Morningstar | Puts and Takes Leave Us Neutral on Polaris’ 2Q; Shares Revisit Undervalued Territory
Wide-moat Polaris reported a second quarter with both bright spots and tarnish, with its legacy segments (off-road/snow) delivering solid performance and new categories (aftermarket and the onboarding of Boat Holdings) acting as a drag on the potential outlook. ORV/snow (66% of 2017 sales) and global adjacent market adjusted sales each ticked up 17%, well ahead of our single-digit outlook for both and offsetting weaker-than-anticipated sales in both the motorcycle (down 10%) and aftermarket (1%) segments. While total sales ticked up 11%, the gross margin was weaker across all segments, contracting 80 basis points to 25.9%, hindered by higher tariffs, commodity and logistics costs, as well as mix.The company updated its full-year outlook, calling for revenue growth of 11%-12% and earnings per share of $6.48-$6.53, relatively in line with our prior forecast for 10% sales growth and $6.41 in EPS. In this vein, we don’t plan to materially alter our $121 fair value estimate and view shares as undervalued, trading at a 15% discount. We surmise that investor concern surrounding the company’s profitability have led to the July 25 trade-off, as headwinds from the continuance of the aforementioned factors (tariffs, logistics) are not set to abate, with gross margin now set to contract 60-80 basis points in 2018 from 25.9% in 2017. Additionally, Boat Holdings' high-teen gross margin is set to pressure the aggregate gross margin (we already modeled total gross margin of 28% in 2022 versus the company target of 30%), but it should help leverage operating expenses, making the drag on overall profitability less pronounced. Our biggest imminent concern remains around cycle risk, and we still believe that normalized sales growth for the overall company should fall to a mid-single-digit clip by 2020, leading to 20% average EPS growth over the next five years.
Like many other manufacturers, Polaris continues to attempt to quantify the impact from political and legislative changes as they evolve, noting that steel/aluminum tariffs and retaliatory tariffs from other countries are set to cost the business $40 million in 2018, but that other changes (including those to the NAFTA relationship or other retaliatory tariffs on other categories) could further weigh on profits. International represented just about $200 million in sales in the second quarter (less than 15%), so we think the company should be able to shift production nimbly to mitigate some of the risk abroad. Additionally, the company has some ability to raise pricing and charge incremental freight surcharges to offset some costs, but these issues will continue to weigh on the overall profit potential of the business.
We think the bright spot in the quarter came in the way of market share gains from strong retail takeaway. The company saw total North American retail sales up 6%, versus an industry that fell at a low-single-digit clip. ORVs had particularly strong gains in a flat industry, with side-by-sides and ATVs both clocking mid-single-digit retail sales growth. Motorcycles also performed well, with Indian capturing mid-single-digit retail sales growth versus the 900+cc market decline at a mid-single-digit pace. Slingshot, however continued to struggle, generating mid-single-digit retail sales declines, acting as a drag on the segment top line. Longer-term, we expect ORV/snow sales to increase 2% on average (in line with market demand), while motorcycles and global adjacent markets sales rise at a high-single-digit share, clocking further market share gains. We think many of these metrics reinforce that the brand intangible asset remains intact at Polaris, underlying our wide moat rating.
Polaris designs, engineers and manufactures powersports vehicles which include, off-road vehicles, including all-terrain vehicles and side-by-side vehicles for recreational and utility use, snowmobiles, motorcycles, global adjacent markets vehicles, including commercial, government and defense vehicles, and boats. The company's products, together with related Parts, Garments and Accessories, as well as aftermarket accessories and apparel, are sold through dealers, distributors and retail stores principally located in the United States, Canada, Western Europe, Australia and Mexico.
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