In 2022, two issues are at the center of investors' attention: rising inflation and an aggressive Federal Reserve willing to accept a recession as a kind of collateral damage to keep inflation in check. As a result, cyclical stocks of industrial companies and consumer goods manufacturers are currently in low demand, and their share prices have often fallen substantially. Such times present excellent opportunities for contrarian investors - inflation will eventually normalize, and the recession now widely expected will also end at some point. Some even argue that we are already in the midst of a recession.
I've written about several more or less cyclical industrial companies lately, but Polaris Inc (NYSE:PII ) is definitely a particularly interesting case from a contrarian investor's perspective: the company makes off-road vehicles, snowmobiles, motorcycles and boats for recreational and utility purposes. Since peaking in April 2021, the stock is down about 25% and currently trades at a price-earnings ratio of approximately 12.
Polaris looks like a fast-growing company currently trading at a discount to fair value - it almost feels like buying a snowmobile in the summer - or a straw hat in the winter, to use the words of 19th century American financier Russell Sage. In this article, I will provide an overview of the company, discuss its past performance with a focus on the Great Financial Crisis, and examine whether it can weather a potentially upcoming storm. I will offer my thoughts on the company's future prospects and conclude with a valuation of the stock.
Polaris Inc. was not founded until 1994, but is the successor to the limited partnership of the same name, whose roots go back to the 1950s. The company is primarily involved in the design, manufacture and sale of the aforementioned powersports vehicles, but also manufactures and sources parts and sells accessories such as apparel. Polaris focuses on Western markets, such as the U.S., Canada, Western Europe, Mexico and Australia. The U.S. is by far the most important market for Polaris, with sales of $6.5 billion in 2021 (79% of total sales), while Canada and other countries contribute 7% and 14%, respectively, to the company's 2021 sales. So, it is understandable that the company pointed to currency-related headwinds in its recent earnings call. However, considering the high correlation between the U.S. and Canadian dollars, I would not overstate Polaris' currency risk given that the company generates only 14% of its revenue in other countries.
Starting in 2022, the company will report its diverse portfolio in four segments: Off-Road Vehicles, On-Road Vehicles, Marine and Aftermarket. Previously, the company had six operating segments, but reported results for the off-road vehicle and snowmobile segments combined. The other four segments were Motorcycles, Boats, Global Adjacent Markets and Aftermarket.
The Off-Road Vehicles & Snowmobiles segments included all-terrain vehicles, side-by-side vehicles and snowmobiles. The segments generated net sales of $5.2 billion in 2021, or 63% of total sales (up 14% year-over-year and 11% on a two-year compounded annual basis). Polaris remains the North American market leader in off-road vehicles. The company's snowmobiles have been manufactured under the Polaris brand name since 1954, and the company holds the second largest market share in the U.S. and Canada. In 2021, demand was back to pre-pandemic levels.
The Motorcycles segment consists mainly of standard, cruiser, and touring bikes in the 900 cc class. In 2021, it was number two in the U.S. and Canada in the corresponding engine size class. The segment accounted for 9% (or $722 million) of the company's revenue in 2021 (+24% year-over-year and 11% on a two-year compounded annual basis).
The Boats segment comprises pontoon and deck boats for the recreational industry. It is one of the company's smaller segments, with revenue of $760 million in 2021 (up 26% year-over-year and 11% on a two-year compounded annual basis).
Global Adjacent Markets is Polaris' business unit that designs and manufactures commercial vehicles (light transport vehicles, commuter vehicles, and also tactical defense vehicles). The company estimates the global target market for these businesses to be over $5.5 billion, of which it takes in $600 million (7% of 2021 sales). Segment revenue increased 41% year-over-year and 14% two-year.
Finally, Polaris' aftermarket segment includes off-road parts, apparel and accessories. Transamerican Auto Parts (TAP), a vertically integrated manufacturer and distributor of off-road vehicle accessories (e.g., suspensions, transmission parts) was part of Polaris until recently and was acquired in October 2016 ( p. 5, 2016 10-K). In 2021, the segment contributed $930 million to Polaris' sales (12% of total sales). It is currently the weakest segment in terms of growth (5% year-over-year and 1% on a two-year compounded annual basis).
Polaris also has a small financing division, but it is nowhere near as significant as, for example, Snap-on, which I recently reported on and for which selling its tools on credit is a key part of its business. Moreover, Polaris does not offer financing directly to end users, but through intermediaries. In 2021, the company generated 7% of its operating income from financial services.
