Polaris Inc (PII) 2002 Q3 法說會逐字稿

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Good morning. My name is Constance and I will be your conference facilitator. At this time, I would like to welcome everyone to the Polaris Industries third quarter conference call. Please be advised this call is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. If you would like to ask a question during this time, simply press star and then the number one on your telephone keypad. If you would like to withdraw your question, press star and then the number two on your telephone keypad. Thank you. Mr. Richard Edwards, you may begin your conference.

Thank you, Constance, and good morning, everyone. Thank you for joining us for our third quarter conference call. Today, Mike Malone, our chief financial officer, and Tom Tiller, our president and chief executive officer, will be participating in the call. Tom will spend a few minutes reviewing the current status of each of our business lines. Then Mike will report on some specifics of our third quarter results released earlier this morning. And as always, we will open it up for questions from analysts. Before we discuss the results, I must remind you that during this presentation we will be discussing certain topics, including product demand and shipment, sales and margin trends, income possibility levels, and other matters including more specific guidance on our expectation for future periods which should be considered forward looking for the purposes of the private securities reform act of 1995. Actual results could differ from those projected in any forward-looking statements, which involves risks and uncertainties. There are a numbers of important factors that could cause results to differ materially from those anticipated. Additional information concerning a number of the factors can be found in Polaris's 2001 annual report, and in the 2001 form 10-K which are on file with the SEC. Now, we'll turn it over to Tom. Tom?

Thank you, Richard. Good morning, everyone. Thank you for being on the call. We are pleased to report increased sales and earnings per share for the 18th consecutive quarter. For third quarter, earnings were $1.57 a share, up 14% from last year on 1% sales growth. This was the best quarter in the history of our company. The quarter met the expectation, driven by a strong performance from the ATV division and solid margin expansion. One of the important highlights of the quarter was the largest introduction of new products in our history, which was well received by our dealers. These new products included an all new motorcycle, a new family of personal watercraft powered by some innovative engine technology, a new utility vehicle, and several new ATVs, including one model which allows us to expand into a large sport ATV segment. For the most part, these new products will begin contributing to growth in early 2003.

Our expectations for the balance of 2002 remains solid. For the full year 2002, we are narrowing the earnings per share guidance to a range of $4.35 per share to $4.40 per share, up 12% to 13% from one year ago on revenue growth of 2% to 3%. The lower end of the earnings range has increased by 5 cents per share from 90 days ago, while the upper end is unchanged. And as we usually do with the third quarter call, we will give you some early qualitative thoughts about 2003.

With that overview, let's turn to the individual business segments, starting with the personal watercraft division. Watercraft business had a relatively good third quarter, closing what has been the best season in recent memory for Polaris. Although the industry showed a decline in sales of about 3% this season, Polaris bucked this trend and grew retail sales for the third consecutive year. Polaris' market share increased slightly as well, again for a third consecutive year. One of the highlights of the quarter was the introduction of a key new watercraft platform, the MSX. This new boat is completely new and represents the foundation of our future product line. It's a beautiful boat, which provides the best ride in the industry, low emissions and noise, and superior handling. Along with the boat, we introduced three engine options including two high performance four-stroke models. In terms of 2003, I would anticipate more of the same in personal watercraft. That is, flat to single digit industry declines. I would expect our business to continue to somewhat outperform the industry.

In motorcycles, Victory had another good quarter in what has turned out to be our best year yet in the motorcycle business. Over the last 12 months, we have made tangible progress with Victory. Retail sales are way up, about 60% higher than one year ago. That is a result of the lower dealer inventory, which has given us the opportunity to improve our dealer network. Even though the financial numbers remain very small, establishing a solid base and then growing the motorcycle business has been among the most important strategic accomplishments of the year for the entire company. As a reminder, the motorcycle market is much larger than ATVs, snowmobiles, and personal watercraft combined. So competing effectively here gives us the opportunity to grow the business over the next decade. And we expect the progress will continue. In the third quarter, we unveiled the all-new Victory Vegas. This custom cruiser has jaw-dropping style, which is the number one factor buyers look for in cruiser motorcycles. It also has terrific performance along with great power and handling. There's been an overwhelmingly positive response to the motorcycle from both dealers and consumers alike.

With the successful introduction of the Vegas, even the most skeptical now agree that we are in the motorcycle business to stay. We also introduced the motorcycle industry's first custom order program, which gives consumers and dealers the ability to build their own motorcycle exactly the way they want it, directly from the production line. This program is similar to the very successful Snow Check Select program in snowmobiles. For the full year 2002, I would anticipate Victory sales to be up in excess of 60%, up from our previous guidance of up 45%. Based on the dealer orders for 2003, and the reaction to the Vegas, I'm virtually certain that 2003 will be another terrific year of progress for our Victory motorcycle division.

