Off-Road Downshift Unlikely to Stall Leisure Firms
Acquisitions and new product categories should bolster long-term sales growth.
We believe the powersports companies we cover-- Polaris Industries (PII), Arctic Cat (ACAT), and BRP (DOO)--offer attractive margins of safety for long-term investors. After near-term risks subside, we expect higher normalized EBIT margins and mid-single-digit sales growth on average for all three through the remainder of our 10-year forecast.
These companies have been under duress over the past 18 months owing to missteps in inventory management by certain participants and the effects of foreign exchange. We view the newest issue--weaker demand in key oil-producing regions--as a medium-term risk that could increase volatility materially for these businesses over the next one to three years, in tandem with the recovery of futures prices. In our opinion, these headwinds are temporary, and the North American players are solidly positioned to at least maintain share and improve margins, as both Arctic Cat and BRP are still executing on operational changes from which they stand to benefit.
We think these businesses' lean operating tenets will provide some stability after this near-term lumpy period subsides, which should lead to healthy economic profits over time. Few competitors hold meaningful market share relative to the leading players, and we think innovation aligned with consumer demand will prove key to ensuring that brand intangible assets hold firm.
Brand Equity Helps Capture Market Share, Keeping Moats Intact
We think all three powersports companies we cover have economic moats, with brand equity a key component that supports unit demand and brand loyalty behind consistent sales growth potential for certain constituents. While we view the more than 50 years of brand-building behind companies like Arctic Cat, Polaris, and BRP as an advantage, we believe other industry peers could benefit from positive sales trends and share shifts if the leading North American players were to slow their spending on research and development.
Creating new products that go from development to market quickly is even more important now than in the past, since the pace of product introductions seems to have increased in recent years, jeopardizing the ability to capture pricing premiums for extended periods. Manufacturers that stay on top of the best technology, consumer-driven products, and value propositions should be the ones that take share. Over the past decade, the top three North American manufacturers--Polaris, Arctic Cat, and BRP--have made investments in new products that have allowed them to take share in key categories such as all-terrain vehicles.
Market share is widely dictated by quality of and demand for products, which stem from a company's willingness to spend on recruiting the best engineers and process-oriented minds to conjure up the next big thing as well as figure out the most efficient production method. Thus, we still see R&D spending as key for market leaders to retain their positions. The top three North American constituents have not materially slowed their R&D spending (which has generally been 3%-5% of sales over the past five years), and we expect them to continue spending around 4% of sales on R&D over the remainder of the decade. However, competitors like Yamaha are attempting to close the gap.
We see these businesses as relatively protected, as the impetus for new competitors to enter the industry is limited at best. Key categories in which powersports manufacturers deal (snowmobiles, ATVs, side-by-sides, and personal watercraft) could have low-single-digit global unit growth ahead, though this is largely contingent on consumers' ability to spend on high-priced discretionary goods, as well as companies' ability to deliver new, innovative products that cater to consumers' changing demands. In the past year, global snowmobile sales were around 150,000 units (up 6% on average annually over the past five years), ATV sales were about 420,000 units (down 3% on average), side-by-side sales were approximately 415,000 units (up 12% on average), and personal watercraft sales were roughly 83,000 units (up 3% on average), according to Powersports Business, BRP's annual report, and Polaris' annual filing.
Even if a new entrant were to capture 25% of any one of these categories, we believe the economics might not be compelling enough for many others to enter, considering the startup costs in setting up or acquiring the proper manufacturing facility, investing in R&D that can outsmart those with meaningful leads, and taking time to build a distribution channel that already has some built-in brand loyalty to current operators.
Nonetheless, in a category such as personal watercraft, a 25% share would lead to around 21,000-unit demand, and in either ATVs or side-by-sides, it might represent just above 100,000 units. We think scale and volume across categories are necessary to support the economic argument for entering this type of category, which is probably why none of the companies we cover make only one of the products mentioned, instead choosing to produce a portfolio of products. In addition, the higher-revenue companies have actually reported better gross and operating margins for at least the past five years. Sourcing inputs, raw materials, distribution, and overall supply-chain expenses tend to be more favorable with volume demand, leaving any new entrant grappling with higher-than-peer input costs and thus lower economic profits.
