Polarizing Fortunes in the Leisure Vehicle Industry

Companies in the consumer discretionary sector are perceived as high-risk stocks, suffering from volatile revenues and cyclical demand. However, it is unwise to tar all stocks in the same sector with the same brush. Polaris Industries (NYSE: PII  ) , a leisure vehicle manufacturer with leading market shares in off-road vehicles (ORVs), snowmobiles and motorcycles (1400+cc category), is a different animal altogether. 

Why Polaris is the best leisure vehicle play
Since all companies in the leisure market are basically fighting for the same share of consumers' dollars, it doesn't help a company much to have a leading market share in one small niche product. But Polaris' broad-based market leadership across various types of leisure vehicles reduces that risk, and helps it continue to post strong results even when demand shifts from one of its product types to another.

In addition, Polaris has spent roughly 4% of its revenues on R&D for the past three fiscal years. While this might not seem very large on a percentage basis, in dollar terms Polaris has in fact increased R&D spending by more than 20% year-over-year for 2011 and 2012, validating its commitment to product innovation. That's crucial for a business that thrives on new, appealing products.

Finally, there are relatively high barriers to entry for Polaris' product segments. Deere, the world's largest manufacturer of agricultural equipment, entered the all-terrain vehicle (ATV) market in 2003, but exited in 2006 after failing to make an impact. Polaris itself introduced its first Victory motorcycle in 1998, but that segment only became profitable in 2006. 

Dealer ordering process boosts working capital efficiency
Since tastes can change quickly in the leisure market, companies don't want to keep a lot of inventory sitting around, lest today's hot product start gathering dust tomorrow. Polaris tackled this problem of inventory obsolescence head-on starting in 2008, with a dealer ordering process known as the Maximum Velocity Program (MVP).

Under the MVP, individual dealers are empowered to make daily orders based on their interpretation of retail sales trends. This in turn drives the production scheduling for the individual products and significantly reduces order fulfillment times. 

As a result, Polaris' cash conversion cycle was reduced from 55 days in 2009 to about 40 days in 2012.

Financial review
In the past decade, Polaris has been free-cash-flow positive and consistently delivered ROICs in excess of 25%.

The company continued that performance with record results for the second quarter of fiscal 2013. Quarterly sales and net income rose by 12% and 15% respectively.

While Polaris' gross margins remained in the low-20s for the first half of the past decade (from 2003 to 2008), they've marched steadily higher since 2009. Higher selling prices and lower product costs contributed to a 120-basis-point expansion in gross margin to 29.9% for the most recent quarter.

I see this significant improvement in financial performance as a validation of Polaris' increased pricing power and economies of scale. At the end of July 2013, Polaris also introduced its new product offerings for its three key ORV brands and three new models for its Victory motorcycles line. Moreover, it also relaunched the legendary Indian Motorcycle brand that it bought in 2011.

In light of this good set of financial results and new product launches, Polaris raised its guidance for the full year. The adjusted guidance sees 2013 revenues and earnings achieving growth rates of 13%-15% and 18%-20% respectively.

Peer comparison
Polaris' peers include Thor Industries (NYSE: THO  ) and Harley-Davidson  (NYSE: HOG  ) .

Thor is the largest recreational vehicle (RV) manufacturer in the world, and represents the best proxy for demand growth. Many families increasingly prefer mobile homes to other vacation alternatives because of their affordability. A typical family of four will spend between 23% and 59% less on average for RV trips vis-à-vis other vacation choices such as cruises, based on research published by the Recreational Vehicle Industry Association.

Thor's fourth quarter of fiscal 2013 results seems to tesitfy to RVs' growing popularity. Its quarterly sales and EPS increased by 19% and 35%, respectively.

Following the planned divestment of its commercial bus business, a move scheduled to be completed in November, Thor is expected to derive all of its revenues from recreational vehicles alone going forward.

Since consumer preferences change rapidly, I'm concerned that any drop in demand for recreational vehicles will hurt Thor, now that it's lost any diversification benefits from its commercial bus business. That segment accounted for close to 14% of Thor's fiscal 2013 revenues.

Harley-Davidson is the global market leader in the heavyweight segment motorcycle industry. In the second quarter of fiscal 2013, its retail motorcycle sales increased by a modest 5.2%; the company blamed poor weather for hurting sales. For the rest of the year, the company plans to spotlight its new lineup of eight new motorcycle models under the banner Project Rushmore. This could potentially increase sales by driving existing owners to buy new bikes.

In the mid-to-long term, Harley-Davidson's continued success is largely dependent on its ability to expand its reach significantly beyond its core customer base of Caucasian men aged 35 and above. While Harley-Davidson claimed to have experienced strong growth from its "non-core" customer base of young adults, women aged between 18 and 34, African-Americans, and Hispanics in 2012, I'm not optimistic about this development. I think that Harley-Davidson's strong brand recognition and loyal core customer base of older white men only make it harder for women and younger riders to identify with the brand.

Thor and Harley-Davidson are not as attractive as Polaris in terms of profitability, given their inferior ROIC metrics. While Polaris delivered a trailing-12-month ROIC of 42%, Thor and Harley-Davidson pale in comparison with ROICs of 18% and 8% respectively. Moreover, Polaris has a more diversified product mix compared with pure plays like Thor (recreational vehicles) and Harley-Davidson (motorcycles).

Conclusion
While a forward P/E of 21 seems expensive for any run-of-the mill stock, Polaris is not your average consumer discretionary play, and its premium valuation looks fully justified. Polaris' diversified leisure vehicle portfolio, commitment to product innovation, and superior working capital management set it apart from its peers.

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