Snowmobiles. As we expected, it was a sluggish quarter for snowmobiles with sales down 29%. As we had previously announced, based upon the warmest winter in 150 years, the dealer orders for snowmobiles were down this year, and the third quarter shipments reflect that. While it's still too early in the selling season, we are seeing, not unexpectedly, a slow start to retail sales. We expect this to remain the case until we get to cold weather and hopefully early snowfall.

During the quarter, the United States Environmental Protection Agency announced final emission regulations for snowmobiles, ATVs, and related off-road vehicles. The snowmobile industry has been working with the EPA for approximately five years to collect data and formulate the proposed regulations. The rule begins to take effect in model year 2006, and will phase in over the next six years. We are confident that we have the plans and technology to meet the rule. For 2003, I would anticipate the snowmobile business to remain under pressure until we have good snow to enable dealers to clear out existing inventory, and to give riders the opportunity to accumulate miles. Importantly, we remain number one in market share in the snowmobile industry, a position that we have held for 12 consecutive years. And according to independent blind surveys, we are now the quality leader as well as the market leader in the snowmobile industry.

ATVs. We had a great quarter in our largest business, ATVs, with shipments up 23% from one year ago. The ATV industry, and more particularly our ATV business, continues to perform very well. The story remains pretty much the same as 90 days ago in many respects. Our growth has been driven by the top end of our line from the Sportsman 700, which was named the ATV of the Year this year, and the Ranger line of super utility vehicles. We continue to see margin expansion and quality improvement, and the dealer inventory of ATVs is lower now than it was at the same time last year. We also made some important new product introductions during the quarter which should help drive our ATV business forward over the next few years. We introduced and began shipping in the third quarter a Sportsman 600, positioned in between two flagship models, the Sportsman 500 and the Sportsman 700. The 600 will build on our historical strength, providing the best large displacement recreation ATV vehicles in the world.

With the sportsman 600, we are attacking with our strength, the Sportsman. We also introduced an exciting new sport model called the Predator. This is a new growth opportunity for Polaris in that we have never offered a truly high-performance sport quad. This market is approximately a $500 million market, and has been growing about 15% per year over the last couple of years. The Predator should be very competitive within this segment and has the potential to grow to perhaps $100 million of sales annually.

The Polaris Professional series continues to come along nicely. We ended the quarter with 145 dealer locations, up from 102 at the end of the second quarter and well on our way to 200 dealer locations for the full year. We're very pleased with the quality of the new PPS dealers. Setting up a quality dealer network remains our top priority for the year. We also announced a new PPS vehicle called a UTV 1500, a utility task vehicle. This new model will allow us to be fully competitive at the lower end of the utility vehicle line, and it will start to ship late in the fourth quarter. Finally, we simplified the entire ATV line and introduced a variety of new selling tools to help our dealers remain competitive, including the bundling of financing, accessory, garments, and extended service contracts.

From our perspective, the ATV industry and our ATV business are performing almost exactly as we forecasted at the beginning of the year. For the full year, we expect the industry to be up around 10%, which is very healthy growth. We feel very good about our new products and programs and our relative competitive position.

Parts, garments, and accessories. We had an okay quarter in the PG & A business with total sales down 3%. While we were disappointed with the year-over-year sales decline, the declines were isolated from our snowmobile-related business. PG & A for snowmobile related items were down 46%, while the rest of the business was up 18%. The snow-related items were softer than we had expected. The remainder of the business was about as expected. It's been harder to forecast PG & A than we had originally anticipated, and the snowfall impact has been greater than we thought.

Quality. Over the last few calls, I have mentioned that we have an important initiative that runs across the business, and that's our quality improvement program. In fact, this is the largest initiative inside the company. Nearly two years ago, we began a massive effort to reduce waste and defects, improve supplier and factory processes, and to drive to industry-leading quality levels across every product line. I'm happy to report that we've made excellent progress in several areas, and I fully expect this progress to continue to deliver significant benefits. Defects are down about 40%, and we have seen big improvements in both internal and external failure costs. The new products that we're introducing, like the Victory Vegas, the Predator, Sportsman 600 and the MSX watercraft have been engineered to produce our best quality ever. While some of the benefits are not immediately visible on the financial statements, they are nevertheless very important barometers for our future success.