Furthermore, we believe brand equity exists in a significant way for powersports companies, creating stickiness with brand enthusiasts. This brand equity along with what we view as the industry's protected nature is what gives us confidence that the powersports companies we cover can sustain their economic profitability over the next 10-20 years or longer. With lack of volume and an as-yet-unsigned dealer network that would be relied upon to facilitate turns, we think a new entrant would face difficulty in attaining returns on invested capital that surpass its weighted average cost of capital.
In our opinion, brand equity depends on awareness (as well as consistent reliability), which in turn depends on each manufacturer's relationship with the distribution channel. We believe retailers' willingness to stock units of any particular brand is contingent on the ability to stock inventory closer to demand, the support of compelling floorplan financing programs, and the manufacturer's ability to facilitate strategic incentives and rebates to drive incremental sales when necessary. Polaris holds the leadership spot here, thanks in part to its sophisticated inventory-management systems, which deliver units closer to purchase and replenish as necessary, offering more flexibility to dealers with their own cash burn. A small new entrant, or one that may be focused on segments outside powersports, would probably face difficulties in replicating this symbiotic relationship; ultimately, these competitors would be unable to coddle dealers in the same way the market leaders do.
Industry Unit Demand Should Slow After Recovering From Last Recession
We expect industry growth will largely come from existing operators, as we don't anticipate sizable new entrants. We forecast that unit sales for traditional powersports business lines (side-by-sides, ATVs, personal watercraft, and snowmobiles) will increase more than 2% on average over the next five years in the aggregate, while total dollar sales will rise at a slightly higher clip than volume as annual price increases boost the total top line. This is much slower than increases of the past five years, during which global powersports industry unit sales increased nearly 5% annually and sales rose at a double-digit rate for the companies we cover. Our outlook is mostly in line with forecasts from other industry aggregators, with IBISWorld expecting revenue growth of 2.4% annually through 2019 for the ATV, golf cart, and snowmobile manufacturing sector. In addition, IBISWorld's forecast considers products that adapt to consumer needs through innovation as the economy continues to recover and consumers have more disposable income, which is also an underlying factor in our growth rate. We suspect that those taking share by offering the best or newest products will increase revenue faster than the 2%-3% growth projected for the traditional categories in the industry. Our outlook for the North American manufacturers assumes they will retain their market share leadership.
We believe there is an economic basis supporting this discretionary spending, with the wealth effect increasing consumers' willingness to purchase these high-ticket items. The U.S. consumer is still riding on rising housing prices, higher equity prices in the stock market (while 2015 was not strong, the three years prior delivered double-digit gains for the S&P 500), and healthy unemployment levels, where supply and demand should begin to support increased wage growth. These should ultimately support the Bureau of Labor Statistics' outlook for 2.4% annual increases for personal consumption expenditure (and 3.2% growth for expenditure on durable goods) between 2014 and 2024. Historically, powersports companies' performance has outstripped personal consumption expenditure for both durable and recreational goods, which have grown at average clips of 5% and 3%, respectively, over the past decade (versus 24% and 10% for Polaris and Arctic Cat, respectively), as new category expansion and consumer spending helped to boost powersports sales. However, as we embark on more-stable consumer spending growth (with disposable personal income expected to rise about 4% annually through 2024), we think North American manufacturers have a reasonable chance of grabbing some portion of this increased spending. In our forecasts, we have used the expected improvement in consumer spending to assess the growth of individual traditional powersports categories by triangulating total spending potential with historical performance and these business lines' likely future avenues for growth.
For the off-road division, we anticipate 2.5% growth over the next five years. 2014 saw total off-road sales of approximately 830,000 units, split nearly evenly between ATVs and side-by-sides. Over the past five years, ATVs have experienced a 3% average annual decline, while side-by-sides have grown at a 12% average annual clip. Over the next five years, we think side-by-side growth will normalize at a mid-single-digit pace (around 4% in 2019), indicative of replacement demand as technology improves and international reach expands. For ATV sales, assumed growth of 1%-2% should account for similar opportunities, including replacement, demand from improved technology, and rising international adoption. This should take the industry (ATVs and side-by-sides combined) from 830,000 units last year to 941,000 units in 2019, still well below peak unit sales of nearly 1.4 million in 2005.
