Wide-Moat Polaris Is Undervalued

Third-quarter performance was mixed at wide-moat

We don’t plan to materially alter our long-term outlook or our $118 fair value estimate for Polaris. Our forecast includes average sales increases of 6% and earnings per share growth of 19% over the next five years, including the 2018 acquisition of Boat Holdings, which should help bolster first-half 2019 growth materially. Trading at a 25% discount to our fair value estimate, the shares look attractive at current levels. Even though we are probably closer to a cyclical peak than in prior years, our long-term estimates incorporate normalized growth projections that adjust for this factor. Polaris remains a market leader with best-in-class innovation, an improving supply chain, and a solid manufacturing process, which should help keep its pricing power and brand intact.

The company’s top-line outlook was largely positive, with the key off-road vehicle/snowmobile segment (66% of 2017 sales) increasing to a low-double-digit growth rate from a high-single-digit pace and global adjacent markets (7% of sales) unchanged. However, the remaining motorcycle and aftermarket segments’ full-year outlooks were reduced to a low-single-digit decline and a low-single-digit increase, respectively, implying around 8% organic growth for 2018. Polaris continues to hold the line on 60-80 basis points of gross margin compression (slightly worse than our 40-basis-point decline, to 25.5%) despite anticipating $40 million in tariff expenses in 2018; this exhibits its ability to tactically pivot, given the mix shift across the motorcycle segment that is adding incremental pressure to the metric. On the disappointing side, the company now expects operating expenses to leverage only around 120 basis points to 17.6%, but we may model a slightly wider benefit, given the ongoing supply chain efforts and the lower levels of promotion the company has utilized recently.

Taking the third quarter into account, we remain positive on the opportunity set for Polaris. First, we think even modest top-line gains for the aftermarket parts and boat businesses should be accretive to the operating margin for the company in 2019, given their existing operating profiles. Second, commentary from Textron suggesting that it could take another year to right the ship at Arctic Cat provides a near-term opportunity for easier off-road market share gains. Finally, liquidity should begin to improve as EBITDA rises at a double-digit clip over the next few years, bringing debt/EBITDA well into investment-grade category and providing room for further strategic acquisitions. While the story isn’t all roses with a struggling motorcycle industry, inconsistent performance at Slingshot, and an uncertain tariff environment, we think the benefits currently handily outweigh the risks at Polaris.