Polaris Inc (PII) 2006 Q2 法說會逐字稿

Good morning. My name is Lakisha, and I will be your conference operator today. At this time I would like to welcome everyone to the Polaris 2006 second quarter earnings release conference call. All lines have been placed on mute to prevent any background noise.

After the speaker's remarks there will be a question and answer session. [OPERATOR INSTRUCTIONS] Thank you.

Mr. Edwards, you may begin your conference.

Thank you, and good morning and thank you all for joining us for our second quarter 2006 earnings conference call. Mike Malone, our Chief Financial Officer, and Tom Tiller, our Chief Executive Officer will be participating in the call. Mr. Bennett Morgan, our President and Chief Operating Officer is also here, and is also available to answer questions.

This morning 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 risks and uncertainties. There are a number of important factors that the could cause results to differ materially from those anticipated. Additional information concerning a number of these factors can be found in Polaris' 2005 Annual Report, and in the 2005 Form 10K, which are on file with the SEC.

Now, I'll turn it over to Tom. Tom?

Good morning. Thank you, Richard, and thank you all for being on the call this morning. For the quarter earnings were $0.53 per share, down from $0.66 last year, on a 13% decline in sales. The results for the second quarter met our expectations. The business in total is performing about as we expected it would 90 days ago.

There have been no major changes either in the environment, or with our performance. It remains a fairly challenging environment, with both consumers and dealers remaining cautious, driven by higher gas prices and increasing interest rates. But we are making progress on reducing dealer inventory with both snowmobiles and ATVs, and our RANGER and Victory motorcycle businesses continue to perform well.

As a result, we are narrowing slightly our earnings per share guidance range for the full year. Previously, we had expected earnings per share for the full year of $3.08 to $3.20 per share. Now, we are anticipating $3.10 to $3.20 per share. Mike will discuss this guidance change more in his portion of the call.

With that overview, let's turn to the individual business segments, starting with All-Terrain Vehicles. The ATV division had a decent second quarter. The business performed about as planned with a 5% decline in revenue.

For the industry, retail sales of ATVs declined between 1 and 2% for the first half of the year. That's about what we had expected. We anticipate low-single digit growth for the industry during the second half of the year. Largely because the comparables during the third quarter of 2005 were quite weak because of the hurricanes.

In terms of Polaris, we continue to make progress in reducing dealer inventory of ATVs. Since the first of the year, we've made significant reductions by restricting production and shipments, and dealer inventory has come down. Dealer inventory of ATVs in North America is now flat with the same time last year, and while that's a helpful development, dealers continue to express concern that inventory levels are still too high, and we anticipate that inventory levels will continue to decline over the second half of the year.

In the market, retail sales of our newer products like the Sportsman X2, the Hawkeye, the Sportsman 500 EFI, and the Sportsman 800 continue to go well, along with the entire RANGER line, which continues to grow very well. Promotions in North America are relatively stable. As we saw in the first quarter, our International business in the second quarter was weaker than expected, particularly in southern Europe. And I'll expand some more on that later.

We are excited about our upcoming dealer meeting in Orlando in a couple of weeks. There, we will unveil our model year 2007 lineup of ATVs, RANGERs, and Victory motorcycles, and secure orders for the next six months. We will have some exciting new products from each division, which we hope will drive strong interest from both consumers and dealers, we will also in introduce some changes to our order process and programs, which we anticipate will be accepted favorably by our dealers.

For the balance of 2006, I expect we'll continue to see more of the same from the ATV business. Essentially, a flat industry with minor swings either positively or negatively, and a continuation of the effort to reduce dealer inventory.

Snowmobiles. There's not much new to report from the snowmobile division over the last 90 days as it's the off-season for retail sales. Production has started with nothing unusual to report this year. One thing that you will notice that's different this year though, is that we reduced shipments of snowmobiles dramatically in the second quarter compared to last year's second quarter. They were down 90%. The only snowmobiles that we shipped during the second quarter were those that had very long delivery times, like international markets in Alaska.

This change in shipping patterns was done to minimize North American dealer inventory, which of course was high at the end of the '05-'06 riding season. The delay in shipments resulted in about a $20 million increase in factory finished goods inventory at the end of the second quarter, as the completed snowmobiles stayed at the factory, rather than being delivered to the dealers, as has typically been the case, those units will ship later this year.

