Description

We are short shares of Polaris (PII). Polaris is a manufacturer of:

• off-road vehicles ("ORV") / snowmobiles - #1 in ORV, #2 in snowmobiles, $6.44B ’22 sales, $1.5B gross profit (78% of overall gross profit)

• on-road vehicles (Indian motorcycles) - #2 player, $1.16B ’22 sales, $206m gross profit

• Marine (pontoon boats) - #1 player, $989m ’22 sales, $223m gross profit

Something I find helpful in screening, particularly in the case of shorting a stock that has been public for at least a few decades (and business cycles), is to just eyeball the all-time stock chart. The idea is not to draw trendlines or to divine the future price, though of course you quickly learn if there has been value creation over time. On the short side, I am more simply asking, has this company fooled the market before? In the case of Polaris, indeed it has.

So, while there is cherry-picking of tops and bottoms here, and most of these periods were market meltdowns, and starting valuation matters, these facts are somewhat mitigated by focusing on alpha and especially alpha to its own sector. Polaris’ stock has a tendency to get mispriced relative to the market, and subsequently underperform its sector meaningfully in the drawdown (essentially batting “4 for its last 4” in that regard). It’s a good sign for a short, but having said that, we should probably do some work.

Red Flags / Thesis Points

• Huge COVID beneficiary, already faltering but masked by channel dynamics - perfect storm of increased demand from COVID (consumer with more free time and spending it outside, having extra income, cheap financing), supply chain challenges limiting dealer inventories. Ultimately, $6-7bn pre-COVID revenue became 8-9bn post-COVID revenue.

End demand has already faltered, but seemingly masked by channel refill. Units at retail (end demand) has been volatile, due to supply availability. Supply chain has now normalized - retail was -8% in Q3 ’22, and -6% in Q4 22. Expectation in guidance from PII is “flattish” retail demand (potential recession, increase in financing costs, and continued demand normalization related to the demand pull-forward seemingly not taken into account here) 

• “Channel fill” opportunity burned up, and creating challenging comparables in the back half of ’23 for volumes, overhead absorption, and margins, yet the Street has operating margins rising in 2023 to 9.77% from 9.26% in ’22. (Note that, as a separate point, I would expect price/promotion and mix to also be a headwind in ’23, as Polaris has pushed price to cover inflation but now faces a more strapped and nervous consumer, along with facing any possible overhang from pulled-forward demand during COVID as noted above).

Regarding the channel fill (which ties into the Floorplan financing point below), Polaris management has discussed an opportunity to refresh the dealer inventory levels, with the table below depicting the quarterly history of that revenue opportunity.

The above is from PII’s Q422 earnings presentation (1/31/23). A few things strike us as odd (1) the graph seems to depict a point in time closer to mid-’22 than 12/31/22, possibly obscuring that we’re closer to the end of this benefit, (2) it seems odd to claim that “2022 dealer inventory was down 35% vs 2019” without a clear point in time, as ORV dealer inventory is seasonal, (3) from a Tegus transcript, we learned that 2019 was artificially high in terms of dealer inventory, and (4) based on data from the 2022 10-K, as noted below, the floorplan financing more than doubled year-over-year as of 12/31 (see next point below), which suggests a more dramatic fill-in than calculated above, and (5) retail demand is clearly weakening, which would seem to make it harder to pinpoint the right dealer inventory level (in-fill could move to destock pretty quickly).

In any case, PII still has at a minimum a $600m revenue and related overhead absorption headwind for 2H23. Management offered their non-answer answer at a 3/7/23 conference on this topic:

A similar dance when asked on the Q4 call on 1/31/23…

Q - James Hardiman

Hey, good morning. Thanks for taking my question here. Wanted to dig into the inventory replenishment dynamic continued conversation we've had the last couple of quarters. What was the -- what was the full year replacement benefit for 2022, is it easiest to just take the 750 that you gave us a couple of quarters and subtract the 150 that you gave us this time around. And I guess if so, doesn't that suggest a pretty sizable headwind this year as we lap that even with the 150 left over?

