Polaris Inc (PII) 2005 Q2 法說會逐字稿

Good morning. I'll be the conference facilitator today. At this time, I'd like to welcome everyone to the second quarter earnings conference call. [OPERATOR INSTRUCTIONS] Mr. Edwards, you may begin your conference.

Good morning and thank you for joining us for our second quarter 2005 conference call. Mike Malone, our Chief Financial Officer and Tom Tiller our President and Chief Executive Officer will be participating in the call. Also this morning, Bennett Morgan our new President and Chief Operating Officer is joining us. As before, during this presentation, we will be discussing certain topics, including product demand and shipments, sales and margin trends, income and profitability levels and other matters including more specific guidance on our expectations 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 by their nature involve risk and uncertainty. There are a number of important factors that could results to differ materially from those anticipated. Additional information concerning a number of these factors can be found in Polaris' 2004 Annual Report and in the 2004 Form 10-K, which are on file with the SEC. Now, I'll turn it over to Tom. Tom?

Thank, Richards. Good morning, everyone and thank you for your interest in Polaris. We're pleased to report increased sales and earnings per share for the 29th consecutive quarter. For the second quarter, earnings were $0.68 per share, up 11% from last year on 12% sales growth. And this was a record second quarter for Polaris. These results met our expectation and were driven by good performances from ATV's, Victory, Ranger and international divisions, amid what continues to be a pretty challenging environment.

For the full year, we are narrowing the range of our expectations for earnings growth. We expect for the full year earnings per share growth of 9% to 13%, or 3.32 to 3.42 per share on revenue growth of 7% to 10%. Compared to 90 days ago, the lower end of the earnings guidance has increased by $0.04, while the upper end remains unchanged. And as usual, there are few changes among the individual businesses and lines on the P&L.

With that overview, let's start with the individual business segments, beginning with ATV's. The ATV division had a good second quarter, with 13% revenue growth. Polaris ATV revenue growth was driven by four factors; very strong Ranger sales, continued good international growth, good acceptance of our newer products and positive mix. As as reminder, the Polaris ATV business results consist of three parts, the traditional North American ATV market, which gets reported on a broad basis by analysts. And two components that are not typically included in those numbers; our Ranger the utility vehicle business and our ATV business outside of North America.

The ATV industry in North America performed about as we anticipated. During the second quarter retail sales of ATV's across the industry increased from last year in the low single digits. And we continue to expect year-over-year growth in the low single digit range. Industry retail sales accelerated modestly from the first quarter. Rangers continue to grow at a rate well above the rest of our domestic ATV business. The 2005 model year Ranger line continues to perform very well, with retail sales growth in excess of 30%. As I've mentioned before, Rangers account for about 20% of our total ATV business. International sales of ATV's were up about the same percentage as Rangers. And international sales account for about 15% of the ATV total. Our newer models continue to perform well and in particular the new Sportsman 800 EFI, the Troy Lee Predator and the new value-priced Phoenix.

Finally, about half the dollar growth we saw was from increases in average selling prices, driven by a richer sales mix and modest price adjustments. The promotional environment for ATV's was somewhat more aggressive during the quarter than it was 90 days ago. That may be partly because of the level of new products, at least what we've seen so far, has been less impressive than in prior years. Most of the other manufacturers have now shown their 2006 models, and generally speaking, the number of the new models being introduced by our competitors is less than it was in prior years. Of course, Polaris has yet to unveil its 2006 model line-up. We will do that next week at our dealer meeting in Nashville.

I think it's fair to say though, that our product introductions will be aggressive and similar to last year's in terms of impact. The increase in promotional spending may also be because dealer inventory across the industry, including Polaris, continues to be a bit higher than we or other dealers would like. We - - or the dealers would like, as we've discussed in the last couple of quarters. From a positive perspective, though, we are making some progress here. The year-over-year change in dealer inventory was less at the end of the second quarter than it was 90 days ago. All in, I'd say that we had a pretty first solid half in ATV's, and we expect a good second half as well, as our slightly improved ATV guidance would indicate. And Mike is going to get into more detail in that in just a minute.

Snowmobiles. Snowmobiles continue to be the largest challenge of our individual businesses. In the second quarter we closed a relatively difficult order-writing session with our dealers. And we now expect a year-over-year decline in shipments in the high single digit range. Going in, we knew we had some challenges from low snowfall in the Midwest. But we were a little disappointed, frankly, in the dealers response to the 2006 line. We remain encouraged with the product. But clearly we have some work to do to prove how terrific the 2006 line-up is on the snow.

Dealers are skeptical. Part of the issue may be related to the frequency of warranty and recall actions on the 2005 models. And in particular the 2005 Fusion 900 model. While it's not unusual for a new chassis to have some problems, we had more than our fair share of challenges introducing this new product. I believe we have those issues worked out for 2006. But I am disappointed we had the problems in the first place. Poor quality costs us both money and more importantly customer loyalty. And both will take some time to recover. We pride ourselves on flawless execution and over our 50-year history in snowmobiles, we have demonstrated we can do much better than we did with the Fusion and we will.

