Polaris Industries PII has changed materially over the past decade, moving from a traditional discretionary spending business to a more diversified industrial conglomerate. Despite operating through a massive economic recession, the company was still able to generate average adjusted returns on invested capital, including goodwill, in excess of 50% in the current decade. This was thanks to its best-in-class innovation and production, which stimulated demand and allowed the company to maintain a market-leading position in many of its product categories. Exiting the downturn, Polaris had some of the best ROICs on our coverage list, averaging 33% including goodwill over the past five years, and it continues to produce robust results well exceeding our 8% weighted average cost of capital estimate. This reinforces our wide economic moat rating, supported by Polaris’ brand intangible asset and cost advantage.
While extremely healthy, Polaris’ ROICs have ticked down materially from levels earlier in the decade. We think this is primarily a function of two factors. First, the company has continued to bolt on a number of disparate businesses that initially come with less efficient operating models, which drag on returns on invested capital. Second, the company has more invested capital in the business than in the past (with a higher denominator in the equation leading to lower calculated returns), as it has funded its last two transactions with debt, making the return profile look less robust. That said, our ROIC forecast, including goodwill, still reaches 22% in 2023 versus a peak of more than 100% in 2011-12 and a trough of 16% in 2016.
Polaris has become a serial acquirer over the last decade, gathering a number of varied businesses outside its legacy categories, tactically and at fair prices (supporting our Exemplary stewardship rating). At the end of 2008, the company’s $1.95 billion in sales were 67% off-road vehicles, 18% parts, garments and accessories, 11% snowmobile, and the remainder on-road (motorcycles). Prior segmentation of the business implied that off-road plus snowmobiles represented nearly 80% of sales at this time, excluding their corresponding parts and accessories sales. However, by our estimate, only 62% should represent off-road and snowmobiles in 2019 versus 14% in aftermarkets and 9% in boats, inclusive of parts and accessories.
Kicking off its entry into workplace vehicles, Polaris acquired Goupil, GEM, Aixam Mega, and Taylor-Dunn and initiated partnerships with Eicher (now eliminated), Ariens, and Bobcat. We found these businesses compelling for their pivot away from traditional discretionary spending categories, potentially providing less cyclicality in Polaris’ revenue base due to the less elastic demand of business or workplace needs. These acquired brands and partnerships also brought a new avenue of growth and, for the European businesses, delivered an expanded international distribution network that offered Polaris a low-cost build-out into underpenetrated geographies. However, we estimate that the first three of these acquisitions--Goupil, GEM, and Aixam Mega during 2011-13--provided roughly $160 million in revenue versus $3.8 billion in total sales at the end of 2013 and thus were not overly significant, representing less than 5% of the total mix.
The prices paid for these businesses have generally been reasonable. At acquisition, Aixam (the largest of the people-mover acquisitions, with more than $100 million in sales) was experiencing slowing revenue growth because of its home market exposure and the struggling economic environment in key Southern European geographies, allowing Polaris to pay just 5 times EBITDA while expanding its European dealer footprint by 40%. These workspace vehicle acquisitions may have played a part in Polaris’ nearly 20% revenue increase over 2012-14, but more important, they helped set the company on a diversification trajectory away from traditional powersports categories, with off-road vehicles falling from 69% of total sales in 2012 to 65% in 2014.
These tie-ups plus a plethora of smaller bolt-on businesses along with new product introductions (Slingshot, Ace, Indian) helped bolster reported revenue growth to an average of 13% over the last 10 years (through 2018), including the recession. With the exception of 2016, when the company was suffering from competitive actions at Arctic Cat and hindered by multiple recalls in its key off-road segment, Polaris has delivered some of the most robust top-line growth in the leisure industry.