Speaking of the future, let's talk about our expectations for next year. We've performed well during 2002 despite some real challenges. As I said in the beginning, we are confirming guidance for the full year. 2002 has been a good year for Polaris in a challenging environment. Like all companies, we face the slow economy, a nervous stock market and most recently a west coast port strike. In addition, we have had a couple of unique challenges, the warmest winter in 150 years and a flooding of our largest facility. Despite these obstacles, we have delivered and we will continue to deliver.

We expect the full year 2002 to have 12% to 13% EPS growth on a modest 2% to 3% revenue growth, which is what we projected at the beginning of this year. We've gotten our motorcycle business going and recently introduced five really important new products. The Polaris Professional series is off to a fast start, and Rangers continue to grow. All in all, I'm very proud of our team and look forward to delivering a strong fourth quarter to close our 21st consecutive record year. I am also optimistic for 2003. It should be our 22nd record year. Sales growth should be higher in '03 than in '02 as a result of the new products we have just introduced, especially in ATVs and motorcycles. We expect that margin expansion will continue as a result of our quality initiative, and other productivity programs.

We face many of the same risks as other companies do: Iraq, an uncertain economy, and in our case, snowfall. To mitigate these risks, we will use our flexibility, our pristine, essentially debt-free balance sheet, very strong cash flow, and most importantly, our strong team to deliver our 22nd record year in a row. In 2003, we will unveil another strong lineup of new products similar to this year's introductions. And as is usually the case, we will give you more quantitative guidance for 2003 in the fourth quarter call. With that, I'll turn it over to Mike Malone.

Thanks, Tom. I'm pleased to report a that our record third quarter results released earlier this morning again finished at the top of our forecasted range, and with the best quarter in the company's history. We are very proud of our 18th consecutive quarter of increasing sales and earning, given the overall soft economy and other uncertain factors currently impacting the country. Tom has given you qualitative comments about the results of the businesses, so I will limit it to the fourth quarter and full year 2002 forecast by business unit, beginning with ATVs.

ATV sales were very strong during the third quarter as Tom mentioned, increasing 23% over last year's third quarter. With the new Polaris Professional series adding sales of $5.8 million in the quarter. For the full year 2002, we expect ATV wholesale sales growth rates to increase slightly from our previous guidance to a range of 12% to 13% ahead of last year. Fourth quarter 2002 sales are expected to increase in the 8% to 10% range compared to the fourth quarter a year ago.

For snowmobiles, we are slightly more conservative in our expectations for the full year '02 and now expect a decline in the range of 20% to 22% compared to last year, with the fourth quarter sales guidance showing a decline in the range of 12% to 16% as we close out shipments of our 2003 model year.

Personal watercraft sales increased 131% during the third quarter of '02 compared to the third quarter a year ago. Timing of the watercraft shipments at the end of the selling season was the primary reason for the increase, as we shipped the remaining year '02 units. We remain cautious in our planning for personal watercraft for the balance of '02. We expect full year sales to decline in the mid to high single digit range. The fourth quarter of '02 will likely see a 20% to 25% decline from a year ago, due to the timing of our watercraft shipments. A higher percentage of the '03 model year build will be shipped to dealers in first half of calendar '03 when the new MSX model production commences. Keep in mind, that personal watercraft represents only 4% of our total sales.

Sales of Victory motorcycles increased substantially during the third quarter over the relatively low base in last year's third quarter. For the full year '02, we remain very positive about our growth in the motorcycle business and now expect sales growth to be in excess of 60%, with the fourth quarter '02 expected to be up significantly from fourth quarter a year ago, given the momentum of the new products, the overall improvement in the motorcycle business in recent quarters,and the reduction in field inventories that we have seen.

Parts, garments, and accessories experienced a slight decline as Tom talked about. All of the product lines of the PG & A business, with the exception of snowmobiles, experienced growth over the prior year period and ATV-related PG & A showed double-digit improvements. You will recall that traditionally, snowmobile parts and accessories account for about 40% of our PG & A business and our sled business has been negatively impacted from the lack of snowfall last year and the dealers conservative ordering patterns. This also impacted the PG & A sales in the third quarter, and for the fourth quarter we expect that overall PG & A sales will be approximately flat to up 3% compared to last year, with the full year '02 about flat with the full year '01.

Although we have experienced slower growth this year than we have seen in recent years, the PG & A business remains a solid business and we expect it to become a larger portion of our overall sales in the future as snowmobile business recovers.