The early signs for '06 are encouraging that we're making some progress. Being the summer, there's almost no retail activity of snowmobiles to report. And that's going to remain so until the fall, of course. We've begun shipments of the 2006 model line-up. And we'll continue that through the third and fourth quarters. I would expect to show a year-over-year increase in snowmobile shipments in the third quarter. And a decrease in the fourth quarter as our production schedule is somewhat more normal compared to last year's introduction of the new chassis, which shipped pretty heavily in the fourth quarter.

Victory Motorcycles. Victory motorcycles are doing great. The progress of the last dozen or so quarters continues. The business is showing strength in product quality, product appeal, retail sales, dealer network improvement and brand momentum. In short, the Victory train is rolling. Retail sales across the model line - - are strong across the model line and throughout North America. We continue to see exceptional strength in retail sales of the two hot new models for 2005. The Victory Hammer and 8-Ball. But all of the products are performing to plan.

Victory continues to dramatically outpace the growth of the industry. And we see more growth coming with new exciting models we'll introduce later this month. Shipments of Victory were up 24% for the quarter, while retail sales for the first half of the year increased in excess of 40%. And that performance comes up against some pretty strong '04 comparisons. As a result, we are, again, modestly raising our Victory guidance for the year. Long-term we continue to expect to see Victory as a significant growth engine for the Company.

Parts, garments and accessories. We had another strong quarter in PG&A with 8% sales growth. We saw double-digit growth in our ATV, Ranger and Victory-related items. This business is our most profitable business and has consistently and reliably delivered quarter after quarter. We expect this boring consistency to continue.

International. International sales remain very good. And we're up 39% for the quarter. Driven primarily by ATV's in Europe. International continues to be a great story for the Company. And we're executing very well outside of North America, despite a generally sluggish economic condition in Europe. The usage of ATV's, particularly in Europe, continues to increase for both offroad and onroad applications. For this quarter, international sales of all products represented almost 15% of the total Company sales.

I'd like to talk a little bit about some challenges that we're facing and what we plan to do about it, our action plans. In addition to the good news, the record quarter, the 29th consecutive quarter with increased revenues and earnings and so forth, we are facing some challenges and had some disappointments during the quarter. You know, the general challenges aren't that hard to figure out. They're pretty clear, just pick up the newspaper. And those issues affect, of course, not just Polaris or even just our industry. I'm referring to things like high oil and gasoline prices, higher interest rates, generally sluggish consumer spending, low snowfall in the Midwest. Those types of things. One needs look only at the auto companies or some of our direct competitors to see the reality of those factors in terms of the challenge that they create. And you can also see it in their reported financial results.

While we can't do too much about these macro factors, we can control our own business. This year there's three specific things that we're focused on. Bringing outstanding new products to the market flawlessly. And we'll unveil those in Nashville. We've not done a great job recently of avoiding quality mistakes. And we can do better there and we will. Secondly, we'll reduce inventory gradually over time. And then finally, we need to perform better in our snowmobile business. I believe we can do these three things successfully because we have done them successfully in the past.

Finally, to wrap up before I turn it over to Mike, I'd just like to summarize my remarks. We had another solid quarter. Our 29th in a row in a pretty tough environment. There's some definite challenges out there, the oil prices, interest rates, commodity pressure and a disappointing snow environment. But there's also some pretty significant opportunities; in international, Ranger, Victory, and ATV's. For the rest of this year, we see those risks and opportunities that lie ahead as about balanced.

For us to achieve our targets, in nut shell, we must execute flawlessly. And based on the fact that each area of the last 23 years has been a record year, I think it's reasonable to assume that we can deliver again this year. We're, therefore, narrowing our full-year guidance for 3.32 to 3.42. With that, I'd like to turn it over to our Chief Financial Officer, Mike Malone.

Thanks, Tom. I'd like to provide a review of our overall guidance for the full year. And then I'll discuss the second quarter 2005 in more detail and give you more specific guidance on the expectations for the third quarter of this year. As during the past several conference calls, my comments and guidance today relate to the results from continuing operations of the Company, unless otherwise noted. The exit of the personal watercraft business that we announced last fall is proceeding on plan. And we would expect it to be substantially completed by the end of '05. Our current expectation is that the loss from discontinued operations, which was $0.19 per diluted share for the full year 2004, will be about $0.02 per share for the full year 2005.

For the year to date period ended in June, 2005, the loss from discontinued operations was $420,000, or about $0.01 impact to EPS. As Tom mentioned earlier, with two quarters now completed and based on the information and expectations of current market trends, we are maintaining our previously announced sales guidance of 7% to 10% sales growth for the full year 2005. And we are narrowing our full-year 2005 earnings per share guidance from the previously announced range of 3.28 to 3.42 to the current range of 3.32 to 3.42 per diluted share. A 9% to 13% increase over the full year last year. For the third quarter 2005, we are expecting sales to increase in the range of 5% to 8%, with earnings per share growing to be in the range of $1.07 per share, to $1.12 per share. An increase of 7% to 12% over the $1 per share generated in the third quarter of last year.