Many of these purchased businesses generated less than $50 million in sales in the year before acquisition, limiting the ability for them to benefit from intangible asset (brand) or scale (cost) competitive advantages as stand-alone entities. However, we don’t see evidence that this is the sole driver of Polaris’ reduced ROIC performance, given that only Kolpin, Hammerhead, and Taylor-Dunn were called out specifically as expected to be either neutral or dilutive to operating earnings in their first year of ownership, and the rest of the transactions were noted as immediately accretive. The fact that operating margin expansion continued through the early part of the decade despite numerous acquisitions would imply that many of these tie-ups didn’t have a long-term impact on Polaris’ return performance alone but could still have a magnified impact on the return on capital employed.
While all of the acquired businesses were generating revenue, not all of them were profitable, according to the most recent PitchBook data (although sizable tie-ups like Boat Holdings and Transamerican Auto Parts were noted as profitable, with double-digit operating margins, by our estimate). In our opinion, this implied that some of these smaller investments may have had lower operating margins and could have temporarily acted as a drag on ROIC calculations as these were rolled into the business, when synergies could be exploited and back-office resources were integrated.
However, as the decade has progressed, the size of the acquisitions has become more significant for Polaris, and 2017 and 2018 have seen stellar top-line results thanks to the transformational purchases of Transamerican Auto Parts and Boat Holdings. With around $740 million sales in the 12 months before its purchase (fourth quarter of 2016), TAP clearly moved the needle on top-line growth and total profit potential for Polaris. By our estimate, in its first full year of ownership (2017), TAP delivered about $790 million in sales, or 15% of Polaris’ total 2017 revenue base, an estimated 6% uptick from our 2016 sales estimate for TAP. Then in July 2018, Polaris expanded into the boat market with the acquisition of Boat Holdings, which had $560 million in sales in 2017 and is forecast to represent around 9% of revenue in its first full year of ownership (2019). Barring no other material acquisitions, off-road and snowmobiles should represent about 62% of sales in 2019, with aftermarket parts (TAP) composing around 14%, motorcycles 8%, and global adjacent markets generating around 7%, indicating that Polaris is still on a mission to further diversify its business. We believe this is a smart strategy, given the maturing demand profile of many of Polaris’ legacy businesses and the slowing revenue growth they are likely to deliver. This is a significant difference from just a decade ago, when off-road and snowmobiles represented nearly 80% of total sales, not including corresponding parts, garments, and accessories revenue.
On the bigger transactions, expected savings, expenses, and financing have been quantified, helping to move the needle on profitability. For example, initial cost synergies for TAP were set at $20 million (3% of trailing 12-month TAP sales) with additional revenue synergy opportunities over time. But until those opportunities are extracted, the profit profile could prove less favorable, given the working capital needs during the integration. This drag could feasibly temper near-term ROIC performance from the point of purchase.
The second factor we presume added pressure to ROICs was the higher level of invested capital that Polaris had in the business over the last five years. The invested capital base rose to $2.9 billion in 2018 from $302 million in 2012 as the company began to utilize its balance sheet more extensively and tap the debt markets to finance the TAP and Boat Holdings transactions. With TAP, Polaris raised approximately $700 million in debt to finance the purchase. For the Boat Holdings purchase, approximately another $800 million in debt was raised. Furthermore, the company was putting incremental capital to work in new facilities, where capital spent failed to generate any real return as the plants were being built and utilization did not exist. As invested capital rose, returns on invested capital declined.
We expect ROICs to stabilize and begin to increase again, assuming that leverage continues to decline as EBITDA increases, making the numerator appear more robust related to the denominator. Over the next five years, we expect Polaris’ debt/EBITDA to fall back to around 1 times by 2023 before remaining below the 1.5-2 times range over the rest of our forecast. With notes rolling off the balance sheet over time (the next $100 million note is due in December 2020), invested capital should become a relatively smaller denominator than it is today, barring the financing of further transformational acquisitions.