The snowmobile industry has been a long-term slow-unit-growth story (after seeing a very slow decline in unit growth between 1997 and 2010), a trend that we anticipate will continue. While this winter's demand is highly at risk with little snowfall to date, we still believe the industry can increase units at a low-single-digit pace as consumers replace older models, new product introductions prompt demand, and product reach expands. This should take the industry from 150,713 units last year to 164,656 units in 2019, still well below the more than 260,000 annual units sold in the late 1990s (and well under peak unit sales of nearly 500,000 in the early 1970s). Over the past five years, as North America recovered from its previous recession, snowmobile sales rose at an annual average pace of 6%. In the five years before that, demand declined 8% on average, leading to a contraction of 1% over the past decade. We believe that by the 2020 season, the low-single-digit growth pace of 2% could return the industry to levels reached nearly a decade ago, particularly if international penetration rises from current levels and weather conditions are beneficial. Because many products are relatively similar, we view significant price increases across industry participants as unlikely; this will weigh on revenue growth as peers attempt to maintain modest price increases to continue attracting consumers.
The personal watercraft industry also has long been below its peak, with sales more than 50% lower relative to 20 years ago (more than 200,000 units were sold in 1995). Over the past five years, worldwide sales have risen 3% annually on average, to 83,000 units in 2014. We suspect that the robust 20% unit growth in 2014 (estimated by BRP) was in response to the launch of the low-priced Sea-Doo Spark and that sales growth is likely to slow again in the years ahead. This niche category caters to high-income consumers in climates that cater to watercraft wants. If we assume 1%-3% unit sales growth on average over the next five years, we believe personal watercraft sales could surpass 90,000 units, a level achieved before the last recession. We arrive at this low-single-digit rate by assuming annual replacement units of 60,000, which implies an average age of about 10 years before replacement (there were 80,000 units sold in 2004 and 83,000 in 2014, implying healthy demand for new products), and decent interest in incremental new ownership. If we assume that the average personal watercraft owner is around 40 years old, we envisage roughly three purchases of personal watercraft over a person's lifetime, with a 10-year product life span assumed and ridership anticipated to slow at around 60 years of age. As some buyers exit the market, some from other demographic cohorts enter, maintaining level sales growth. Additional demand stems from attracting new consumers and launching compelling new products.
Overall, this brings estimated unit growth for the powersports industry to 2.4% over the next five years (versus 4.8% over the past five years), which does not set the scene for robust top-line growth at operators based solely on volume. The ability to take very moderate price alongside share will be more important as new product offerings are launched, which will enable companies to increase sales faster than volume. Additional volume upside could come from new category introductions and disruptive product changes that would capture incremental discretionary dollar allocation from end users. We see three near-term pressures that could derail this growth over the next few years, leading to medium-term uncertainty for Polaris, BRP, and Arctic Cat.
Inventory levels continue to plague the powersports industry on a widespread basis. Some industry participants (Arctic Cat in particular) had been front-loading dealers with inventory, leading to widespread discounting of stale or prior-year products as new model years came on line. Commentary from Polaris and BRP has indicated that inventory growth at North American dealers has been increasing at as much as a double-digit clip over the past 18 months; to us, this means an increased risk of stale inventory in the retail channel. The promotional environment may persist longer than we originally anticipated--as demand remains weak and as time passes, more units at retail become at risk of irrelevance.
Operators have responded by reducing retail inventories; manufacturers, concerned about inflated stock levels at dealers, have launched strategic discounting and financing strategies to reduce out-of-date product. But now, with key regional demand at risk, manufacturers' ability to clear ATVs and snowmobiles at a sufficiently fast pace could be at risk through at least 2016. The lack of snow this winter could be another issue for those with stale inventory, creating more near-term downside risk.