Now. let me give you some additional qualitative comments in each of our business. Sales of Polaris ATV's for the year, are expected to continue to grow for the reasons Tom talked about. Driven by our new products, our very successful utility vehicle business, continued growth in our international business, and an ongoing but modest growth in the overall ATV industry. Remember, that our ATV reported sales include our Ranger and international businesses that continue to grow significantly faster than the overall industry and our base North American ATV business. I also want would reiterate our confidence in our ability to compete effectively in a very competitive North American ATV business. We will continue to lead with innovative models and technologies to maintain our position of strength in the market.

Our guidance for ATV's for the full year 2005 has been increased slightly. And we now expect ATV sales to increase in the upper single digit range for the full year 2005. This guidance reflects the anticipated success of our new 2006 model introductions, which will take place next week, a modestly growing marketplace, continued growth in our Rangers, and our international business and a continued competitive promotional environment.

Victory Motorcycles are expected to continue to grow significantly during the year and have another strong year. The Hammer and 8 -Ball models are selling well. And of course, we will have new models to be introduced next week at our dealer meeting. The Vegas and Kingpin also continue to grow. And finally, our dealer network continues to gain strength and the overall heavy weight cruiser market remains healthy. Our guidance for Victory sales for the full year 2005, has also increased. We now expect sales growth in the mid to upper 20% range for the full year.

For snowmobiles, we continue to expect a difficult year in 2005. As we reported to you in the last call, our snowmobile orders were coming in at disappointing levels. With the dealer orders now final and confirmed, our snowmobile sales will be, unfortunately, lower than last year. Somewhere in the range of down upper single digits for the full year 2005. Year-to-date through June 30, our snowmobile sales shipments were down 5%. As we have previously stated, our parts, garments and accessory sales are expected to continue grow in line with our overall growth rates of the Company for the full year 2005. The Lock & Ride accessory system is selling well for ATV's and Rangers. And our motorcycle apparel and accessories continue to improve as the number of items available increases and the brand continues to grow.

Now, let me talk about gross profits. We expect gross profits to benefit from cost reduction efforts, some select pricing adjustments, efficiency improvement initiatives and savings from more effective sourcing of component parts. However, we also expect fuel and transportation costs, which increased dramatically throughout the last year and some commodity costs to continue at their current higher levels for the remainder of '05. Steel costs have been one exception. And that's where the spot rate for rolled steel has declined during the second quarter. We expect to benefit from this decline if it is sustainable. But not until later in 2005 or perhaps the first quarter of 2006. Additionally, gross margins have been, and are expected to continue to be, negatively impacted by the higher floor plan financing costs this year, due to a combination of higher interest rates, and higher levels of dealer inventories, particularly snowmobiles.

I would also like to note that our warranty costs were significantly higher in the second quarter of 2005 than a year ago. Caused by an increase in quality issues and recalls on the 2005 model 900 Fusion snowmobile in its first season, as Tom talked about. And most recently through an expanse of an earlier ATV recall. While I'm speaking of warranty, let me tell you that the expense recorded as a component of the costs of sales for the second quarter 2005, was $10.6 million, compared to $4.9 million last year. So, this additional warranty expense alone is responsible for 129 basis point erosion of our second quarter 2005 gross margins. The ending warranty reserve on the balance sheet in June of 2005 is $23.4 million, compared to 22.3 million at the end of June last year.

Giving all of these anticipated factors, our expectations now for the gross margin percentage for the full year 2005 compared to last year, have declined. We expect now gross margin percentage to be in the range of down 50 to down 70 basis points. Which is a change from our previously issued guidance of flat to up 20 basis points that we gave at the end of the last quarter call. Although the gross margin percentage did decline in the second quarter, we did generate operating margin expansion for the quarter. Partly from leverage generated at the operating expense line as a percentage of sales.

Operating expenses as a percent of sales for the full year 2005, are expected to continue to leverage the realized leverage from the higher sales growth. In the second quarter 2005 we realized 171 basis point improvement in operating expenses, as a percent of sales. Generated from lower general and administrative expenses and slower growth in selling and marketing expenses. The lower Polaris stock price during the second quarter and its effect on our stock-based compensation programs has been a benefit to the lower general and administrative costs by about 84 basis points. At the same time, we continue to invest in research and development efforts to drive growth through new products. In total, operating expenses are expected to be lower as a percentage of sales for the full year 2005 in the range of 50 to 70 basis points.