To summarize, our forecast for total company sales growth for the full year 2002 is expected to be in the range of 2% to 3%, with fourth quarter '02 sales growth expected in the 1% to 4% range, versus the fourth quarter of last year. On a consolidated basis, gross profit in '02 experienced a 13% increase to $102.4 million or 23.9% of sales, compared to the third quarter last year of 21.5% of sales. As we have been guiding for some time now, gross margins continue to be positively impacted by several cost savings and efficiency improving initiatives that the company has implemented over the last several quartersand that we are now beginning to show a positive results from, including number one, efficiency gains from the facility redesign completed earlier this year, new higher margin products introduced over the past several quarters, including the greater sales of new Sportsman 700 and most recently the Sportsman 600, an increase in the number of engines produced in-house, for instance the Sportsman 600 and 700 ATVs, and improved product quality resulting in lower warranty expense that we realized this quarter compared to the third quarter last year, as we strive to achieve our goal to be number one in quality in the power sports industry.

In addition, the Japanese Yen exchange rate improved for us compared to the third quarter a year ago, which reduced our purchase cost of engines delivered from Japan. The Yen rate was 120 during the third quarter of '02 the compared to about 110 a year ago. Additionally, improved margins from the acquisition of our last independent distributor, Ryerson Company, which was completed a year ago, allows us to sell 100% dealer direct in the United States and Canada. Each of these increases in gross margin were partially offset during the quarter by approximately $6 million of higher ATV promotional expenses, compared to the third quarter a year ago, resulting from a price protection program for our '02 models initiated during the third quarter and the negative sales mix impact resulting from the lower PG & A sales in the third quarter.

Looking forward, we expect to see continued improvements in the gross margin percentage for the fourth quarter, and well into next year. We are increasing our gross profit percentage guidance range for the full year '02 to be in the 140 to 150 basis point improvement over the full year 2001, and the fourth quarter gross margin percentage improving 90 to 120 basis points over the 22.3% in the fourth quarter of last year.

One final comment before we leave gross margins, and it relates to the impact from the west coast port strike that perhaps will impact us in the fourth quarter. We really didn't see any impact at all from that in the third quarter. As most of you know, we source some of our engines and various other components from Japan and other parts of Asia. Fortunately, all of our engines purchased are cleared through the Vancouver port, which is not impacted by the west coast port strike. However, other components do clear through the ports that were affected, and we are taking every possible action to reduce or eliminate our exposure in those areas. We are now receiving deliveries of parts that were hung up in the ports, and we believe that the disruptions on our plants will be minimal. However, we're monitoring this on a day to day basis, and in addition, we are preparing for the end of the 80-day cool down period by bringing in some inventory earlier than normal. Operating expenses in the third quarter of '02 were up 16% from the third quarter a year ago.

As a percentage of sales, operating expenses increased to 11.8% compared to 10.3% a year ago. Continued cost control efforts during the quarter were offset by a 32% increase in research and development expenses, as well as a 32% increase in selling and marketing expenses, both of which relate to recent and future new product introductions. We expect operating expenses as a percentage of sales for the full year of 2002 to increase in the range of 80 to 90 basis points from the full year '01, with the fourth quarter showing flat to a slight increase in the operating expenses as a percent of sales when compared to the prior year's fourth quarter. Income from financial services in the third quarter increased 11% to 3.9 million compared to 3.5 million in the third quarter last year. Growth in the profitability of our retail credit portfolio with households, and income generated from extended service contracts, contributed to the improvement for the third quarter. For the fourth quarter of '02, we expect income from financial services to be about flat with the fourth quarter of last year as the higher income from retail financing and service contracts is offset by lower interest rates, which narrow the wholesale financing margins. As of the end of September of '02, the wholesale portfolio related to floor plan financing for our dealers in the United States was approximately $605 million, up just 3% from $588 million at the end of the third quarter last year. Losses in the dealer portfolio continue to be very reasonable, averaging less than 1% of the portfolio over the six-year life of our partnership. The household retail credit portfolio balance as of the end of September was approximately $223 million, up from $172 million in the third quarter of last year and up sequentially from $192 million at the end of the second quarter of '02. This portfolio continues to grow as we integrate the financing alternatives better with our product line promotional efforts. Receivable losses have averaged about 3% in the life of this portfolio in line with industry norms. We have established reserves at a conservative level for both the wholesale and retail credit portfolios, and together with our partners continue to pay close attention to loss reserve levels and monitor delinquency trends closely.

Earlier this year, during the first quarter, the income tax provision rate was reduced to 33.5%, a reduction from 34.5% recorded during the 2001 period. Due to benefits derived from continued tax planning initiatives, particularly the implementation of some new tax laws related to the treatment of foreign sales, we were able to lower the income tax provision rate again in the third quarter to 32.5% of sales. We expect the 32.5% income tax provision rate to be sustainable for the foreseeable future.

