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Arctic Cat Repositions for Growth

Investors could be rewarded if management executes its operational turnaround, but patience is key.

We expect unit demand to stem from the delivery of new, innovative products after retail inventory levels are restored to normal, which should help improve the gross margin profile. Management has articulated its willingness to expand in new channels, through bolt-on acquisitions as well as partnerships. We liken this updated strategy to the one Polaris PII has implemented in recent years and see acquisitions like Motorfist (parts, garments, and accessories) and partnerships with Toro and Yamaha as integral to scaling faster and becoming more operationally efficient and better diversified. With no debt on the balance sheet and the likelihood of rising free cash flow, Arctic Cat should be able to capitalize on appropriate acquisition opportunities at will.

However, the firm has robust 2020 goals that include an 11% sales compound annual growth rate (to $1 billion), operating margins that grow more than 20-fold, and gross margins that rise more than 1,000 basis points; these would represent never-before highs in both margins, above prerecession levels. Though our model incorporates significant traction in these metrics, our forecast includes lower 2020 results ($804 million in sales, gross profit margins of 25%, and EBIT margins of 10%), since much of this expansion depends on precise operational execution and a stable economic environment.

Valuable Brand Equity We believe Arctic Cat has a narrow economic moat, delivering healthy returns on invested capital during periods of economic resilience--an average of 38% over the past five years. Because of the extremely cyclical and economically sensitive end users of Arctic Cat's products, ROICs were negative during 2008-10. We expect ROICs to rise back to double digits by fiscal 2018 from our single-digit projection for 2015.

With a new management team, we suspect that inventory management processes will improve both internally and at the dealer level, which could prevent gross margin pressure longer term, helping improve brand equity. The company operates in the concentrated powersports manufacturing space, where only four companies make snowmobiles and the top four all-terrain vehicle builders make up nearly 70% of industry volume. Although it doesn't hold the top position in either of these markets, we think its brand equity allows Arctic Cat to charge competitive prices relative to its peers.

Manufacturing under the Arctic Cat brand for more than 40 years has garnered brand awareness and a leading position in the segments in which it operates. We believe this brand equity and awareness could be difficult to replicate. While there are no barriers to entry in the industry, the relationships that have been built with dealers over the past 60 years have created goodwill that new entrants would find hard to capture, with an extensive dealer base that sells Arctic Cat products. None of these are exclusive Arctic Cat dealers, and the firm's products share floor space with competitors' offerings. However, new competitors would have to develop a high-volume business to garner any power with vendors and move significant inventory through the retail channel. We believe it would take some lead time to set up a new manufacturing facility, produce product and inventory, and have dealers commit to selling these new products. During periods of economic uncertainty, we view risk in consumers trading down to some of the lower-priced, simpler products, but we think the company has enough low-price products to allay this fear.

ATV Market Holds Promise The company is tied for fourth place in worldwide ATV market share (ATVs and side-by-sides are 41% of total sales). Over the past decade, we have seen North America manufacturers' share rise while Japanese manufacturers have lost share. Arctic Cat has grown from 7% to 11% share, while Polaris has risen from 21% to 34% and Can-Am has increased from 3% to 11%. Cumulative Japanese share, including Yamaha, Suzuki, Kawasaki, and Honda, has slipped from 69% to 45% worldwide. The side-by-side market didn't develop until the end of the last decade, but we see similar trends in this market. Over the past five years, Japanese manufacturers' share has fallen from 49% to 24% while the North American innovators have risen from 40% to 62%. Arctic Cat is tied three ways for third place in the faster-growing side-by-side market, with 9% share.

Over the next five years, IBISWorld projects ATV manufacturing should continue its upward trend, albeit at a slower rate (IBISWorld data indicates 2009-14 growth of 7.8%). The research firm attributes this to disposable income levels that should rise, stimulating demand for recreational purchases along with demand related to agriculture, forestry, fishing, and hunting that is expected to increase, bolstering demand for utility ATVs.

That said, an expected rise in interest rates is likely to hamper industry revenue growth. As interest rates increase, consumers will be less willing to finance their vehicle purchases, resulting in shrinking demand for ATVs. Nevertheless, positive trends are expected to outweigh rising interest rates, and industry revenue is anticipated to grow over the five years to 2019. In our opinion, market share leaders in the side-by-side market will probably allocate capital to innovate in this faster-growing segment of the ATV universe. If we assume growth slows to a low- to mid-single-digit pace (3%-5% for the industry), then Polaris and Arctic Cat should be set to maintain or take share, as we expect both of these companies to increase top-line results in ATVs faster than the industry rate.