Income from financial services, for the full year 2005, is now expected to grow in the upper single digit range. As stated before, most of the growth in financial services income in 2005 has come from the wholesale portfolio financing of our dealer receivables. The income growth from the retail credit portfolio has moderated, reflecting a maturing of the portfolio. For the first half of 2005, we have financed about 38% of our products sold to consumers in the United States. Up from 30% from the first half of last year and up from 37% in the first quarter of '05. At the end of June, the wholesale portfolio related to our floor plan financing for dealers in the United States, was approximately 629 million. Up from last year's second quarter receivable balance of 549 million.

Credit losses in this dealer portfolio continue to be minimal, averaging well less than 1% of the portfolio. The household retail credit portfolio balance at the end of June was approximately $685 million, up from 540 million a year ago, and up modestly from 658 million at the end of March of this year. As expected in the maturing portfolio, receivable losses have been increasing over the last few quarters and now average about 4% of the portfolio. But remain in line with our expectations and household experience with portfolios similar in nature and maturity.

Now, let me comment a little bit on currency fluctuations on our operating results. For the second quarter of this year, the currency fluctuation of both the Canadian dollar and the Euro have had a positive impact on sales and gross margins. While the movement in the Japanese Yen has had a negative impact on margins when compared to the second quarter a year ago. These currency movements had a slightly positive impact on the gross margin percentage for the second quarter when combined. We currently have foreign currency hedges in place for the remainder of the calendar year, for the Japanese Yen. Which average approximately 105 Yen to the dollar. And also for the remainder of the calendar year for the Canadian dollar, which average about $0.80.

We currently do not have any Euro currency hedging contracts in place. Primarily due to the natural hedge that we have between our purchases of component parts from Europe and shipments to our international operations in Europe. Based on the foreign currency hedges we have in place and the current exchange rates of each of the currencies, we expect a positive impact on profits from the Canadian dollar for the balance of the year. While the Yen is expected to have a negative impact on the gross margins for the second half of the year. Our current expectation is that net/net for all of the currencies combined, the impact on profit for the second half of '05 will have an offsetting impact resulting in a minimal impact on the gross margin percentage year-over-year.

Some balance sheet and cash flow information for the end of June are as follows. We ended the quarter with 14.3 million of cash. After we paid cash dividends year to date of $23.6 million and made investments in the business through capital expenditures, which for the year-to-date period have totaled $47.2 million. Due to the weakness in the stock price during the second quarter, we stepped up our share repurchase activity significantly. In the second quarter we repurchased 1.2 million shares, for a little over $70 million. Which is heavier than what we typically repurchase in any quarter. This incremental share repurchase activity during the second quarter added about $0.01 to our second quarter reported EPS.

We currently have approximately 1.5 million shares remaining under our Board of Directors current authorization. And expect to continue our repurchase activity throughout the balance of the year. Although, perhaps, not as aggressively as we did in the second quarter. During the second quarter 2005, the net cash flow provided by operating activities was $64.1 million, a 3% increase from the $62 million in the second quarter of 2004.

Now, some additional cash flow items for the year-to-date period ended June 30. Depreciation and amortization year-to-date was 28.4 million. And other non-cash items netted a positive 5.3 million. Working capital items were a net use of cash of 77 million, which is higher than the 40 million used in the same period a year ago. The resulting net cash flow provided by operations is 5.4 million for the six-month period ended June, compared to 37.8 million a year ago. The lower cash flow year-to-date is primarily due to the Polaris inventory levels that are 23% higher than at this time a year ago.

The inventory levels were higher also at the end of the first quarter. And they remain higher at the end of the second quarter, both in terms of finished and raw materials. Our expectation is that the inventory levels will come down somewhat by the end of the year. But we do have some structural increases in inventories, particularly our growing international business and our global sourcing strategies. Though, about one half of the inventory increase of $45 million at the end of June is short-term in nature and should be reduced by year-end. The remainder is due to more structural changes and more than likely will remain as an increase at the end of the year.

Regarding capital expenditures, our expectation is that the full year 2005 capital expenditures will be in the range of $85 to $95 million. As we continue to invest in new product tooling, engine and technology projects and wrap up the funding of our new product development facility. We continue to expect depreciation for the full year to be in the range of $60 to $65 million. At the end of June, our receivable balance was $57 million, which is down 10% from last year's second quarter, due to the timing of shipments near quarter end. Our debt to total capital was just 8% at the end of June, up slightly from 5% this time last year.

So, to re-cap for the full year 2005, we expect total Company sales to increase in the 7% to 10% range. With EPS from continuing operations growing to $3.32 to $3.42 per share range. An increase of 9% to 13% over the $3.04 per share earned last year. Third quarter sales are expected to increase in the range of 5% to 8%. With earnings per share in the third quarter expected to be in the $1.07 to $1.12 per share range. At this time, we would like to take any questions that the analysts may have. Would you please open up the lines for question?

Thank you. [OPERATOR INSTRUCTIONS]

We're ready.

Okay. Your first question comes from Rami Abdel of J.P. Morgan.

Hi guys. Just a couple of questions. You talked on affects. Could you comment on how much a benefit on the top line? Secondly, could you comment about what kind of promotional activity is going on there amongst all your competitors? If it's increased over the past quarter? And lastly, market share changes that you've seen between your competitor on the ATV level?