Now, let's move oon to some select balance sheet and cash flow sheet items. Cash and cash equivalents were $67.5 million at the end of September, a significant improvement compared to $11.7 million a year ago. Receivables at the end of September were $52.6 million, down from $89 million at the end of last year's third quarter. This 41% decrease is attributable to lower receivables from our international customers this year, and also the effect of last year's September 11th attack, which drove our shipments to be later in the third quarter a year ago. Inventories at the end of September '02 were $181 million, up 2% from third quarter '01 levels and comparable to the overall sales growth rates. The total capital was 6% at the end of September, compared to 15% at this time last year, due to lower working capital requirements. We expect our debts to remain at very modest levels as we continue to reduce our working capital needs and improve profitability.

Year-to-date cash flow items are as follows. The depreciation and amortization was 41.6 million. Other non-cash charges netted a positive $10.4 million and working capital items were a net use of cash flow of $1.7 million. This results in a net cash flow provided by operations of $118.8 million for the nine months ended September 30th, and improvement of 14% over the first nine months of last year driven primarily by improved profitability. We expect this trend to continue in the fourth quarter as well. Property, equipment and tooling purchases totaled $77.2 million. Capital expenditures are now expected to be in the $55 million to $60 million range as we continue to invest in new product tooling, engine and technology projects, many of which we introduced at our dealer show of about 2 1/2 months ago.

Since the first of the year, we have used cash of $50.2 million to repurchase and retire approximately 767,000 shares of Polaris stock with 307,000 shares being purchased in the third quarter for approximately $20 million. This brings our cumulative repurchases since 1996 to over 7.6 million shares and leaves a little less than 1.9 million authorized shares remaining to be purchased. We currently anticipate that we'll be active in the stock buy back program in the upcoming quarters.

Summarizing our outlook for the remainder of '02 as I stated earlier, we are on track forachieving another record year of sales and our 21st consecutive year of record earnings. Our plan continues to be built on modest expectations for sales growth in a soft economy while delivering double digit EPS growth from gross margin expansion and cost control measures. To recap the fourth quarter and full-year guidance, the sales for the fourth quarter of '02 are expected to increase 1% to 4% and EPS is expected to be in the $1.46 to $1.51 range, an increase of 8% to 12% over the $1.35 earned in the fourth quarter of last year. For the full year, we expect 2002 sales to increase in the 2% to 3% range and where increasing the lower end of our previously announced full year '02 EPS guidance to $4.35 from the previously announced $4.30 per share. The upper end of the guidance range remains unchanged at $4.40 per share, resulting in a 12% to 13% expected earnings growth rate for 2002 over the prior year. At this time, we'd like to take any questions that the analysts may have. Constance, can you open it up?

At this time, I would like to remind everyone if you would like to ask a question please press star and then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. The first question comes from Gary Cooper from Bank of America Securities.

Good morning, guys. A couple of questions. Mike, could you repeat the promotional spend on the ATV side and then, Tom, could you comment on what you think about the ATV environment going forward, in terms of promotions? And maybe you can give us some idea of what might lead to some softening in the promotional environment out there? And then I'll also ask about the Predator. You talked of the sport market. Any sense for how that's growing recently? You mentioned the past few years, but given the weak economy, is that market still holding up as well on the sports side? And when exactly did or does the Predator launch? Thanks.

First of all, the ATV promotional costs in the third quarter were about $6 million higher than they were in the third quarter a year ago.

With regard to the promotions, some of that is because of, as Mike mentioned, a price protection program that we talked about down in Orlando in a fair bit of detail for '02 model years as we shift from '02 into '03, of course, with the introduction of sportsman 600, we move the Sportsman 500 down a little bit, and the 700, to create some space in the price ladder for the 600. So I would say that the promotional environment is fairly stable right now. I don't see any significant changes from 90 days ago in terms of anybody making major changes in terms of compelling new finance programs or any of that kind of stuff. I think it's relatively the same that it's been 90 days ago, 180 days ago. Probably the single biggest thing that we've seen over the last quarter is everybody's new product lineup for model year 2003. And I would say that I feel pretty good about seeing what everybody else has to offer. Of course, we all know what our plans are, but we don't know what the competitors are going to announce. Certainly, everybody had some new news, but compared to the last couple of years where maybe there'd been some pretty strong shots at kind of our core product line, I feel pretty good about the strength of our introduction, vis-a-vis the competition. With regard to the Predator, the market has been growing the last 18 months or so. I don't have that specific segment information for you here this morning, Gary, I can get it for you if you'd like. But the sport ATV sales have been growing in excess of the overall ATV market largely as a result of new products. A number of competitors have brought new sport quads on the market, and this is a new segment for us, so we're going into a place that we haven't been before. I do feel pretty confident about how the Predator is going to do there. You may have seen we issued a press release a week or so ago that we started racing the bike. We had it over in Wisconsin. We actually won the Wisconsin State Championship, not that that's a huge deal or anything, but to demonstrate that the Predator is as competitive on the racetrack as it is on the trail. In terms of when it will launch, production will start here in another month or so. So you'll see some shipments in the fourth quarter. Of course, that ramps up a little bit with any new product and then you'll see pretty significant shipments in the next year.