TAP Brings Enhanced Brand Equity and Profit Potential Acquiring market leaders and best-in-class operators helps Polaris bolster the brand equity it has already harnessed in operating for many decades across the powersports universe while leading to increased profit growth. More important, the focus on immediately accretive acquisitions outside Polaris' core competency helps expand global brand awareness and cross-selling reach, which should also help boost ROICs. However, we think the TAP and Boat Holdings acquisitions (with the aftermarket parts/other and boats segment together set to represent 23% of sales in 2019) have pushed the company back into more cyclical territory, increasing its reliance on discretionary spending consistency and increasing the potential volatility of revenue and earnings in the event of an economic downturn. As such, we are maintaining our high fair value uncertainty rating for Polaris.
In the second half of 2016, Polaris made its first transformational transaction in more than a decade with the purchase of Transamerican Auto Parts for $655 million. It expected TAP to be immediately accretive, adding $0.25-$0.30 in earnings per share in 2017 (excluding purchase accounting and acquisition costs) on $3.48 in earnings per share in 2016. We believe Polaris took a conservative assessment in possible gains for TAP, identifying around $20 million in cost synergies by 2019 via areas including improved procurement, plant utilization, and distribution. While these cost savings could seem low, TAP was expected to be run as a distinct entity, potentially limiting some savings that would be captured if a full integration into Polaris were to occur on the operating side.
However, Polaris did not offer an assessment of existing revenue opportunities, which in our opinion could have provided some upside, given cross-selling product opportunities--with Polaris’ parts, garments, and accessories in TAP’s 75 retail stores and with at least some of TAP’s off-road Jeep and truck accessory stock-keeping units distributed across Polaris’ entrenched dealer network. While these opportunities were not included in the return assessment of TAP, they had the ability to stimulate incremental upside in sales.
Strategically, we think the acquisition was solid, with an obvious fit with Polaris’ adjacent markets and an operating profit profile that wasn’t significantly different from its new parent. TAP’s gross margin of 27% was higher than Polaris’ 24% at the time of acquisition, while EBITDA margin was a bit lower; Polaris has noted previously that it could get TAP’s EBITDA margin into the low double digits over time, which would put it closer to Polaris’ 2018 adjusted EBITDA margin of 14%.
The purchase price represented 9 times EBITDA, net of the present value of estimated tax benefits, a valuation that could be warranted given the market leadership position of TAP (nearly 10% of the $8 billion Jeep and truck aftermarket accessories industry at the time of acquisition). Additionally, Polaris paid less than 1 times trailing 12-month sales, which on a relative transaction basis appeared to be a fair price. With around $740 million in trailing 12-month sales in a fragmented industry at the time of acquisition, Polaris paid for an already established and visible brand to enhance its portfolio, supporting its brand intangible asset. Even on an enterprise value/sales basis, the transaction was valued at 0.9 times, near the trading range of TAP’s peer group (1.1 times) at the time, suggesting the price paid was not egregious.
Our concern surrounding TAP doesn’t lie in the price of the transaction, but rather in the growth potential of the Jeep and truck parts aftermarket. At the time of the acquisition, Polaris had expected a declining truck market over the next five years, something we believe was reasonable, given our position in the economic cycle and recent trends in vehicle sales. While the majority of TAP sales are for used vehicles, around 45% of sales are for vehicles that are 0-3 years old, implying that both new- and used-vehicle sales are a relevant factor in the opportunity set.
For new vehicles, sales have averaged 17.2 million units over the last five years, with the last three years delivering little variance at 17.3 million-17.6 million units. While trucks have had slightly better growth over the past five years (averaging 9% versus 2% for all new vehicles), their growth appears to have moderated to a mid-single-digit clip on average over the past three years versus a double-digit pace in the three years prior.
Moreover, used-vehicle sales have been relatively flat over the last decade. More than half of TAP’s sales are on Jeep and trucks that are four years old or older, and we suspect many of these purchases surround a change of ownership as well. Over the past 10 years, used-vehicle sales have averaged around 38 million per year, ranging from 35.5 million (2009) to 39.3 million (2017), implying fairly consistent demand across those making used purchases and corresponding adjustments stemming from the aftermarket parts market.
