PII - Still Happily Avoiding Polaris

2023-07-18 05:58:00 ET

Summary

• I remain cautious on Polaris Inc. despite its shares returning about 22.4% in the past six months, due to concerns over the company's deteriorating capital structure and rising interest expenses.
• The company's recent financial results show an 11.4% increase in revenue and 62% rise in net income year-on-year, but obligations have risen by 8.6% to over $2.1 billion, causing a 140% increase in interest expenses.
• While I would consider buying the stock at the right price, I currently recommend much less risky bonds.

It's just shy of the six month anniversary since I put out my cautious piece on Polaris Inc. (PII), and in that time, the shares have returned about 22.4, against a gain of about 13.25% for the S&P 500. I really earned my nickname "Granny Doyle" on this one. Anyway, it's time to decide whether to finally join the party here and buy a stock that's a winner because it's going up, or to continue to eschew the shares. I'll make that determination by looking at the latest financial results, and by comparing those to the valuation of the stock. Finally, since all things in investing are relative, I think it would also be worthwhile considering what else I could buy with my capital, and how much relative risk that other investment would impose upon me.

It's "thesis statement" time, where I give my readers a bit more than they would normally get from a title and bullet points, but much less than they would be subjected to with one of my full articles. So, in case my view isn't obvious from the title and the bullet points, this paragraph's for you. There's much to like about this fast growing, profitable company. Revenue and net income are up nicely over the past year, and there's no reason to think this will stop. My problem relates to the fact that the capital structure has deteriorated over the past 5 quarters, and interest expenses have exploded higher. This, coupled with the fact that an investor can receive 90% more income in a risk free investment causes me to remain cautious here. I'm a fan of the business, but investments must be judged by the risk they impose, and not just the potential returns associated with them. Finally, my experience with this stock is telling in my view. The shares rose dramatically after I recommended avoiding them, because of course they did. The people who ignored my advice made over 10% in a month. The problem is that the shares were down by 2% 16 months later. So, the market may continue to run from here, but that is less relevant than being able to sleep at night in my view. I would remind investors, once again, that the market giveth, and the market taketh awayeth.

Financial Snapshot

The most recent financial results have been very good in most ways in my view. Relative to this time last year, revenue and net income were up by 11.4% and 62%, respectively. This is in spite of a $60 million uptick in costs, including an uptick of 23% in selling and marketing, 19.4% in R&D, and a 26.6% uptick in G&A. The one fly in the soup is the capital structure, given that obligations have risen by about 8.6%, and now top $2.1 billion. This might explain the fact that interest expenses were up 140% from the year ago period. If you've been paying attention at home, you'll know that interest rates are a bit higher at the moment, and this may have significant impacts on profitability here over the coming years. To put the current interest expense in context, the company spent nearly as much on interest in the first quarter of this year than it did throughout 2017. Additionally, the interest expense represented 76.5% of the current dividend payment, and 25% of net income. I think the leverage is a problem here, which is why I'm glad to see that the company spent "only" $49.6 million buying back stock in a three month period.

All that written, I'd be very happy to buy the stock at the right price.

The Stock

As you might expect if you're one of my regular readers, I'm about to write to you that I treat the business and the stock that supposedly represents the business to be two distinctly different things. The business designs, engineers, makes, and sells powersports vehicles around the world. The stock, on the other hand, is a piece of virtual paper that gets traded around in a public marketplace, and its movements are driven by the crowd's ever-changing moods about the future. The mood can be impacted by the waxing and waning of the overall demand for "stocks" as an asset class. The mood can be impacted by short term interest rates. For those who don't believe me on this score because they've been convinced that "we don't buy stocks, we buy businesses", consider an investment in Polaris at different times.

Let's assume that someone decided that I was too unreasonably pessimistic, and that they would buy when I was recommending people avoid this stock. Over the next month, they would have "earned" about 12.5% as, right on time, the market spiked in price after I became cautious. If they held on, though, their investment would have turned negative, with the shares about 2% lower 16 months after I turned cautious. What the market giveth, the market taketh awayeth. Now, here we are, and the shares have spiked higher over the summer months. I'm willing to buy back in, as long as the price is reasonable.

Another word for "reasonable" is "cheap." I like cheap stocks because they offer the greatest combination of higher returns at lower risk. They represent the potential for higher returns because any bit of good news may very well send shares higher when only bad news has been "priced in." They represent lower risk because at some point, the market just expects terrible results, so the stock doesn't have much farther to fall. This tendency on my part to buy when the crowd is most pessimistic is a way of playing against crowd expectations.

Anyway, as my regular readers know, I measure "cheap" or "low expectations" in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at the ratio of price to some measure of economic value, like sales, book value, and the like. I want to see a company trading at a discount to both its own history and the overall market. When I last reviewed Polaris, I avoided the shares because they were trading at a price to free cash flow from operations per share of 24.75 and the market was paying, in spite of the fact that the shares were trading on the low side on a PS basis. The shares are now significantly cheaper on these bases, per the following:

I previously suggested stock investing is about spotting discrepancies between expectations and likely future results. When the crowd's expectations are too pessimistic, I buy. When the crowd becomes too optimistic, I want to sell. I do like to quantify things whenever I can, and to do that I turn to the works of Stephen Penman and/or Mauboussin and Rappaport. The former wrote a great book called "Accounting for Value" and the latter pair recently updated their classic "Expectations Investing." The idea expressed in both of these works is that the stock price itself is a great source of information, and the former in particular helps investors with some of the arithmetic necessary to work out what the market is currently "thinking" about the future of a given business. This involves a bit of high school algebra, where the "g" (growth) variable is isolated in a standard finance formula. Applying this approach to Polaris today suggests the market is assuming that earnings will grow at a rate of about 3% in perpetuity. I'm of the view that over the long term, profits can grow at the same rate as the overall economy, especially for discretionary products like the ones Polaris sells. For that reason, I consider this stock to be neither cheap nor expensive on this basis.

The issue continues to be for me that the risk-free rate is about 90% greater than the dividend yield at the moment. The investors in this stock are receiving far less income and are taking on much more risk than I would recommend they do. For that reason, I can't recommend buying the stock. This stock is a wonderful example of the fact that today's gains can turn into tomorrow's losses, as demonstrated above. Given that I'm not inclined to risk a great deal of capital in more risky endeavours at the moment, I must continue to eschew these shares, though they are in some ways cheaper than they were 24% ago. I'm not looking for "returns." I'm looking for "risk-adjusted returns." For that reason, I'm very comfortable buying bonds in lieu of these shares.

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