Thank you.

Our next question comes from Chris Cox of Goldman Sachs.

Good morning, guys. I had a few questions. First, is $25 million still a fair target for Polaris Professional series this year, and could you give us a qualitative sense of what we can expect from that division next year? Then I'm not sure if you gave the finance losses either for both wholesale and retail at quarter end versus year over year last year. And then finally, could you just give us a sense of how Snow Check Select did this year compared to 2001? Is it accurate to say, you know, that people were more willing to buy sleds last year before snowfall versus this year?

Okay. Let me take first one. How is PPS doing? I think when we originally started, Chris, we talked about a range of $20 million to $25 million. My sense is it will be closer to the 20 than the 25. In the grand scheme of things, I don't view that as a significant event. The primary thing that's got to happen with PPS is we've got to establish the brand and the dealer network this year. Again, the basic economics of this business are really pretty compelling. We think that this business has a potential to be a couple hundred million dollar business in a few years. And traditionally the way Polaris has grown is by investing and adding product line to our existing dealer networks. So we add a snowmobile dealer network and then we added ATV and then watercraft and accessories. So essentially the way we've always grown is by adding products to our existing distribution. And that's okay, but it's reasonably expensive. If we want to go into another product line, and there are some that are available, you can think about investments on the order of about $100 million to tool and develop the brand and all that sort of stuff. The neat part about PPS is that we're going to drive kind of the same type of growth that we would expect to by adding an additional product line, but do it on about $1 million of investment. And the trick here is to adapt the consumer vehicle to the commercial marketplace, and establish the brand and the distribution. So this is really a distribution bet more so than product. First time we've grown this way. It's a neat idea, but it's like everything else, you're starting out new. We have been really pleased so far with the interest we have had from the outdoor power equipment dealers. We've had over a thousand dealers that have contacted us. The trick is trying to figure out the right dealers. You might remember in Victory a couple years into it, we had to go back and really kind of redo a good part of our dealer network because they weren't successful in selling motorcycles. So I think the number, the direct answer to your question is probably around $20 million for the year, but the critical factor which you probably can't judge from a financial perspective is what's the quality of that dealer network and for whatever it's worth, I'm very happy with the quality of the dealer network. They are on average about ten times larger and ten times stronger than our consumer dealer network, and the whole hope is if we can establish a brand and a dealer network on a commercial side, maybe over the next ten years we can build a commercial side of our business that will, even further diversify our recreation business, which is a pretty cool idea on a million bucks. That's kind of where we are at PPS. With regard to '03, it's going to be up significantly. I can't give you a number, we're just seating the distribution now. We're going to add more than 100 additional dealers in '03, in addition to the couple hundred that we have year this year, and the couple hundred that we have in place will retail the product and reorder, and this kind of thing. So I expect it to be a strong and in particular this UTV 1500 is a nice addition to the fleet. The Snow Check Select question, I'm pretty sure we talked about this even in the first quarter call and I'm sure we talked about it in the second. Snow Checks were down significantly this year because people simply didn't ride their sleds and that was true across the industry. Our Snow Checks were down substantially and that's part of the reason that you're seeing kind of a sluggish start to the year, is that people weren't able to ride last year so they didn't buy a sled in spring and are going to wait to see what the snowfall looks like this fall. There's one other question?

Yeah. You asked about the credit losses in the finance business. We don't specifically identify the credit losses quarter to quarter, but we have not seen any deterioration in the trend of either delinquencies in either one of our wholesale or retail credit portfolio or the actual losses that we're experiencing. Historically, our losses on the wholesale business have been well less than 1% of the portfolio. And in the new more recent retail credit portfolio, they have been around 3% of the portfolio.

Okay. Thanks a lot, guys. Nice job.

Our next question comes from Tim Under of AG Edwards.

