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Morningstar | Tariffs Stall Polaris’ 2019 Profit Growth, but Demand Remains Solid; Shares Undervalued

The full-year impact of tariffs, along with other factors have weighed on wide-moat Polaris' 2019 opportunity for profit growth. Shares initially tumbled on the company’s 2019 earnings per share outlook of $6.00-$6.25, representing a 7% decline from 2018’s $6.56 in EPS at the midpoint, leading to a reset of both our and consensus $6.87 and $6.96 EPS forecasts, respectively. However, tariffs penalized Polaris’ 2019 outlook by $1.00 in EPS, implying that the company could have seen EPS above both our and consensus expectations had it been able to successfully lobby for tariff relief (which is still possible). Moreover, the top-line growth outlook for 2019 was ahead of the 7% we anticipated, at 11%-13%, indicating that demand for the brands is set to persist.

We don’t expect to raise our full-year sales outlook to the guided range of 11%-13% given the persistent struggle in demand the heavyweight motorcycle segment (9% of 2018 sales) is likely to see in the near term, a sentiment echoed by wide-moat peer Harley-Davidson, and where Polaris anticipates a mid-teens increase in revenue. However, the outlook for mid-single-digit sales growth in the legacy ORV/snowmobile segment (64% of 2018 sales) is ahead of the flattish sales we anticipated, offsetting any slower than guided outlook we might include in the motorcycle business. Furthermore, mid-single-digit sales hikes in both global adjacent markets and aftermarket parts were largely in line with our outlook for 2019. In turn, our long-term prognosis for 4% average sales and low-double-digit operating margin performance through 2027 should remain unchanged. In this vein, we don’t plan any material change to our $107 fair value estimate and view shares as undervalued, trading at 13 times the midpoint of 2019 guidance.

Most of our revenue projections were modestly higher than reported numbers in the fourth quarter, with motorcycles and global adjacent markets delivering the biggest shortfalls. Motorcycle shipment revenue contracted 13%, to $87 million, versus our forecast 3% decline, as retail sales of Slingshot tumbled by more than 30%, indicating that brand turnaround remains at bay. Indian retail sales declined at a low-double-digit pace, around industry performance, implying only modest share gains in the struggling heavyweight market. Global adjacent market sales declined 3%, to $231 million, versus the mid-single-digit increase we had anticipated. Additionally, off-road and snowmobile shipments rose 7% to $1.1 billion, versus our 9% outlook, outpacing industry sales, bolstered by the timing of snowmobile shipments. Moreover, snowmobile retail sales marked more than a 30% increase in an industry that declined at a mid-single-digit clip, backing demand for Polaris’ innovative legacy products.

The adjusted gross profit margin contracted 190 basis points in the quarter, to 24.2%, as tariffs, logistic, and commodity costs along with mix hindered the metric. However, the operating cost side of the business was largely better than we anticipated, with selling and marketing, research and development, and general and administrative expenses all coming in at a lower percentage of sales than we had modeled. We’d expect any savings from the current period to be reinvested back into the business via way of R&D to continue to bolster the product line up.

Financially, the company remains focused on paying down its debt load, bringing the firm back to its 2.0 times-2.5 times debt/EBITDA target range, helping preserve capital and increase financial flexibility in the event of an economic downturn. We expect to incorporate only modest share repurchases into our updated 2019 outlook and a single-digit increase in the annual dividend, despite anticipated 20%-30% growth in operating cash flow (due to working capital gains), as debt paydown remains a priority for management.

We further discussed the opportunity set that recent transformational acquisitions have provided Polaris in our January 2019 report, “Polaris Revs Up Profit Growth With Adjacent Business Tie-Ups,” vetting the Transamerican Auto Part and Boat Holdings businesses verticals for sales and profit growth despite likely increased sales volatility with exposure to more cyclical businesses. Despite Polaris’ tie up with new entities, and that integration of new businesses can act as a drag on economic rents, the company’s ROIC profile remains well above our weighted average cost of capital estimate, and we expect it will continue generating excess economic profits over the remainder of our forecast, reinforcing our view that the company's wide moat should remain intact.