Okay. The impact of the currencies on our top line I would characterize as relatively modest. Of our 12% top line growth in the quarter, it's between 1% and 2% of that growth is related to currency movements.

Regarding the promotional activity and market share, I think as I mentioned, Rami, in my prepared remarks. We did see somewhat of an increase in the level of promotional activity, particularly revolving around ATV's in the second quarter. I think - - I don't know specifically what each competitor bases their decisions on. But I think it's logical, based on what we see, to attribute it to primarily two factors. One is somewhat higher dealer inventory on the part of all manufacturers like what we're seeing.

And then secondly, the amount of new product news that the other manufacturers have introduced so far is relatively modest. So I think those are the two factors. It's not a dramatic increase that we've seen. But it has been relatively for a number of quarters. And we've seen somewhat of an increase. Obviously, it's something that we're watching and we'll continue to report on as we go through the balance of the year. In terms of market share changes, that's not really an area that we typically discuss. But we haven't seen any dramatic changes in market share so far this year in ATV's. Obviously, there are quarter-to-quarter fluctuations this year as there were last year and the year before and the year before. But no big changes in market share.

Okay. And just one last question. You mentioned sort of the inventory levels at the dealer level has come down in the past quarter. And you also mentioned that retail sales were up low single digit. Since that's sort of the forecast for the back half of the year, would you expect - - or obviously the hope is but would you expect inventory levels to continue to improve in the back half of the year?

I want to make absolutely certain you understand clearly what I said. I said that inventory levels are higher at the end of the second quarter of the end of 2005 than they were at the end of the second quarter of 2004.

Right.

But the level of increase at the end of the second quarter is less than the level of increase at the end of first quarter. So relatively speaking, there was improvement over the last 90 days. But I think you said that I said that inventory levels are lower. And they're not lower. But they're not quite as high as they were at the end of the first quarter.

Right. So they're higher than Q2 '04 but lowe than 1Q '05?

Right. On a relative basis. On a year-over-year basis.

Right. Okay. And do you expect that sort of that to continue in the back half?

We don't really provide forward-looking guidance on dealer inventory. There's a lot of factors that impact that, retail sales and that kind of thing. I think, generally speaking we believe that dealer inventories are a little higher than we'd like them to see. And over time we expect those to work their way down. In terms of quarterly forecasts for dealer inventory, that's not something we provide.

Okay. Thank you.

Next question.

Your next question comes from Greg Badishkanian of Smith Barney.

Great. Thanks. On the ATV segment, what do you think lead to the little bit of acceleration, low single digits? You look at the other industries, whether it's R.V.'s or motorcycles at Harley's. Everything has sort of just been pretty poor. And you guys see a nice acceleration. What do you think lead to that?

I think, Greg, it's not - - what we forecasted at the beginning of the year was we expected ATV industry growth to be in the low single digit range. I think that's what we're seeing, low dingle digit growth. It's going to bounce around a little bit, kind of month to month and quarter-to-quarter. But it's doing about what we expect it to do. The desire on the part of consumers to buy ATV's continues to be there. It's a very versatile product with lots of usage across segments. We expect ATV's to begun to grow for several years. But at modest rates, kind of low single digit rates.

Okay. And with respect to motorcycles, then, very nice performance. Can you maybe discuss the dealer network improvements? Maybe quantify, if you could, maybe the number of dealers carrying the product last year versus this year? And what's leading to that? Is it just - - is it the product, the acceptance of the product by consumers? Can you talk a little bit about that?

Sure. Victory continues to do quite as well as I said in my speech. And I would not attribute it to one factor. I would attribute it to the growing strength of the brand. It's still a relatively new brand. This is a durable purchase. And consumers are growing in their awareness of Victory. Certainly, the appeal of the product has improved dramatically over the last three or four model years. We've broadened the product range. So, if you went back two or three years ago we would have sold bikes in a pretty range, maybe around $13,000 to $15,000. Now we're in a much broader range, around $13,000 to the low $21,000, $22,000 range.

We are improving both the quality and the number in of our Victory dealers. If you look at the number of people that are interested in carrying Victory at this point, it's up significantly over what it was a number of years ago. So, we're very pleased with the distribution improvement. In terms of quantifying that, we think that the dealer network, I think last year we were about this time, we would have been around 300 Victory dealers. I'd say at the end of this year, the number to be in the area of 350 Victory dealers. So, some modest expansion there. If you look over the next 3-4 years, that number will growing the range of around 500, 450, 500 dealers. So, as the business continues to grow and the market continues to grow, we do find the areas of the country that maybe didn't justify a dealer that as we continue to grow, will justify that.

So, it's both the quantity and the quality of those dealers. So, a lot of factors are driving the growth. The brand, the awareness, the product, the product quality, the appeal, the dealer, the dealer network. It takes a variety of factors to drive the kind of results that we're seeing.