Congratulations on a great quarter. A few items. Tom, you alluded on the inventory side for the dealers how it was down year over year. Any quantification both there and on the ATVs, and just refresh us on the sled side. And then also if you could just remind us where you stand at this point as far as your engine mix, how much comes directly from Fuji, how much from the Robin JV and then how much you're producing fully internally. And then finally, Mike, comment on currency, both the Yen and Canadian dollar. Are you locked in for '03, and how much of '03, and then if you want to give any information to the levels.

Okay. Let's take those one at a time. Despite the ATV business being up pretty nicely for the year, dealer inventory in ATVs is actually down a few percent. The quality of that inventory, which is probably as important as the absolute quantity of it, I would describe as very good. We're seeing more things like Rangers, for example. When we went through the '02-'03 model year transition, dealers were very clean of '02 products, so that they have extremely fresh model year '03 stock. So they have the newest stuff and I have very little concern about ATV inventory at either retail or wholesale. On a scale from one to ten, I don't know, I'd give it an eight or a nine or something like that. It's really good. Sleds I give five or six, something like that. We had a poor retail year last year. Dealers ended the year with more inventory than they would have liked to have, or we would have liked to have. That's why we cut production. That's why shipments are down 29% for the quarter. And I would say that sled inventory in the dealer channel right now is up single digit percent, but at an absolute level, it's higher than we'd like to see, so that's why we've taken the production decisions that we have. In terms of engines, we are making more of our own engines. This year, it will be somewhere between 35% and 40% of our own engines. The new Sportsman 600 is actually a derivative of the Sportsman 700, which of course is the first ATV engine that we'd made. The 700 has been an absolute home run and the 600 is off to a terrific start as well. So I think that that percentage seems to go up a little bit every year. It's a very good thing for our margins and for our diversification, long term, to have control over engine technology. Again this isn't something that a lot of financial investors worry about, but strategically, particularly as you look at emissions regulations coming in to snowmobiles and ATVs, it is really good to be able to have a variety of engine options in terms of technology. You know, many of our competitors are kind of locked into one engine source, and one of our real advantages is we have our own engine expertise, we have Fuji's engine expertise, and we have a European partner that we're working with on some of our the new high performance four-stroke technology. So we can take the best ideas from all around the world. I think that can play a significant benefit. Again, not in the next quarter, but as you look at how the company competes on the basis of innovation over the next two, three, four years that's a big advantage. I will give Mike the currency question.

Okay. The Yen at this point is hedged for the fourth quarter at rates that would be positive over the fourth quarter of '01. At this point, we're also hedged with the Yen for both the first quarter and the second quarter of '03. And the rate there is just slightly positive to '02. Its kind of break even to slightly positive over the first and second quarter of '02. The Canadian dollar right now is hedged for the fourth quarter of '02 at rates that are below or negative to our margins from the fourth quarter of '01. And right now we are not hedged, Tim, for any of our '03 exposure on the Canadian dollar.

But we are, obviously, hedged to the end of this year.

Yeah. We're hedged to the end of this year.

Okay. And then Tom, you alluded somewhat to the customization at the factory on the motorcycles, and that was very successful for you on the Snow Check Select especially with margins. Any preliminary read as to how much of your full year estimate for motorcycles will come through that customization program?

Yeah. It's gone well, Tim. It's a little bit different situation than what we saw in sleds. I guess in the sled situation, with the market leader and people have been snow checking or bordering on a preseason basis snowmobiles for a long time, what we did that was unique was we gave them the opportunity to order the vehicle the way they wanted it. But the basic consumer behavior was in place. What we saw with motorcycles was a little bit different. Again the program was very successful, but it was frankly more successful at the dealer level than we thought it was going to be, and maybe a little weaker at the consumer level than we thought. The net benefit to the company is still terrific. Very attractive margin expansion. But what happened was more of our dealers actually custom ordered the motorcycles than we would have thought, and the consumer reaction, at least at this point, is a little bit weaker than we would have hoped. Now, you know, we're not the market leader. We're the smallest significant motorcycle manufacturer there is. And no one does motorcycle check yet. We're going to build that. So I'm not real disappointed in that. I was very pleasantly surprised with how well the dealers took to it. And the net effect in terms of financial performance was a little better than we had hoped. So a good program, not a huge deal in terms of the overall company, but I think longer term a pretty significant competitive advantage that's pretty hard for the other guys to copy. Not impossible, certainly, but if you look at certainly Harley, for example, they have trained their customers and the dealers for many, many years to buy $20,000 motorcycle and then throw away $4,000 or $5,000 worth of parts. We think it's a competitive advantage, people being able to order what they want. So not exactly the way we would have expected it, but it's the first year and I'm sure we're going to learn from it and we'll definitely keep going with it.

