operations (and thus smaller scale), we think it would be difficult for them to close the gap that Polaris has created over the past decade, leaving Polaris in a class of its own.

Improved Brand Perception, Operating Efficiencies Widen Moat
We believe Polaris has established a wide economic moat, delivering healthy returns on invested capital (an average of 41% over the past five years, which we project rising to an average above 49% over the next decade). Though nonexistent switching costs could weigh on pricing power intermittently, we believe the company's innovative product offerings and expansion of adjacent categories through acquisitions (and organic growth) have positioned the business to continue to capture increasing volume and profits as it reaches new end users.

More than 60 years ago, Polaris started to build its reputation and brand by producing snowmobiles. Since then, 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 it operates in (the company is number one in ATVs, utility side-by-sides, recreational side-by-sides, quadricycles in Europe, and ULTVs for military and is number two in snowmobiles and domestic motorcycles) has ensured that Polaris' 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 the company stability in pricing and positive brand perception. Currently, one in three powersports sales is of a Polaris product in North America.

​

Data suggests that Polaris has been able to raise prices in all of the past seven years, including during the recession. In comparison, over the past five years, Harley-Davidson's pricing has increased an average of 2% annually on a price/unit basis (which represents data just for motorcycles). Also, its strong price and product mix, as well as the consistent tick-up in volume--leading to greater operating efficiency--has helped Polaris achieve strong gross margin performance relative to its peers. We believe solid margin performance helps distinguish a cost advantage as well, as pricing of Polaris products remain in line with their peers, but gross and operating margins are well above both Arctic Car and BRP, the company's closest competitors.

Polaris' motorcycles remain priced just under Harley bikes, as Polaris continues to try and steal share of the heavyweight motorcycle market. However, Polaris' ATVs and snowmobiles are priced in line with peers. We think the company could capture higher pricing in the ATV category but has been pressured to maintain fair pricing (only moderate price growth annually) as peers have increased the cadence of their discounts in recent periods. That said, each new model year provides the company with an opportunity to offer a better product and a higher price, leading to at least moderate price increases annually.

Operating margin performance remains best in class, thanks to cost advantages and controlled spending as a percentage of sales. We believe the volume of product that Polaris manufactures and ships leads to meaningful cost leverage. Polaris sold $3.8 billion in goods during 2013 versus $730 million for Arctic Cat and CAD 1.1 billion for BRP.

Historical Operating Margins of Peer Motorsport Manufacturers

Source: Company reports

Our longer-term forecast calls for Polaris to expand operating margins to more than 17%, while Harley-Davidson motorcycle operating margins normalize around 19%. Direct powersports peer goals are much lower, with Arctic Cat looking to achieve operating margins around 10% and BRP seeking 11%–15% EBITDA margins in the near term.

Operating Improvement Should Continue
We think Polaris' operating metrics can continue to improve as the company's expansion of its brand presence overseas leads to further unit volume growth. While the relaunch of Indian in 2013 and the continued evolution of off-road products (such as the recently launched Slingshot and Ace) should drive domestic demand, small vehicles are set to experience robust growth overseas. Over the past few years, management has pieced together a significant stake in the global small vehicle business, including the acquisitions of GEM, Goupil, and Aixam Mega. Polaris expects to grow from an estimated $160 million in small vehicle sales in 2014 to $1 billion in 2020 (implying a 36% compound annual growth rate) through a series of further acquisitions. Our model forecasts some of these acquisitions being completed while others fail, bringing our category revenue target below the $1 billion mark, to $659 million in 2020, representing a 27% CAGR. Regardless, this implies material growth in international markets, where the majority of Polaris' small vehicle business resides, and with new manufacturing facilities abroad, we could see operating efficiencies improving easily. This is partially due to a distribution network already intact overseas, helping acquired sales rise quickly. This should boost Polaris' scale more quickly overseas, helping the business capture further operating efficiencies and possibly boosting operating margins higher than we currently anticipate, as Lean should remain a persistent theme.

We think the company's brand strength predicates its economic moat, and low-cost production further supports our wide 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. It also has added adjacencies and extra capacity in Milford, Iowa; added more space at Spirit Lake, Iowa, for liquid paint; expanded room at Roseau, Minnesota, for the Lean transformation; acquired plants from Aixam for people movers; and built an entirely new facility for production in Poland, set to open in the second half of 2014. In addition, new vehicle production in India through the joint venture with Eicher--set to begin in 2015--will provide Polaris with quick distribution to the Far East (and possibly a better tariff situation), increasing the company's visibility and footprint significantly.

As capacity constraints close in on the business, it seems imperative that Polaris increase capacity to match the growing demand for expanded product lines in order to maintain or expand its already impressive market share, which will help solidify its wide moat. The company recently said that utilization is close to maximized, as volume demands have caused the business to bump up against capacity constraints. We don't want the company to lose out on sales due to limited manufacturing capacity, but we believe higher utilization protects the business from having less slack capacity in periods of slower economic growth.