You're doing a great job on it. Thanks. See you next quarter.

Thanks,

Your next question comes from Bob Evans, of Craig-Hallum Capital Group.

Good morning, guys.

Good morning, Bob.

Good morning.

Can you comment on the warranty expense for this quarter? Should we view this as kind of a nonrecurring expense? Will we see this in future quarters? Or how should we view it going forward?

Yes, I think it's fair to view it as more or less a one-time blip. We - - as Tom indicated, we were disappointed in the quality of our new snowmobile. And as the season progressed, we had more and more issues that came up that we had to address and adjust our reserves for. That by and large is - - the season is pretty well over. And we've got our 2006 models in production. So, generally speaking, I would say tha most of that stuff is behind us. And we're pretty confident that the warranty reserve that we've established at this point in time is - - covers all of the issues that we're aware of it for the products that we've got in the field.

Okay. And on the operating expense side, obviously stock prices you're not going to be able to predict. But other than that, the decline that we saw in operating expense, should we view that as a structural change as well? Where we should view that the change - - the cost reductions that you've made or productivity that you've made and should we view that as going forward reductions?

Well, I guess the way I'd answer that, Bob, is that we've given guidance. You're right. I can't predict what the stock price is going do and how that's going to bounce around. And when it goes up we absorb the additional costs of those compensations and of plans and when it goes down, we get the benefit of that. So, that's unpredictable. But we have given guidance of lower operating expenses as a percent of sales of 60 to - - 50 to 70 basis points for the balance of the year. So, that's - - that includes our expectation of what the stock price will be and all of the other factors for the year.

Okay. Fair enough. And final question on the dealer inventory. Should we expect any specific actions? I think you had a factory authorized clearance roughly a year ago or a little less. Anything in particular that we should look to as this model year closes out?

Nothing that we're prepared to announce to you. Just as a matter of business policy. Any changes that we would make, we would obviously announce to our dealers before we would announce to the financial community. So - -

Sure.

But the cost of anything that we may or may not have planned are obviously all in the financial forecasts that we give today.

Okay. And conceptually it's not going to be a far astray from what would you've done in the past?

No.

Okay. Okay. All right, thank you.

Your next question comes from Tim Conder, of AG Edwards.

Thank you, operator. Congratulations, gentlemen again on a solid quarter.

Thanks, Tim.

Thank you, Tim.

A couple of items here. Follow-up on Bob's question, Mike. I guess to approach it more from the standpoint on warranty expense. Yes, you had some one-time issues and you guys have reserved for that. But historically you've done a very good job of improving quality over the last several years. And you've brought down your warranty reserve, rightfully so. Have we kind of reached the bottom of that? And we should sort of see that warranty expense - - or grow along with the - - basically in line with sales? Is that a fair assumption?

Let me just jump in that one Tim before maybe Mike wants to add to it. To be perfectly candid, I'm not very happy with what happened with the '05 snowmobiles. I think we do have a pretty good track record of improving quality around here. And we stumbled. And I'm not particularly proud of that. But that's the reality of life. So, we are going to work very hard to kind of get things back on a trajectory that they were across the business. And we'll see whether we're successful in doing that. But I have some confidence that we can do a dramatically better job than we did with the '05 snowmobile. Now, it is not unusual when you do a completely new chassis, particularly with a level of technology that's in that vehicle, to have a few problems. But we've had more than our fair share of problems. And we're now in the second year of production. Now I think it's fairly logical to assume that things will be better. But we can do better than we did on the sleds.

I guess what I'd add to that, Tim. Looking forward, I do expect continued improvement in quality and warranty costs. One of our long-term strategic objectives is to build a dominant brand through industry-leading quality. And I don't view that as a game that's ever over. And we always are going to be pushing for improvements in our quality and reduction in our warranty costs. So, I think we're going to continue to focus on that. And adjust from the stumble that we made and continue to get better in future quarters.

So, I guess what you're saying is X the issues that you guys have already reserved for here in the second quarter; you feel that you haven't reached that point of where the incremental improvement, I guess the law of diminishing returns. At some point everybody reaches that. And you have to basically grow it in line with sales. But you feel there's some substantial opportunities left?

Yes. I'm not sure I agree with the assumption in your question Tim that there is kind of a bottom that you can reach. I quote 0 as the bottom. [Laughter] But it's very, very important for the future of this business that we continue to improve quality on a year-over-year basis, really, essentially forever. And while the absolute numbers maybe less, the warranty as a percent sales, for example, can continue to go down for many, many years. And must for us to execute our plan. So we can drive further improvement for the foreseeable future.

Okay. Great. On the overall ATV and motorcycle market. Tom, what's your view for the industry as a whole? I guess just looking at the U.S. that's what's the MIC and then granted with the ATV's, you've guys have done a fabulous job internationally and with the Ranger. But what's your view of the U.S. market, the MIC type of approach for both ATV's and motorcycles for this year?

