Why Polaris Industries Inc. Shareholders Might Have Something to Worry About

By Rich Duprey Markets Fool.com

As the dominant player in the powersports vehicle market, Polaris Industries (NYSE: PII)enjoys a comfortable competitive advantage that should allow it to weather the series of quality-control setbacks it is currently suffering through. From off-road vehicles and snowmobiles to motorcycles and utility vehicles, Polaris has maintained the No. 1 or 2 position in each.

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Yet industry trends in several of those markets could significantly erode its margin of leadership, and though it's not likely to be displaced anytime soon, Polaris Industries could still find itself coming under greater pressure that could narrow profits.

Image source: Polaris Images.

Running off the road

Three-quarters of Polaris' revenue comes from off-road vehicles (ORVs). Its RZR side-by-side is far and away the top dog in the industry, but persistent recalls for manufacturing defects that have caused injury and even death to some riders could jeopardize its preeminence.

Polaris generated over $3 billion in ORV segment sales in 2016, down 9% from the year-ago period as industry weakness and the recalls took their toll. Even though the company reported 2% higher revenue in the first quarter, the situationdidn't improve, because the gains were mostly driven by parts, garments, and accessories. Retail sales of ATVs were down by low-double-digit percentage rates and side-by-sides were off by low single digits. Snowmobile sales were also down.

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As much as Polaris has been dragged lower by the repeated recalls and their growing cost, it also is contending with a depressed market for its off-road vehicles. It is highly reliant upon oil- and agriculture-dependent states, and those two regions have been hit hard by a collapse in commodity pricing. With the protracted slump, Polaris may be in for a long wait for sales to perk up again.

That could give rivals an opportunity to make up ground on the leader. Textron (NYSE: TXT), for example, recently purchased Arctic Cat, and both it and Can-Am have been amping up the power and features of their competing vehicles, which, coupled with the hit Polaris' reputation is taking on its quality, could give them a chance to narrow the gap between them. RZR, after all, has twice the market share of all its competitors combined, but that could quickly change.

Image source: Indian Motorcycle.

A muscular performance

Conversely, although Polaris owns the No. 2 position in motorcycles, it trails Harley-Davidson (NYSE: HOG) by a wide margin. While its Indian Motorcycle brand continues to rack up sales in a down market -- retail sales were up by low-double-digit percentage rates even as Harley's sales resumed their fall -- it's not about to overtake its rival any time in the foreseeable future.

Not that it has to, as long as it can continue building on the legacy of the brand, but Honda, Kawasaki, Suzuki, and other bike brands will constantly be nipping at its heels if it doesn't.

It smartly rolled out models that built on Indian's heritage first, and then picked up style points from its Victory brand that it recently killed off. By not being unalterably wedded to history, Polaris shows a willingness to take chances that could pay off down the road. And by focusing all of its energy on the one motorcycle brand that's succeeding, it won't be competing against itself with a nameplate that was siphoning off resources.

Yet, like ORVs, the motorcycle industry is also in a downturn. Polaris estimates that the market for bikes 900 cubic centimeters and above was down mid-single-digit percentages while its own retail demand in North America was off by a similar rate. That's partially because its Slingshot three-wheel motorcycle suffered from limited availability also due to recalls. The trike was popular right out of the box, but the same sort of manufacturing defects plaguing Polaris' ORVs have hit just about every vehicle it produces.

Image source: Fiat Chrysler.

A new retail play

Now Polaris did buy Transamerican Auto Parts, a network of retail stores for Jeep and truck aftermarket parts. It is the leading name in that niche and ought to provide Polaris with a new stream of revenue, but Jeep and truck sales are soft right now and it is Polaris' first foray into the retail segment. The jump may not be as seamless and smooth as it appears.

Polaris Industries has a wide competitive moat at the moment that is holding its rivals at bay, but by turns its own miscues and the right steps taken by the competition mean that moat is not as broad as it once was. It also finds itself caught up in a promotional environment in several markets that could pressure profits, not to mention the harm being done by the costs associated with the recalls.

Assuming the latter is a problem it finally contains, Polaris Industries should come out all right in the end, but the powersports vehicle maker has yet to prove it has the recall issue in hand, and investors are likely to experience volatility, and maybe even a further erosion of value in their holdings.

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Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Polaris Industries. The Motley Fool has a disclosure policy.