Okay. Great. Thank you.

Our next question comes from Bob Evans of Craig Hill.

Good morning and congratulations on a nice quarter. A number of my questions were answered, but a couple others. First, the trends on the operating expense side were a little higher than I had modeled for this quarter. Into '03, what do you see the trends for the selling and marketing expense as well as the R&D expense?

I would expect that R&D expenses will continue to increase as a percentage of our sales. We are aggressively investing in new technologies, be it engines or platforms. We saw a lot of that introduced to the dealers in our Orlando show with the new Vegas and the MSX and some of the four-stroke technologies in engines. So that kind of activity is what we're seeing on that research and development line and that will continue at a faster pace. I would expect the other operating expenses to be a percentage of sales, to be about flat as we look into the future periods.

Okay.

If I could jump in, Bob, just on the R&D expenses, there are good expenses and bad expenses. Scrap and rework is a bad expense. R&D expense is a pretty good thing and you probably noticed during the quarter we announced a significant investment and expansion to our R&D facility. You expect to see us continue to be on the gas hard in developing new products. They're the lifeblood of our business, and events like we just had in Orlando propel the future of the company and you can expect us over the next couple, three years to be very, very strong in introducing new products.

No arguments that's where I'd like you to spend your money. So I fully agree. Can you also comment on the gross margin side, you've got a number of initiatives in terms of increasing margins. What are the one or two that you think will have the biggest impact, at least going into next year? From market improvement?

I think the largest is a combination of our factory efficiency and productivity programs. We've talked a lot about those over the last couple of years. They're things, like platform consolidation, working more closely with our suppliers. Basic productivity programs which have had very, very nice benefits this year, and we continue to drive structural costs out of the business that way by doing things like the Snow Check Select program and now the custom motorcycles where you see both benefit on the revenue side and also a cost reduction. So I think productivity would be item number one. Item number two without a doubt is quality. When we started a couple years ago on the quality program, we knew there would be long-term savings. Quality and productivity is kind of like diet and exercise for our business. They're hard work, but they pay terrific long-term benefit. I would say that the quality numbers have been better, faster than I anticipated them to be. Things like scrap and rework and internal failure costs and external failure costs. And the benefits are falling to the bottom line more quickly than I would have expected them to. So I'm very encouraged that we should continue to see nice progress as a result of the quality initiative. We're on the gas as I mentioned on the number one internal initiative in the company. We're on the gas on that real hard and you will see benefit to that for a long time.

And two final quick questions. When does Vegas start shipping to your dealers?

Yeah. That will ship in the first quarter of '03.

Okay. Could you clarify, is there some confusion in the marketplace exposure on your retail credit portfolio?

Sure. The economic exposure on our retail credit portfolio is limited. We're operating this through a partnership, and as part of that arrangement, we have very specific risk limitations. It's limited to no worse than the investment that we've made in the retail credit portfolio, which is on our balance sheet at the end of September at about $15 million. Plus, a no worse than a total basket of $15 million of additional exposure in the losses. So worst case end of the world scenario, it's a maximum of $30 million. ))

MaybeI can jump in and try to add a little bit more of context to the finance effort. You know, we started 4 1/2 years ago with the idea of trying to build a financing arm to help make the purchase of our products easier and more convenient. It all fits with our basic theme of making it easy for people to get away from the stresses of everyday life. And part of the whole brand effort was to build a PG & A business in both the retail and financial wholesale business. We have made steady progress on that objective. Right now, we're financing about 16% of the new machines and that's gone up 3% or 4% a year. Every year that we have been at this thing. And I would not expect us to make dramatic increases in that, but it is a great opportunity for us to make it more convenient for our customers, for us to make money and for our dealers to make money. You know, Harley is financing about 35% to 40% of the new machines now. They have made a lot of money doing that. We've clearly seen that and very prudently, very cautiously we want to step forward. As Mike mentioned, if the world completely blew up, we've got $30 million of exposure, but we don't expect the world to completely blow up. Just like every other element of the business, we're watching the reserves on this very carefully. We'll aware of what's happened in some of the other consumer credit situations. And we frankly don't expect that to happen here.

Okay. Thank you.

Thanks, Constance, we're out of time now. I want to thank everyone for participating in today's calls. Please remember that our presentation and responses to your questions contain certain statements that could be considered forward looking for purposes of the private securities reform act of 1995, and actually results could differ materially from those projected in any forward-looking statements. Thank you again for listening to our third quarter conference call. And we look forward to talking to you at year end. Good-bye.

Thank you for participating in today's conference.