Well, I think for ATV's, we've said that we expect the industry to be - - to increase. It will be a record year for the ATV industry. But that rate of increase will be in the low single digits. That's exactly what we've seen through the first half of the year. And absent some terrorist attack or some completely unforeseen event, that's what we expect to see for the full year. And we're right on plan for that through the first half. So, modest but still growing off from a record level.

The overall motorcycle market, I would say, we do - - we spend less time trying to forecast than figure out than we do in ATV's. Because our market share in motorcycles is much, much less than it is in ATV's. And really our motorcycles success or failure is primarily, at this point, determined by our own success or failures. What happens to the overall market is probably less of an impact than it is in ATV's. So, I would expect low growth, modest single digit growth in the segment of the motorcycle market that we compete in. Certainly not run away growth. Certainly not a collapse of anything like that. And that's absolutely fine. We're growing at a rate multiple times faster than the overall motorcycle market. And I think that's going to continue.

Okay. And on the ATV's sales, you mentioned that North America you were up nicely. Again, is that tilted a little bit towards Canada versus the U.S.? Is the Canadian growth a little bit faster than the U.S.? If you want to give some specific numbers that's fine. Or if you just want to give directional that's fine too.

We've had a good year so far in Canada. But again, we're not break it down sort of state by state.

Okay. Shifting over to the inventories, Mike, you mentioned about half of it was structural and half was short-term in nature. First of all, what is your finished goods number at the end of the second quarter? And then if you could maybe expand a little bit on that structural component?

Yes. The structural component primarily relates to our international operations. As we have grown substantially, we've done business - - we've evolved our business internationally. And we're choosing to do business a little differently. As you know, we're making product today that's specific for the European market, this quadricycle product. So we've got incremental models and incremental inventory that's required for that.

Okay.

That's structurally permanent. In addition, we've started to actually warehouse product in Europe. So that we can get it to our customers over there on a quicker turnaround basis. So that's required us to invest a little bit more in inventory on the finished goods side. And we're also seeing it on the raw materials side. So, we've talked for a while about how we're trying to source more globally. And when we do that and buy products, raw materials from China and other sources, we've had to carry more inventory. The transit time is longer, the lead times are longer. Our just in time approach needs a little bit more cushion when it's coming from overseas. So we have seen an increase in our raw material inventory to compensate for some of those structural changes in our component costs.

And the finished goods number at the end of the second quarter?

I don't have that right in front of me.

I'll follow-up with you.

Tim, let me just jump in on a couple of things here. I think again, at the end of the second quarter, we were roughly $45 million over the '04 inventory level. We expect about half of that to go away between now and the end of the year. The only other point I'd mention, is right now we're exporting everything from our domestic factories to serve the European market. And one of the things I think we've talked about in previous calls, is as that volume grows, there is the opportunity now to consider manufacturing site in Europe some place that would be probably a little more efficient in terms of serving that market from a logistics point of view. And that's something that we are continuing to work on a couple of different options to do that.

What type of timing, Tom? Would you expect a two to three year horizon there or shorter than that?

I guess I wouldn't characterize that at this point, Tim. But we are pretty active in examining alternatives there. And obviously it takes some time once we decide. But I would expect we would decide no later than the end of the year.

Okay. And last question relates - -

Tim?

Yes.

Let me answer your question on the factory inventories. It's about $140 million. And we'll have the am exact number in the Q.

Okay.

But that's about what it is.

The last group - - the last couple of questions here, gentlemen. Given, Tom, you'd said that really your competitors, from what you've seen so far in the assessment, hasn't been that much in anything overly exciting on ATV's. And we'll see you what you guys roll out here next week. And again, you've alluded that you're going to be very aggressive. What's your feel on the retail side? Again, you've already talked somewhat on the wholesale side. What's your feel on the retail promotions? Could you see some of your competitors potentially get more aggressive? And if so, how much cushion or - - have you factored in anything should that happen in your guidance?

Well, yes, it's hard to know for sure, Tim. They don't send us their promotional schedule for the second half of the year. If that's something you could get, we'd really appreciate that. That would make our life quite a bit easier.

Will try. Will try.

I guess - - what I can say is exactly what we've seen. Which was, in the first quarter I'd say promotions were pretty stable. In the second quarter, we saw a little bit of a blip up. Obviously, everybody knew what they had for new product coming at that point. And so they made the decisions that they've made. I think, we know what we have coming. We've made assumptions as to what other people will do from a promotional point of view. Time will tell whether those assumptions are right or not. But I think based on - - I've been in the game for a little while here. I feel pretty confident that our balance of new product news and promotional spending will be sufficient for us to remain competitive in an industry that's going to grow kind of in the low single digit range.

Okay. Bottom line you have some things factored into the question of whether you have too much, too little or just about right.