Morningstar ranks Polaris with a wide economic moat, citing a "top-notch brand intangible asset" as one of the reasons. This does not seem unreasonable, considering the company's top position in several segments.
The sales development of Polaris shown in Figure 1 is certainly spectacular. Since 2010, the company has managed to grow its revenue at a compound annual growth rate (CAGR) of 14%. It seems worth noting that PII has grown organically to a significant degree. Between 2010 and 2021, the company spent $1.8 billion on acquisitions, i.e., mainly related to aftermarket and transportation-related businesses TAP and Taylor-Dunn in 2016 and Boat Holdings in 2018, respectively. Post-pandemic, Polaris posted strong revenue growth (16.6%) in 2021, driven by 12% revenue growth in the U.S., 52% in Canada, and 34% in Europe.
Figure 1: Historical sales growth of Polaris Inc. (own work, based on the company’s 2010 to 2021 10-Ks and the Q2 2022 earnings release)
Given that sales growth has been very strong over the last decade, especially for a manufacturing company, it is important to look at volume trends - perhaps the company is achieving most of its sales growth by exercising its pricing power? Polaris reports annual changes in sales volume, and the correlation with sales in dollar terms is strongly positive (i.e., r = 0.949), suggesting that rising sales are supported by volume increases (Figure 2).
I traced sales and volume trends back to 2006 and 2007 to get a sense of the cyclicality of the business. Polaris' business model has not changed significantly since the Great Financial Crisis, so it is likely that sales will decline as much as they did in 2008 if the U.S. does indeed experience a deep recession as it did then. However, the sharp decline in sales in 2009 should be evaluated in the context of the company's operating leverage. As a manufacturing company, one might expect high operating leverage (i.e., the company benefits disproportionately from a small increase in sales thanks to its high fixed costs, but at the same time sees its profits dwindle if sales decline only moderately). However, between 2006 and 2021, Polaris' median operating leverage was only 1.2 (mean of 2.1), suggesting that the company is less capital intensive than intuition would suggest (see next section).
Figure 2: Year-over-year change in Polaris’ sales volume and sales (own work, based on the company’s 2007 to 2021 10-Ks)
For 2022, management expects year-over-year sales growth of 13% to 16% and continues to see a healthy consumer and stable demand. In the second quarter of 2022, the company reported 8% year-over-year sales growth. The company's marine segment reported strong volume growth (+20% year-over-year) and overall good performance in the second quarter. The off-road segment is expected to report positive volume growth in the second half of the year, according to Chief Financial Officer Bob Mack.
As a vehicle manufacturer, Polaris relies on a large number of suppliers and therefore continues to struggle with supply chain disruptions and increased commodity prices. However, management has seen improvements on several fronts in recent quarters and is also focused on containing selling, general and administrative (SG&A) expenses. In part due to the ongoing challenges, management has slightly lowered the high end of its full-year earnings per share (EPS) guidance, the company currently expects EPS growth of 11% to 14%.
Going forward, the thought of a decline in demand should be considered against the backdrop of likely further deteriorating consumer sentiment and lower discretionary income - even though management's expectations remain very positive. As has been shown, Polaris' sales are sensitive to economic cycles, but operating results are not particularly vulnerable due to low operating leverage.
Polaris' free cash flow, normalized for working capital movements and taking into account share-based compensation and recurring impairment and restructuring charges, grew at a similar rate to net sales (Figure 3).
Figure 3: Polaris’ historical normalized free cash flow (own work, based on the company’s 2010 to 2021 10-Ks and own estimates for 2022)
Note that non-normalized free cash flow was much lower in 2021 due to the increase in inventories that year ($503 million). This trend continued in the first half of 2022 ($409 million increase), but I expect the company to reduce its excess inventory over time. Reasons for the increase in working capital include increased inventory in transit due to supply chain bottlenecks and an intentional increase to support strong demand. Investors should be wary of converting excess inventory into free cash flow on a one-for-one basis, as such situations can lead to increased markdowns that translate into shrinking gross margins, among other things.