Polaris has topnotch inventory management systems to deliver supply that is generally in line with demand, thanks to the just-in-time replenishment systems it uses. In our view, BRP and Arctic Cat are behind by a wide margin in this arena. To ensure appropriate inventory at retail on a consistent basis, the industry would be best served by moving toward just-in-time ordering to replace recently sold units. Until all three North American players, which make up a majority of supply across traditional powersports categories, are delivering this type of replenishment, stale inventory risk will remain inflated.
Foreign exchange could remain a wild card. The powersports industry's disproportionate exposure to Canada has been particularly difficult, and the Canadian dollar and the euro are key currencies for translational risk, particularly for Polaris and Arctic Cat, which respectively derive roughly 10% and 28% of total sales from Canada, with roughly 15% and 12% of international sales exposed to the euro. BRP has escaped some of the translational pain--because its functional currency is the Canadian dollar, the company has benefited from the strengthening dollar sales translation--but local and international demand has waned for its business as well. The continued strengthening of the U.S. dollar has pressured top-line and gross margin results in recent periods.
Although we do not anticipate that the Canadian dollar and euro will continue to depreciate at the same rate, a reversal seems equally unlikely. The current futures exchange rate price (CME) for the Canadian dollar is set to rise to only 0.75 by the end of the decade, which would represent a 1% gain in the currency from current levels, while the euro is set to close the same time frame at around EUR 1.18, leading to a currency gain of nearly 8% from current levels. Many factors can change these estimates rapidly, and we are using forward rates solely to think directionally about top-line and gross margin pressures, which at this time are likely to be greater in the Canadian market than in the European markets over the next five years.
Lower employment across oil-producing regions could suppress demand through 2018. Our main concern is the duration of lower energy prices and the magnitude of their impact on the spending pattern of businesses that purchase products like utility vehicles, as well as those employed in energy-producing industries and those who benefit from healthy employment in the sectors (hoteliers, convenience store owners, and more) and who spend discretionary income on items like off-road vehicles and snowmobiles. Morningstar's energy team does not currently expect midcycle prices to resume until 2018. At current low prices, we fear production could remain constrained among the oil companies that own properties with higher-than-average extraction costs, tempering production. However, if oil prices tick higher, we believe some producers' willingness to extract will rise, boosting employment among a portion of powersports customers. As these potential customers return to work, we don't anticipate that they will immediately allocate most of their discretionary dollars to the purchase of a high-ticket discretionary product; rather, they are likely to spend on other durable good items and necessities that they have been postponing during the current period of lower employment.
BRP Best Positioned to Navigate Near-Term Pressures
We see BRP as the best positioned to defend against these aforementioned pressures over the next one to three years, with its inventory plight in certain categories being offset by entry into new categories, leading to fresh demand in previously untapped markets. We also anticipate that foreign exchange will remain a tailwind for BRP, as the translation of U.S. dollars into Canadian currency benefits its financial statements. We think Polaris' position as an industry leader in ATVs and side-by-sides puts it in a risky position as peers attempt to compete its leading market share away, creating a challenging inventory environment in upcoming years. In addition, continued foreign exchange volatility for those translating into the U.S. dollar leads to some downside. Arctic Cat, which has the best opportunity for long-term improvement in operational excellence, has the broadest near-term downside risk. The company operates in only two categories with significant near-term demand uncertainty, jeopardizing its chances to capture operating improvement in the short term.
In the longer term, we believe the three companies on our powersports coverage list stand to benefit from their specific opportunity sets. We think BRP has the best medium-term certainty (three to five years) surrounding its ability to drive top-line and bottom-line expansion, with new opportunities clearly laid out and operational reorganization ongoing. Arctic Cat has the most intriguing long-term operational opportunity (over the next 5 to 10 years) as it tries to clean up the organizational chaos left by the prior management team and attempts to discover compelling growth avenues. We still believe Polaris is a strong long-term competitor that has historically delivered enviable performance. Despite near-term blips in execution leading to negative sentiment surrounding the name, we believe the story is not yet over, despite slower growth ahead for the sizable off-road segment.
Jaime M. Katz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.