Sure. You're forecasting. You're trying to forecast the behavior of competitors, which is always difficult. But, generally speaking, this industry is, compared to say the auto industry, it's pretty rational. Even at the level of promotions that we're now, it's nothing like the goofiness that's going on over in Detroit. People are making money in the ATV industry. It's a very lucrative industry. The industry is at an all-time record high. This year we expect will be another record year in the ATV industry. So, we're kind of tweaking around the edges in terms of promotions and those kinds of things. And that's nothing new. That's happened over the last few years. And we think it's going to continue to happen. We're not going to back to the days of no promotions in ATV's and 20% growth rates. That's not going to happen. But we're also not going to go to employee pricing and the types of stuff you see coming out of Detroit.

Okay.

I think it will continue like the last few years, which is kind of quarter-to-quarter skirmishes and market shares, change in place, sort of a 1/10 of a point one way or another. And we'll battle our way through this thing based on new product innovation. Other people will battle more on the base of dollars. And it's sort of a battle of good versus evil and we're optimistic that good will win. Sounds good, Mr. Skywalker. [ Laughter ]

Next question.

Your next question comes from Joe Hovorka of Raymond James.

Hi, thanks guys. A question on the G&A again. It was down, of course, $5 million, which is 27% or so. And from the comments you made earlier in the call, I infer that $3.7 million or so of that decline is this stock compensation expense. What was the stock expense last year? What was it this year? Did you charge off the same number of shares last year versus this year? And then can you tell me what the difference is between the total decline and the decline in the stock expense?

Okay. The - - I'm not sure I have everything you're looking for there right in front of me here. I don't - - I'm not - - I don't have the specific expense last - - I do too. I'm going to give you round numbers here. In the quarter we expensed roughly 600,000 this year. And it was roughly 4.3 million in the quarter last year. So, that's the 3.7 million benefit that I talked about.

Okay. Did you charge off less shares at that point or is it - -?

No

And maybe you can kind of explain how it works. This is an accrual, right and then it gets - - or are awards given later?

So, what this relates to is, we have a number of compensation plans that are - - that's variable based on the performance of the stock price. So we have restricted stock grants to management. We have our deferred director compensation plan, where we grant stock to our directors. And we have a long-term incentive plan that's actually paid in cash. But it's based on movement in the stock price. So, stock options. Well, stock options aren't expensed yet this year. But next year a component of this will be the stock options. So, those are the compensation plans that are related to movement in the stock prices. And as the stock price goes up and we're amortizing these costs to the P&L, we need to adjust the cumulative benefit to the employees and adjust for the stock price, whether it goes up and down. So, that's what's happening. And as the stock price went up quite a bit in the second half of last year, we absorbed a significant increase in our operating costs to reflect that. And as it's gone down, it's reflected here. So, I would say Joe, that there's not a material change in the number of shares that are being reflected here.

Okay. And then what's the other part of the decline in the G&A?

The other part is just operational efficiencies and controls. A year ago we had some legal issues that were in the year ago number that aren't necessarily this year and other operational efficiencies.

Okay. If we were able to look at - - that's fine. That's everything. Thanks, guys.

All right. Thanks, Joe.

We have time for one more question.

Your last question comes from Ed Aaron of RBC Capital Markets.

Thanks, good morning.

Good morning, Ed.

I just wanted to ask you, I know you don't like to talk too much about the competition. But could you address Bombardier and their recent announcement about their ATV business and what you read into that as far as John Deere is concerned?

No, I really can't. I haven't studied that in enough detail Ed to comment intelligently at this point. We've heard 1 million rumors floating around the marketplace relative to that. And I guess until we have a little more solid information, I just wouldn't be prepared to comment on that in morning.

Okay.

If you'd like, we can follow-up with you directly on that. We just want to talk intelligently about it.

Sure. Second on the cash flow from operations, I was having a little bit of trouble getting to the $64 million number based on what you had in the press release in terms of detail on the balance sheet items. Is there something in there that I might be missing that will get me there?

Yes Ed, I'm sure - - well I'm not sure. I'm speculating that perhaps you're looking at historical numbers that don't reflect the discontinued operations business. As we recorded - - or reported data at the end of the second quarter last year, we didn't - - we had watercraft in those numbers. And then we've had to reclassify the cash flow statement to pull out discontinued operations. So, you have to adjust for the discontinued operations.

Okay. Okay. And then lastly on just a quick one on Victory. Actually, it seems like your retail is growing faster than your wholesale shipments. Even if you assume the higher guidance that you talked about today. And that seems to be a little bit unusual given the kind of growth curve there and the fact that you're adding dealers. I would actually expect it to be the other way around. It's a good problem to have. But just why would we be seeing shipments kind of lag sell through?

I don't know. I'm comfortable with where Victory is growing from a retail perspective, from a wholesale perspective, from a dealer inventory. Those are obviously the factors that we balance. I'm comfortable with it, Ed.

Okay. Thank you.

Okay, that's all the time we have for this call. 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. In that actual results could differ materially from those projected in any forward-looking statements. Thanks again for listening. And goodbye.

This now concludes today's conference call. You may now disconnect