Morningstar’s prognosis for new light-vehicle sales over the next five years is tepid, potentially weighing on the full growth opportunity TAP could have captured in a more robust, rising sales environment. We expect modest declines in light-vehicle sales on average in the United States over the next five years, with units shrinking more than 10% by 2020 before positive unit growth resumes in 2021.
By our estimate, TAP experienced slower demand growth in its first year with Polaris, with sales rising just 6% to around $790 million in 2017 from around $750 million in 2016. This is versus sales growth at TAP of 13% in 2013, 21% in 2014, 11% in 2015, and 11% in 2016 (by our estimate). Furthermore, during periods in 2018, sales had been weaker, declining in the first and third quarters versus their respective 2017 periods, supporting management’s initial prognosis for declining truck market demand.
We expect slowing truck sales and the flattening of the used-vehicle market to drag on our aftermarket parts market sales outlook, which is set to continue to slow. Despite the negative near-term outlook for new unit sales and less-than-robust upside for used sales, we still have the segment rising at a low-single-digit pace (albeit notably lower than the double-digit clip before acquisition). In our opinion, TAP still has the ability to take share of the aftermarket parts market as it expands away from its Jeep and truck roots and potentially moves into other product categories in the Polaris portfolio of brands. Over the next five years, we expect average sales growth in the aftermarket parts segment to average 3% (as TAP utilizes Polaris’ platform and vice versa to cross-sell products and take share) and gross margin to average above 27%, in excess of the company average (25.5%), implying that the brand is carrying enough weight to escape discounting.
While we don’t expect TAP to significantly change the operating profile of the overall business, we do think it was a decent acquisition at a fair price, albeit with limited growth opportunities on the top line relative to historical levels. We continue to believe that gains from the purchase will stem from cross-selling opportunities on the revenue side and the consolidation of a modest level of back-office expenses and scale on the cost side, validating the prudence of the strategic partnership.
Sales and Profits Should Float With Boat Holdings Polaris' second recent transformational acquisition was announced in May 2018 for Boat Holdings, a top manufacturer of pontoon boats. The boat business appears to be a natural adjacency for companies in the powersports and leisure landscape, catering to a similar end user. Over the past year, Polaris has purchased Boat Holdings (estimated 26% share of the pontoon market) and Larson, Winnebago WGO has bought Chris-Craft (sterndrive and outboard boats), and BRP DOOO has acquired Triton/Manitou (pontoon boats) and Alumacraft (fishing boats), as the overall boat industry has improved its profit profile after exiting the last recession. The concerns we have about the addition of a boat business are the same as those raised about the aftermarket parts market: first, that we could be closer to a peak than a trough in the economic cycle, and second, that this has moved Polaris to expose itself to increasing cyclicality, given the discretionary nature of boat purchases (relative to other segments like work and transportation) and the likelihood that we are currently experiencing near-peak unit demand.
As evidence of the boat business’ cyclicality, Boat Holdings generated sales of about $150 million before and after the last economic downturn (according to PitchBook) versus $560 million in 2017 as it benefited from the upswing in consumer confidence. Sales fell by about half in the year ended 2008, to $74 million, according to PitchBook data--a proportional sales decline that could prove harder to leverage for certain operators in the boat business (but which is not evidenced in Boat Holdings’ recent performance). There are multiple points of evidence from competitors that even a modest downturn could still have a magnified impact on unit sales in the boating sector.
In the more modest 2001 recession, Malibu Boats noted in its filings that performance sports boat sales fell to 10,500 units in 2002 from 11,100 in the year prior, a more than 5% downtick, slightly wider than what we would expect from a GDP decline in a low-grade recession. Brunswick filings indicated increasing sales in the same period, but this was due to acquisitions. MarineMax, the largest recreational boat and yacht retailer in the U.S., experienced a sales decline of around 8% during the 2001 recession, supporting our thoughts that another modest downturn would lead boat revenue to swing more widely to the downside than GDP might decline. MarineMax’s sales still have not recovered to levels before the Great Recession, and consensus does not expect the company to eclipse that 2007 revenue figure ($1.26 billion) until 2019, indicating that the depth of the next recession could determine the duration of the recovery to previous heights.
