PII: Polaris Plowing Through Economic Blizzard

This article is a reprint of my 5 August 2008 RealMoney column.

With consumers under duress, it is likely wise to avoid consumer-discretionary stocks, especially those in companies that sell goods that cost thousands of dollars. But few fortunes are made by following conventional logic, and often investors must look for unconventional opportunities that may be unfairly priced. I think Polaris Industries (PII) may be one such opportunity.

Polaris make all-terrain vehicles (ATVs), snowmobiles and motorcycles and markets them — together with related replacement parts, garments and accessories — through dealers and distributors principally located in the United States, Canada and Europe. Its primary competitors include Arctic Cat (ACAT) , Bombardier and Honda Motors (HMC - Annual Report) .

Polaris shares are down 20% over the last year, as investors appear to expect a slowdown in sales and profits. Yet those metrics are rising. Second-quarter sales were up 21%, and earnings were up 16% compared to last year. The earnings beat the consensus estimate by 4 cents, and the company raised its full-year guidance by a similar amount.

Polaris’ strength is being driven by sales of ATVs, which account for two-thirds of total revenue. In particular, the company’s popular Ranger and RZR brands of multi-passenger “side-by-side” ATVs have given the company the top market share in that category. Polaris grew sales of its side-by-sides by more than 50% in the latest quarter, even as the overall ATV industry has been essentially flat. On the recent conference call, investors heard that channel checks indicate continued supply shortages. With the hot side-by-side ATVs in short supply, moderating sales would simply bring supply and demand into balance.

Over the last 12 months, Polaris generated $140 million in free cash flow, measured as cash flow from operating activity less capital expenditures. At 9.8% of the company’s market capitalization, the cash-flow yield represents a healthy premium to the yield on five-year Treasuries. The company has been using its free cash flow to pay out a healthy dividend (the yield is now 3.5%, itself comparable to the Treasury yield) and to buy back shares. From nearly 44 million diluted shares in 2005, the share count has been reduced by nearly a quarter, to less than 34 million today.

Analysts expect the company to grow earnings by 12% per year over the next three to five years, a rate that is well below the rate that can be sustained given the company’s high returns on equity. I think the estimate is a reasonable one. If growth remains in double-digits, as I suspect, then investors won’t continue to require such a high free-cash-flow yield from the stock. Even at a 7% yield, the risk premium over Treasuries would be 100%, a level often cited by value investors as a target premium.

If free cash flow per share rose by 12% next year, and the shares were priced for a 7% free-cash-flow yield, the resulting $65 share price would represent nearly a 48% premium from the current level. Even if it took five years for the valuation to adjust to a 7% yield, total returns would be 15%-20% annually. With that kind of return, I’d be willing to wait for the valuation to correct.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned in this column.