While I have a distinct preference for businesses that provide products or services that are necessary to our way of life, it is not an actual requirement for me. Sometimes it can also depend on where you live and what you do as to whether a particular product or service is required.
For example, I have some friends in rural parts of Canada who would tell you they could not survive in the winter without their snowmobiles. I have other friends who live a bit off the beaten track in Arkansas and Montana who don’t think they would get by without their all-terrain vehicles.
What we need to survive varies depending on our own circumstances. Today, I have found an opportunity in a business that supplies critical products for some of their customers and just big boys’ toys to others.
The business and products
Polaris Industries Inc. (PII, Financial), designs, engineers, manufactures, and markets off-road vehicles, snowmobiles, motorcycles, and small vehicles primarily in the U.S., Canada, Western Europe, Australia, and Mexico. It offers off-road vehicles, such as all-terrain vehicles, such as its Ranger line. It produces side-by-side vehicles for recreational and utility use; snowmobiles consisting of various models; V-twin cruiser motorcycles under both the Victory and iconic Indian brands. It also has a line of small vehicles.
The company also has a robust business for replacement parts and accessories consisting of winches, bumper/brush guards, plows, racks, mowers, tires, pull-behinds, cabs, cargo box accessories, tracks, and oil for off-road vehicles; covers, traction products, reverse kits, electric starters, tracks, bags, windshields, oil, and lubricants for snowmobiles; and saddle bags, handlebars, backrests, exhausts, windshields, seats, oil, and various chrome accessories for motorcycles.
Further, the company markets recreational apparel, which includes helmets, jackets, bibs and pants, leathers, and hats through dealers and distributors, as well as through sites polaris.com, indianmotorcycle.com, klim.com, kolpin.com, and proarmor.com.
Why Polaris, and why now?
At this time, we are deep into a long-term bull market that has been driven by low interest rates and easy credit. Stock valuations have pulled back over the past 12 months but are still not cheap overall.
We all know that all bull markets have to end; we just don’t know when.
When I look around, I can easily find troubling signs that tell me to guard my capital closely right now. But what if my concerns are too early or completely misplaced? I want to maintain some exposure to potential upside in the market but I also want to minimize the risk to my capital should my concerns prove to be correct.
Since the first of the year, as shown in the table below, the major indexes have all posted significant declines for the five-week period. Polaris, on the other hand has only declined by 3.8%. Even though the stock is down, it has dramatically outperformed the major averages. This is a very good sign going forward. The recent price action is even more positive when considering that the stock is down a catastrophic 42.73% over the past 12 months. Polaris’ stock price seems to be forming a bottom here and the recent outperformance against the indexes is a very positive sign.
Polaris’s stock price was very richly valued at its peak, but it was well ahead of the overall market in its decline. Now the broader markets seem to be falling steadily, while Polaris is finding some traction.
Finding a solid business with a share price that was punished in front of a broad market decline, but seems to be finding its footing and outperforming the broad market now, signals me that it might have less remaining downside than the broad market should the decline continue.
How is the business currently valued?
Based on the currently estimated earnings of $6.38 per share for 2016, Friday’s closing price of $82.68 prices the stock at about 13 times current year earnings.
| Earnings estimate |
Current quarter March 2016 |
Next quarter June 2016 |
Current year Dec. 2016 |
Next year Dec. 2017 |
| Avg. estimate | 0.69 | 1.37 | 6.38 | 7.10 |
| No. of analysts | 19.00 | 19.00 | 20.00 | 18.00 |
| Low estimate | 0.55 | 1.18 | 6.00 | 6.39 |
| High estimate | 0.81 | 1.52 | 6.83 | 7.74 |
| Year ago EPS | 1.30 | 1.49 | 6.75 | 6.38 |
When we consider the projections for earnings growth in the business of 13% per year over the next five years, we can see that the business is price right in line with its projected growth rate. Not stupid cheap but not expensive by any means.
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But, with a long position in Polaris, there is a little extra kicker for investors. At the current stock price, the company’s dividend payments yield 2.66%, which is pretty attractive in a zero interest world.
Given the projected forward growth rate of 13% per year and the current 2.66% dividend yield, new investors in Polaris today should be able to achieve an annualized return of around 15% over the coming years.
Is the dividend safe?
Last year, Polaris generated cash from operations of $440 million and spent $249 million on capital expenditures. This produces a free cash flow number of $191 million.
The company paid out dividends of $139 million or 55.8% of free cash flow. Considering the capital investments made last year were 39.6% above the five-year average, I believe any level below 60% of free cash flow is well-covered. Keep in mind that this means the business is paying out less than 60% of the cash that is left over after it has fully funded all of its operational expenses.
The healthy amount of cash flow being returned to shareholders as a dividend today is also a positive sign as to management’s view of returning profits and value to the shareholders.
Polaris’ current dividend would appear to be safe.
Here’s the risk with Polaris
While the valuation of Polaris has come down to earth over the past 12 months, it is not yet completely clear that the decline is over. It is up from its recent 52-week low set on Jan. 28 of $67.80, but there is no guarantee that the broad market decline we are experiencing might not take the stock lower.
We all know that during serious corrections or bear markets, very few stocks will be spared. As long term investors, we simply need to position our long holdings in those stocks that will outperform the overall market by declining less or even returning a modest gain.
If the current downtrend continues in earnest, it is likely that Polaris’s share price will follow the market lower. However, I would expect it to fall less than the broad market.
A rock solid balance sheet provides an extra margin of safety
In addition to some of my concerns regarding the length and strength of the current bull market in stocks, I have some additional concerns regarding the continued liquidity in the credit markets. It is not that I don’t believe really good businesses will be able to obtain financing, I just believe it will become more difficult for those with weaker balance sheets to roll over their debt in the coming months.
That should not pose a problem for Polaris. As of Dec. 31, 2015, Polaris was holding cash, receivables and inventory equal to $1.062 billion against total liabilities of $1.396 billion. This means the company is holding liquid assets equal to 76% of its total obligations. Admittedly, this is not on par with the fortress-like balance sheets I have seen in some of the businesses I analyze, but it is certainly far above average in today’s market.
Just one last little plus
Even though Peter Lynch was always more growth-oriented than value-based in the selection of his investments, he is one of the most successful fund managers of all time. Applying GuruFocus’ Peter Lynch Fair Value criteria to the stock chart produces a current fair value of about $160 per share. This is pretty much in line with where the stock was priced before it began its decline of the last 12 months.
With all due respect to the enormous talent and superb results produced by Lynch during his stellar career, I think the stock is a bit undervalued at today’s valuation, but seriously overvalued a year ago.
However, when compared to the current valuation of the broad market today, Polaris is quite inexpensive. Therefore, should the market continue down, it should move down less from here and should the market begin another leg higher, I would expect the stock price to outperform.
Final thoughts and actionable conclusions
The strong selling in Polaris over the past year appears to be grossly overdone. While the stock was significantly overvalued at its peak, it has now moved to the other end of the spectrum.
New positions in Polaris opened between $80.00 and $85.00 per share should expose investors to less risk than the broad market, while still providing exposure to very solid upside potential should the bull market continue higher.
From today’s price, new investors should anticipate a long-term average return of 12% to 15% per year after including the rich dividend.