In the second quarter of 2022, Polaris' gross margin fell by over 300 basis points to 23%. However, this is not to say that the company had to markdown its inventories excessively in order to stabilize sales. The industry in which the company operates is moving much more slowly than other sectors. Moreover, Polaris' is a quality leader in its industry. Management cited exchange rate headwinds and inflationary pressures (i.e., timing aspects of price increases) as the main reasons for the gross margin decline. A reversion to the mean seems likely: the appreciation of the U.S. dollar will most likely level off eventually, and I am confident that Polaris will be able to offset the increased cost of goods sold through price increases. Of course, if sales slow significantly due to a significant deterioration in consumer sentiment, the company will be forced to markdown some of its inventory, especially if the downturn lasts longer than expected.
Polaris' average capex ratio since 2010 has been 43% (±10%) of normalized operating cash flow. This is somewhat surprising considering the relatively low degree of operating leverage mentioned above.
A closer look reveals that the company's operating profitability took a hit in 2016. Polaris' asset turnover rate declined from a typical 2.2 in the early 2010s, but has stabilized at about 1.6 since 2016. However, it is unlikely that the Taylor-Dunn and TAP acquisitions are related to the decline in profitability, which was mainly associated with a 270 basis point decline in the gross margin of the Off-Road Vehicles and Snowmobiles segment this year. Investors should therefore keep a close eye on the profitability of these business units, which will be incorporated into the Off-Road Vehicles segment in 2022.
Another possible reason for the decline could be that the company has been trying to outspend its competitors to gain market share. As an investor, I wouldn't have a problem with that as long as the company doesn't put its balance sheet at risk and improves its profitability by other means, e.g., by lowering its operating expenses.
Speaking of which, the company has reduced its SG&A expenses as a percentage of sales (a decrease of more than 270 basis points between 2016 and 2021). Working capital management has also improved significantly and is now approaching levels seen in the early 2010s (i.e., a cash conversion cycle of 40-45 days). The company has also increased its use of leased property, plant and equipment, as evidenced by the increase in undiscounted lease obligations as a percentage of sales (3.1% vs. 1.9% vs. 1.4% in 2016, 2015 and 2014, respectively), and in recent years, lease obligations have increased at a much slower rate rather than in proportion to sales.
As a result, Polaris' normalized free cash flow margin is approaching the level to which investors became accustomed in the early 2010s, or about 6%. Accordingly, returns on invested capital have also improved, but are still not nearly as high as they were at the beginning of the last decade (Figure 4). Nevertheless, Polaris' ROIC and CROIC are definitely above the cost of capital at present.
Figure 4: Polaris’ historical return (based on net operating profit after taxes) and cash return (based on normalized free cash flow) on invested capital (own work, based on the company’s 2010 to 2021 10-Ks)
Given that Polaris is a cyclical company operating in the consumer discretionary sector, a prerequisite for a sound long-term investment is a strong balance sheet that will allow the company to weather a prolonged recession.
Figure 5 shows Polaris' net debt to normalized free cash flow ratio, indicating that management is increasingly turning to debt as free cash flow has grown strongly, as shown above. In 2016, the company's leverage increased to approximately eight times normalized free cash flow, primarily due to debt incurred to finance the TAP and Taylor-Dunn acquisitions (cash outflow of $724 million, net of cash acquired). In 2017, leverage declined due to growing free cash flow, but in 2018 Polaris acquired Boat Holdings for a total consideration of $807 million (p. 5, 2018 10-K). Since then, the company has not made any significant acquisitions, and leverage has been declining, largely due to growing free cash flow - at the end of 2021, Polaris' net debt was $1.3 billion. Polaris' long-term debt is not currently rated by the three major rating agencies.
Figure 5: Polaris’ historical net debt to normalized free cash flow (own work, based on the company’s 2010 10-Ks and own estimates)
The company's interest coverage ratio naturally followed the debt trend, but is still anything but worrisome today, standing at around 11 times normalized free cash flow before interest at the end of 2021. It should be noted that this ratio does not take into account a potential tax shield effect and should therefore be regarded as a rough estimate. In any case, the company's weighted average interest rate on its long-term debt of 1.77% at the end of 2021 is very low. The low interest rate is mainly due to the $500 million incremental term loan maturing in December 2022 (i.e., 28% of total debt). Therefore, Polaris' interest coverage ratio is expected to decrease significantly in 2023, taking into account the recent increase in interest rates. The senior notes maturing in 2028 bear a fixed interest rate of 4.23%, and the credit facility maturing in June 2026 had an average interest rate of 1.23% as of December 31, 2021. Figure 6 shows the maturity structure of the company's debt.
