Polaris (PII) Stock: Hitting The Short-Term Brakes

Shares of Polaris (NYSE:PII) have been struggling around the $100 mark for a while, as it is time to provide an update on the company after I concluded that Polaris was demonstrating on appealing earnings power in the summer of 2019.

At the time, the company was battling with margin pressure on the back of input cost inflation and tariffs, yet the risk-reward was decent enough in my eyes to keep a position which I had initiated before. That stagnation in the business was “addressed” by management, which was handing out higher dividends and engaged in share buybacks to please investors, as the company made a huge $800 million deal into boats as well, a deal which raised some question marks.

Former Take

Polaris has been a very successful manufacturer of off-road vehicles, but late in the 2010s, the company was diversifying, starting to focus more on snowmobiles, boats and other adjacent product categories which all focus on the outdoor (recreation) industry.

In the summer of 2019, the base case started with the 2018 results which revealed that sales came in at $6.1 billion on which operating profits of $487 million were posted with net earnings coming in at $5.24 per share. Adjusted earnings came in at $6.56 per share, with the difference mostly stemming from amortization and restructuring charges, among others, but not sustainable and real stock-based compensation expenses.

Net debt stood at $1.8 billion, yet with EBITDA trending at three-quarters of a billion, the leverage ratio came in around 2.4 times. This came ahead of a guided 11-13% increase in sales to 2019, yet adjusted earnings were actually seen down to $6.00-$6.25 per share, driven by higher interest expenses, but mostly cost input inflation, as valuations were not demanding in the mid-$80s, resulting in a 13-14 times earnings multiple.

The resulting 7% earnings yield was pretty decent, certainly in a low interest rate environment, even as the actual operations were quite cyclical, as we were clearly not trading at the peak of the cycle, although I would like management to be a bit more conservative with the use of leverage. My belief was that Polaris should be able to post operating earnings close to a billion on $7 billion in sales, allowing for earnings at $10 or more at a good point in the cycle. With earnings power coming in the middle of my range, I believed that valuations were compelling enough, certainly compelling enough to compensate for the risks in the business cycle.

What Happened?

After trading in the $80s in the middle of 2019, shares rallied to a high of $140 in spring of 2021, amidst the recovery in industrial names and markets at large at the time, but by now, shares have come down to $110 again.

In January of this year, the company posted its 2021 results, and they marked solid progress from the 2018 numbers. Full year sales rose 17% to $8.2 billion as the post-pandemic outdoor spending spree showed up in the results. The company posted operating earnings of $709 million, or $7.88 per share based on GAAP accounting, with adjusted earnings coming in just above the $9 per share mark. The company furthermore posted solid growth for 2022 with sales seen up 12-15% to $9.2-$9.5 billion, as adjusted earnings per share are expected to rise similarly to a midpoint of $10.25 per share.

Net debt has come down to $1.3 billion which is very manageable as EBITDA is on the verge of hitting the billion mark here, translating into very reasonable leverage ratios.

In April, Polaris posted first quarter results as developments in the economy provided both benefits and drawbacks. A lot of the equipment is used outdoor, with farmers and other producers, and generally, these businesses have seen solid times amidst rising commodity prices. This is about the good news as much discretionary spending has come under pressure amidst rising inflation and the fact that much discretionary spending has already taken place in recent years.

The first quarter results were a clear negative, however. While first quarter sales were flat at $1.96 billion, it were gross margins which fell more than four points to 20% and change. This resulted in severe margin pressure with reported operating profits essentially cut in half to $95 million as net earnings of $70 million, or $1.14 per share, were down a dollar from the year. Net debt inched up to $1.5 billion here, yet with EBITDA still trending near $700 million, leverage ratios remain controllable, as net debt inched up a bit following some share buybacks. Despite the severe margin pressure, the company maintained the full year sales and earnings guidance, but it is very clear that risks to this outlook have been on the rise.

In June, Polaris announced substantial divestment, basically an admittance of wrongdoing in terms of capital allocation. Polaris has reached a deal to sell Transamerican Auto Parts, which is most of its aftermarket sales. The TAP business generated $760 million in sales, thereby responsible for the vast majority of the aftermarket business in 2021. Net cash proceeds are pegged at just $50 million, less than a dollar per share as the deal will cut sales by around a tenth here. The deal is particularly painful as Polaris paid $665 million for the business around six years ago, indicating that it has been a very painful roundtrip transaction.

What Now?

The truth is that Polaris has seen a few solid years with earnings power trending here around $10 per share, translating into a mere 10 times multiple. In fact, while the first quarter results are dramatic as a result of inflation and supply chain issues, the good news is that demand is (still) intact. The issue is that while near-term earnings power trends at $5 per share, the company maintained the >$10 earnings per share guidance, as I clearly see risks to that guidance, but even in that case, multiple looks pretty decent.

While all this is positive, Polaris has lost some of its mojo and dealmaking track record, as overall valuation remains non-demanding. Hence, a continued long position seems warranted, yet I would be happy to sell out of Polaris after some potential outperformance, as momentum in terms of capital allocation has not been as strong in recent years. It seems as if investors are rightfully discounting the premium historically attached to Polaris following the value destruction move for Transamerican while the timing into the marine business has not been too great either.