Despite the boat business’ cyclicality, Boat Holdings’ profit profile remains promising and trumps the more discretionary nature of the segment, in our opinion. However, with more than one fourth of the pontoon market already captured by Boat Holdings’ Bennington and Godfrey brands, we expect market share gains to be relatively difficult to come by. Tracker is a close second in the market with around 15%-20% share (by our estimate) and other brands represent less than 10% share each, none of which we expect of be ceded easily to Polaris.
We anticipate that independent of the position in the economic cycle, Boat Holdings can remain accretive to Polaris’ overall business, given the margin profile at acquisition and the flexibility of the cost structure. While Boat Holdings’ gross margin was recently below Polaris’ gross margin (at 23% versus 26% in 2017), its operating margin was well ahead. In the most recent stand-alone fiscal year, Boat Holdings clocked an operating margin of 13% versus Polaris’ sub-9%, supporting Polaris’ assertion that the transaction should be accretive for the company in 2019. Similar players in the boat manufacturing space, including MasterCraft, Malibu, and Marine Products, have recently delivered double-digit operating margin performance (as high as 17% at Mastercraft) versus 10% or below at traditional leisure companies Polaris, BRP, and Brunswick.
Boat Holdings has experienced significant growth in just the last five years, more than doubling sales to around $560 million at the time of acquisition from $240 million in 2013 (with the help of its own acquisition of the Godfrey, Hurricane, and Rinker brands in 2013). EBITDA rose even faster, hiking up more than 150% since 2013 versus the more than 130% increase in sales, indicating that profitability is improving modestly with scale. With EBITDA at 13% of sales in 2017, higher than Polaris’ consolidated level, we don’t anticipate the boat segment will act as a drag on profitability. Even with a lower sales base, Boat Holdings’ EBITDA margin has remained relatively steady over the last five years, implying that a downshift may not impair operating margin performance (offering an asymmetrical payoff in the segment) as widely as we would expect due to the low fixed expenses surrounding the business. In 2014, Boat Holdings generated $260 million in sales with a 13.5% EBITDA margin, while in 2017 it delivered $560 million in sales with a 13.4% EBITDA margin, displaying the flexibility of the cost structure in the segment.
Because we believe Boat Holdings is likely to experience a full economic cycle over the next decade, we forecast top-line growth that normalizes around at 2% as the pontoon company expands into other product adjacencies slowly, boosting its total addressable end market. The wider audience should help generate a growth rate that is modestly slower than the mid-single-digit top-line growth consensus for Brunswick’s boat segment or MarineMax’s boat sales and well below the double-digit clip that is anticipated at publicly traded Malibu as it folds in an acquisition. We don’t think prior growth rates are sustainable, given the duration of the current economic expansion and the possibility of an economic slowdown ahead.
Our low-single-digit growth projection is an organic rate, although we understand the boating industry is undergoing significant transformation through consolidation, and Polaris has historically been an acquirer of best-in-breed businesses in different categories, driving segment sales at a significantly faster clip than we have currently embedded in our valuation. However, we don’t expect Polaris to pursue further meaningful acquisitions, given its desire to deleverage. Additionally, Boat Holdings operates primarily in the roughly $2 billion pontoon market, but it could alternatively grow into other powersports boats, a much larger overall market that represents more than $8 billion in spending, according to Polaris (the National Marine Manufacturers Association pegs this number closer to $10 billion including outboard, sterndrive, performance sport, jet boat, and cruiser boats). We model no new acquisitions in the boat category. We’d expect peer BRP to more likely be the serial acquirer of new boat businesses, as it has already articulated its interest in further expanding its marine segment.
We don’t think Polaris overpaid for Boat Holdings, given its market leadership position and scale, which would justify a modest premium. At 1.4 times sales, it remains the most expensive of recent boat-related transactions, but by a slight margin to BRP’s purchase price for Triton (1.3 times sales).