Snowmobiles Need to Go Overseas In snowmobiles, both Arctic Cat and Polaris have lost share to BRP (Bombardier BBD.B) over the past decade as BRP has captured an additional 6 percentage points of share. Arctic Cat remains the third player in snowmobiles, a very concentrated and slow-growing industry, which accounts for 43% of sales. The snowmobile industry has grown slowly over the past few years (with peak sales of 495,000 units in 1971, declining to less than 100,000 in 1983 before bouncing back; worldwide sales were just 157,000 in 2014), rising less than 3% annually since the end of the recession (including the 24% decline in the year ending March 2010). Since sleds have a fairly long life expectancy--10 years or more depending on care and levels of usage--replacement doesn't necessarily have to be frequent. We don't expect the technology for engine, chassis, and accessories to change enough incrementally each year to drive substantial replacement demand annually, leading to our long-term outlook for low-single-digit industry growth. Over the past five years, unit sales have risen 2% annually, so secular growth prospects for the industry lie largely in international growth opportunities where the brand has been underrepresented (this constituted 12% of total sales at Arctic Cat and 35% of total industry snowmobile unit sales).

Like Polaris, Arctic Cat's brand has a long history. But in the decades since, Polaris and BRP have delivered more compelling and technologically advanced products. This has led competitors to take stronger market share positions than Arctic Cat in recent years. Thus, 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 has largely provided in the past, yielding Arctic Cat less demand and lower market share than its larger peers. Nonexistent switching costs, which could weigh on pricing power intermittently, and delayed innovation in product offerings (it was 2012 before Arctic Cat got into the side-by-side market, which was extremely lucrative for Polaris starting in 2008) have acted as a drag on performance. However, a renewed focus on better utilization, sourcing, and innovation should help restore operating margins to more normalized levels. We will continue to watch gross margin performance (indicative of pricing power) and level of market share to ascertain whether innovation is outpacing, keeping pace with, or underperforming the competitive set.

While the company holds some of the lowest sales numbers and share in the industry versus its peers, the new management team has put into place multiple cost and volume initiatives to drive better performance. New leadership with a plan and a vision, along with a clean balance sheet holding no long-term debt, positions Arctic Cat to rebuild its brand equity with both dealers and consumers. The company has taken fiscal 2016 to assess its shortcomings and reposition itself for growth.

Industry Rife With Formidable Rivals Arctic Cat faces a number of risks regarding the demand for its products. We remain concerned that the powersports industry already has a number of key players that can compete on price to take share from Arctic Cat. In ATVs, competitors like Polaris and Deere DE are formidable players, while in snowmobiles, Arctic Cat also has to compete with bigger rival BRP. All of the aforementioned brands have huge franchises and financial resources, which could cause the competitive environment to become promotional. Snowmobiles, ATVs, and side-by-sides 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 (floor plan) and retail levels. As the company becomes more acquisitive, pursuing bolt-on transactions, it also faces integration risk. Litigation risk remains a concern, with an outstanding suit from Polaris claiming that Arctic Cat has used its patented technology and with BRP about snowmobile patent infringement. Weather is the biggest factor that Arctic Cat cannot control; sales of snowmobiles are correlated with the amount of snowfall, making volume in this segment volatile. Finally, foreign exchange exposure could prove unpredictable as the firm grows internationally, and we have seen the magnitude of impact from exposure to the Canadian dollar over the last year, which represents nearly 30% of sales.

Although we believe calendar 2015 and 2016 could be rebuilding years for the Arctic Cat brand that could keep net income depressed, a lack of long-term debt on the balance sheet has kept the financial strength of the company stable. If the management team can execute on its 2020 plan, Arctic Cat will be set to generate decent free cash flow again by fiscal 2018, which should help keep borrowings on the company's revolver to a minimum. The firm has no defined-benefit pension scheme, so it will not be required to make cash payments to employees' pensions. We like the flexibility that Arctic Cat's dividend provides, as it could be cut in the event of a liquidity crisis--the company suspended the dividend in response to the last economic recession in 2009 and didn't resume payments until 2013.

The company maintains flexibility in its capital structure through stock repurchases and dividends. Arctic Cat's board authorized up to $25 million in stock repurchases in August 2014 (of which $24 million remained at year-end); however, we expect management to take a conservative approach to repurchases in fiscal 2016 in light of the lower expected cash flow in the current year. The dividend also allows the firm to manage the cash it keeps on the balance sheet, at $0.125 per share per quarter; we expect Arctic Cat to maintain this rate over the next year, until it begins to see brand equity regaining its momentum as new products are launched.

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