Figure 6: Polaris’ upcoming debt maturities at the end of 2021 (own work, based on the company’s 2021 10-K)
Given that the company currently pays out only about 30% of its normalized free cash flow in dividends, I do not expect the company to cut its dividend in the event of a recession. Although the dividend payout ratio indicates a conservative allocation of capital, it should be noted that between 2010 and 2021, the company returned more cash to shareholders via buybacks and dividends than it generated in normalized free cash flow over the same period. Of course, my free cash flow estimates could be considered somewhat conservative, but the magnitude of the theoretical overspend (28%) is still significant.
The low payout ratio and strong growth in free cash flow suggest that Polaris could be a solid dividend growth investment. However, those looking to generate passive income should probably look elsewhere. As of September 1, the stock offers an acceptable yield of 2.27%. However, dividend growth has slowed significantly over the past decade and appears to have bottomed out at 2% per year. The company has increased its dividend by four cents every year since 2018. However, the company's dividend track record of 28 years of uninterrupted growth is quite solid for a cyclical consumer goods company.
In the short term, investors should not expect a return to growth, especially in light of a potential recession. In the long term, there is no fundamental reason to expect this weak growth trend to continue, but ultimately, of course, the decision about further meaningful increases rests with management.
In my opinion, Polaris should be viewed as a total return investment rather than a pure income investment - it would take 13 years for the yield on cost to reach 3% if management continues to increase the dividend by an average of 2% per year. A patient investor in Polaris would achieve a 4% cost return after 28 years.
Polaris is certainly a good company, operating in a specialized segment and holding a market-leading position. Fundamentally, the company is well managed, growing strongly, and the improving cash flow profitability in recent years suggests that the acquisitions in 2016 and 2018 have been integrated slowly, but ultimately well. TAP, Polaris' most significant acquisition in 2016, was recently divested. Management is quite optimistic about full-year guidance, and so far, the company has performed very well. In view of the fact that several other cyclical consumer goods companies have revised their earnings downwards to a more or less significant extent, it remains to be seen whether Polaris can actually survive the current environment unscathed.
FAST Graphs' two-year analyst scorecard (Figure 7) shows that analysts are far from predicting the company's earnings with reasonable accuracy. Therefore, the growth trend of Polaris' FAST Graphs chart in Figure 8 should be taken with a grain of salt. As can be seen from the divergence between earnings expectations and the share price, the market does not currently believe in a continuation of Polaris' strong growth trend. Given the current environment and the increasing likelihood of a decline in demand, this seems reasonable. The stock is currently trading at an EV/EBITDA multiple of about 9, a discount of almost 20% to the 12-year average multiple. The current normalized free cash flow yield of 6.3% also compares favorably to the long-term average of 4.0%, and the stock also appears quite cheap from a price-to-sales ratio perspective (currently 0.9 times 2021 sales, 1.4 times historical average). Morningstar sees a potential upside of about 60%, meaning a fair valuation of $175.
Figure 7: FAST Graphs’ two-year analyst scorecard of Polaris’ adjusted operating earnings per share estimates (obtained with permission from FAST Graphs; Copyright © 2022, Fastgraphs™ - All Rights Reserved)
Figure 8: Polaris’ FAST Graphs chart based on adjusted operating earnings (obtained with permission from FAST Graphs; Copyright © 2022, Fastgraphs™ - All Rights Reserved)
Personally, I have lost interest in this otherwise good company because of its weak dividend growth, especially when combined with its relatively low yield. I invest mainly for the cash flow, and Polaris falls into the realm of total return investments. The stock looks very promising from this perspective, and the current valuation seems quite conservative, even if Polaris is not growing in line with analysts' expectations. However, if there is a prolonged, deep recession, Polaris will certainly fall significantly, as demonstrated by its sharp decline in early 2020 and during the Great Financial Crisis. Investing in cyclical companies in the run-up to a recession certainly requires good nerves, even though the market is already relatively pessimistic about Polaris.
I do not want to add another low-growth dividend stock to my portfolio at this point, so I decided against investing in Polaris. However, total return investors who can tolerate significant volatility during a market downturn should do well with Polaris - especially over the long term.
Thank you very much for taking the time to read my article. In case of any questions or comments, I am very happy to read from you in the comments section below.
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