A – CEO Michael T. Speetzen 

Yeah. I mean, I think the basic math has that is part of the equation. I think the more challenging aspect is, yeah, 150 is what's mathematically left after you look at the end of the year. But as I pointed out earlier, we're already clearing through some of that dealer inventory. So, you have to consider the fact that we had a fair number of RZRs on hold, coming out of the end of the year and even into January and part of February. And then, a lot of RANGERs that got delivered in the last week or two.

And as you know, between transportation time and set up time, those things aren't retailing until January, even into February. And so, it's difficult because it kind of moves around. I would suggest that 150 is probably understated because you cleared through in January and February, the recall holds, as well as the backlog of consumer deposits for some of the higher-end RANGERs. But it's in that ballpark.

But as we look forward, one, we still have opportunity to refill with RANGER and that demand is holding up. So that 150, we said first half and it's really going to depend on how that demand profile plays out because we're still going to be plan, expect, catch up. But we then have in the second half. We have some new products coming on the scene that we feel pretty confident, given the redefining of the segments, new areas of opportunity and growth coupled with all the factors I talked about before outside of just North American retail that drive growth in this business. That's why we're pretty confident that we'll see revenue growth as well as lapping of pricing and some of the other dynamics that we have.

• Floorplan financing:

• PII’s sub Polaris Acceptance has a 50-50 joint venture with Wells Fargo to provide dealer financing in the United States. Not perfect, but tracking this number gives a sense of inventory sitting on dealer floors - that number has returned to 2019 levels

• That number has also tracked well with the above “channel fill” that PII talks about in September, but started to surpass it in December

• Huge jump in the worldwide number - only disclosed annually, but up almost $1bn in 2022 and significantly higher than 2018-2019 levels

• A Tegus expert transcript describes 2019 as being a year of oversupply, which would make it questionable as a basis for a normalization argument – 

• The company in Q4 22 presentation says dealer inventory is down 35% vs. 2019 - there seems to be a disconnect there relative to the Worldwide Financing Agreements Outstanding/Securitized. They also said it would be at “optimal levels” in 1H 2023, but it may be that they are already there.

  • Note that higher interest rates are going to take floorplan up, but by our math not a ton because product has not sat on dealer floors that long (yet). As it does, there will be more product and more interest cost so the floorplan outstanding should balloon - either way a bad sign

• Other Tegus transcripts paint the picture that current inventories are normal at dealers and demand is down

• Summary: channel seems to be full, or even overfull, in a time when demand is down and could easily collapse

• DSO increase – The Company gets paid by the floorplan entities (including its own JV), so it gets paid within a few days of shipment to dealers. DSOs, a metric that shouldn’t move around too much has been elevated for 3 quarters now, and up substantially over 2019 levels and on a year over year basis. This could come from shipments more skewed later in the quarter, and done outside the Floorplan financing, perhaps indicative of some channel stuffing outside of the primary channels. The chart below shows the quarterly DSO, with the line showing the yoy growth in that metric.

• Though improving, CFFO generation was horrendous throughout the pandemic and still well below prior levels

• Management is skilled at selling shares at local highs on the stock price, with chunky $1-3mm sales:
  
  
  

Risks / Mitigants

• The main risk is that PII appears fairly cheap at 10.2x on guided EPS, relative to its 5 year average P/E of 13.3x. Perhaps there is some risk of an acquisition as well due to the optics. Mitigants to this risk are (1) the 5 year average is a ZIRP P/E that needs to be adjusted downward for current interest rates, (2) PII only generated $199m in FCF in ‘22, well short of its 625m in adjusted NI, suggesting a possible element of low quality earnings inherent in the base year from which we are forecasting, (3) we view guidance as unachievable for the reasons stated in this report.

• The business has shown an ability to grow organically outside of the cycles, making this a short to not necessarily get too cozy in.

Disclaimer: the author of this posting has a short position in the security discussed. The author reserves the right to transact in any way in the shares or to change his views without any obligation to inform anyone. Please do your own diligence and consult your financial, legal, and/or tax advisors before acting on any advice. While the author has tried to present facts it believes are accurate, the author makes no representation as to the accuracy or completeness of the analysis herein. Reader waives any cause of action against author related to the analysis above.

Catalyst

Earnings estimates to deteriorate throughout 2023