PII - Polaris Gives You Value And Amazing Upside Potential

2024-01-04 08:40:00 ET

Summary

• Despite the market rally, there remain plenty of undervalued stocks like Polaris that offer potentially strong returns.
• Polaris has a strong position in the outdoors powersports market and has demonstrated consistent revenue growth over the long run.
• While there may be short-term challenges, Polaris is well-positioned for future growth through market share dominance, and is returning capital through buybacks and dividends.

2023 was a banner year for the market, and while the 'value party' is over in the near term for giants like Meta Platforms (META) and Amazon (AMZN), it's important to keep in mind that these names have outsized influence over the market index, and therefore the rebound in the market has been rather lopsided.

That's because a number of names remain undervalued despite the broad market rally, and that makes them ripe for the picking amidst an overall frothy market.

This brings me to Polaris (PII), which trades solidly in value range with its price having declined by 6% over the past year despite having a moat-worthy reputation and brand in an environment where interest rates could be headed lower. In this article, I explore this stock and discuss the attributes that make it a solid value pick at present for potentially strong returns, so let's get started!

Why PII?

Polaris carries plenty of hefts in the outdoors powersports market, with leading positions in off-road vehicles, snowmobiles, quadricycles, and pontoon boats, among others. Notably, it also serves the military beyond its core commercial market and serves over 100 countries worldwide.

PII's investments in branding and product innovations has paid off for the company, as reflected by very strong and steady revenue growth over the past decade and half. Consumers' propensity to spend on Pll's outdoors products barely dipped during the 2008- 2009 recession and in 2020, when many retailers were closed due to the pandemic. Since 2015, revenue has nearly doubled from $5 billion to $9.05 billion over the trailing 12 months, as shown below.

This is not to say that PII is immune from short-term economic cycles, however, as inflation and higher interest rates have pressured consumers, especially those who rely on credit to purchase Pll's products. These factors contributed to sales declining by 4% YoY to $2.2 billion during the third quarter, driven by lower sales in the U.S., EMEA, and Asia Pacific partially offset by positive contribution from Latin America.

Moreover, consumers have been downgrading toward lower end models in the current inflationary market, most notable of which was in the Off-Road segment, which saw a 265 basis point drop YoY in Gross Margin to 23.1% in Q3, and this contributed to a 110 basis point drop in adjusted EBITDA margin on an overall company basis.

Looking ahead to Q4 results and beyond, I would expect for margin pressure to persist in the near term, as consumer spending has slowed in recent months. While management is guiding for full year 2023 sales to be up by 4% at the midpoint, this is expected to be driven by lower margin off road products while being offset by higher margin marine products. As shown below, adjusted EPS is expected to be down by 6% at the midpoint for 2023 as a result of margin pressures.

Despite near term concerns, I believe PII is positioned to turn a corner (pun intended) this year as the interest rate forecast has changed dramatically over the past couple of months, with the market now anticipating three rate cuts by the Federal Reserve this year. This is supported by better-than-expected results from industry peer THOR Industries (THO), a maker of recreational vehicles, in its fiscal first quarter results.

Moreover, Pll could emerge from the current slum stronger than before, as it's set to benefit from recently launched the RZR XP multi-terrain vehicle, which targets the largest sub-segment of the recreational market. This model now makes up 35% of RZR sales and is helping PII to maintain 2x the market share of its nearest competitor. Morningstar also sees positives for Pll's market share going forward, as noted in its recent analyst report :

We think Polaris' continued focus on innovation and product development positions the firm to win when consumer confidence is restored. This was evidenced in the firm's ability to take share in off-road, on-road, and marine in the third quarter, signaling the brand resonance with end users. With dealer inventory largely optimized across manufacturers, we expect Polaris can restore market share over the next year.

Furthermore, even with flat top-line sales, we contend efforts to optimize labor costs, operating schedules, and restore lean manufacturing processes will surface in modest profit gains in 2024 over 2023. This could put Polaris back on the trajectory to achieve its targeted 15%-20% EPS growth in 2024-26, partially achieved via more active share buybacks.

Meanwhile, Pll maintains a well-balanced investment profile that balances capital investments into the business (around $400 million in 2023) with share buybacks, which amounted to $286 million to repurchase 2.6 million shares over the last 12 reported months. As shown below, PII has retired 18% of its outstanding share float over the past 10 years.

Share buybacks appear to be a good use of capital, as PII currently trades at $94.36 with a forward PE of 9.7, implying a 10% earnings yield for every dollar spent on buybacks. Its history of share buybacks is also a key reason for why PII carries a high return on equity of 51% , sitting far higher than the 11.4% median for the Consumer Discretionary sector.

Importantly for dividend investors, PII carries an investment grade credit rating of BBB from S&P and is reasonably low leveraged with a net debt to EBITDA ratio of 1.7x, sitting below the 3.0x level generally considered to be safe by ratings agencies.

This lends support to the 2.8% dividend yield, which is well-protected by a 24% payout ratio. It's worth noting that PII is a dividend aristocrat with 27 years of consecutive raises under its belt. While PII's 5-year dividend CAGR of 1.6% leaves a lot to be desired, its total return potential is what makes the stock attractive.

At the current forward PE of 9.7, the stock sits well below its normal PE of 16.6. Plus, while analysts expect a 5% decline in EPS this year, they expect for growth to resume at 12% EPS growth next year. With an earnings yield of 10% on share buybacks, a near 3% dividend yield, and a potential return to its normal valuation, PII could produce market-beating returns over the next 1-5 years.

PII also trades cheaply compared to the Consumer Discretionary segment. As shown below, it scores A/A- grades on basis of PE and EV/EBITDA by comparison to the sector median.

Investor Takeaway

Overall, PII's current valuation is attractive not just because of its earnings yield (which can be realized through share buybacks) and dividend yield, but also due to its potential for multiple expansion. While the near-term outlook may be challenging, PII has positioned itself well in terms of market share and innovation to emerge stronger from the current economic downturn. With a solid balance sheet and history of returning capital to shareholders, PII is a compelling investment opportunity for dividend and growth investors alike for potentially strong total returns. As such, I rate PII as a 'Buy' at present.

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