Victory motorcycles. Victory motorcycles are continuing to do very well. The progress of the last several years has continued into 2006. The business is showing strength in product quality, product appeal, retail sales, dealer network improvement, and brand momentum. Shipments of Victory motorcycles were up 26% for the quarter. More importantly, retail sales continued to be very strong. The U.S. Motorcycle industry as a whole is growing, and is up about 7% season to date.

We continue to significantly outperform the industry and are maintaining solid momentum through the heart of the riding and selling season, and as a result, we are modestly raising our full year sales guidance for Victory to the low 20% range. We continue to add new quality Victory dealers with 10 new dealers added during the second quarter. The quality of the new dealer additions is excellent. And more potential Victory dealers will attend the Orlando dealer show, where they will have a chance to see the expanded 2007 line-up.

We have the strongest marketing communications campaign in Victory's history under way combining TV, magazines, and internet exposure generating more than 125 million impressions. Victory's product quality and appeal continues to increase according to every measure, and we believe now that we have the highest level of customer satisfaction in the motorcycle industry. The lower warranty costs and additional volume have helped Victory's gross margins expand as well. And longer term, we continue to see Victory and motorcycles more generally as a significant growth engine for the Company.

Parts, Garments, and Accessories. The PG&A division had a decent second quarter, given the reduced shipments of both ATVs and snowmobiles. PG&A sales were down 2% compared to a 13% decline for the total Company. We continue to expect sales of PG&A to grow a little faster than the overall Company sales. Our innovation in the PG&A category continues with a new Polaris winch, and a number of proprietary products to be introduced in Orlando.

International. As I mentioned international sales were 11% lower for the second quarter, which is weaker than we had expected. As we discussed in the first quarter call, we're seeing a slower market in Europe, particularly in southern Europe, including France and Spain. Northern Europe remains relatively better.

We're seeing concern in France, for example, about riding restrictions, and continue to face some very competitive pricing pressure in Spain. But for the second half and for the full year, we do expect international sales to increase over 2005, on the strength of our new product introductions for the European market, which again will be introduced in a couple of weeks.

KTM. The KTM relationship and projects continue to progress as planned. The teams are working and there have been no significant surprises. The relationships are growing, and you can expect to see some early results from the projects to be announced in the next 30 days or so. Separately, the KTM base business continues to perform reasonably well, given the economic environment that they're facing, which is of course quite similar to ours.

In summary, the first two quarters of 2006 have been tough. We've had some real challenges in our snowmobile business, and with high dealer inventory of ATVs, but the first half is behind us now, and I think there are some reasons for optimism about the future. In the immediate term, say the next six months, we expect the second half to be better than the first. Dealer inventory is in better shape now than it was six months ago, and it will continue to get better in the second half.

Our product cost reduction and quality improvement efforts are beginning to pay off. Gross margins were up a little bit in the second quarter, and we'll continue to expand for the balance of the year, especially in the fourth quarter despite significantly lower production volumes. And even with all of the first half challenges, there is a decent shot that we can grow earnings per share from continuing operations for the 25th year in a row, which is a nice accomplishment.

Beyond the next six months, I think 2007 will be a better year for the Company. We expect to to see a nice lift from snowmobiles, we will demonstrate solid progress on cost reduction, and you can expect to see some category expanding new products introduced in 2007. Of course, we will start the year from a cleaner position in terms of dealer inventory, both for ATVs and snowmobiles, than we did this year. We'll have another year of benefit from our relationship with KTM, and in the fall of 2007 we will enter into discussions concerning Phase 2 of the KTM agreement.

And as we look beyond the next 18 months or so, towards the end of the decade, we continue to see Polaris as a much stronger Company with better technology, higher quality, a larger and more profitable motorcycle business, and an even bigger global footprint.

So with that, I'll turn it over to Mike Malone. Mike?

Thanks, Tom and good morning to everyone. As before, my comments and guidance today relate only to the results from continuing operations of the Company, unless otherwise noted.

The exit of the personal watercraft business that we announced a couple years ago is substantially complete; however, during the second quarter we did take an additional non-recurring charge of 3.1 million pretax, or 2.0 million and $0.05 cents per share after-tax, that were related to product liability, litigation claim reserves, and warranty payments to customers which have been higher than originally anticipated. Similar to the original accounting treatment upon our announcement of the exit of the watercraft business, this loss will be reflected below the line, as a loss on disposal of discontinued operations.

Also, you will recall that starting in the first quarter of this year, we began expensing stock options in accordance with Statement of Financial Accounting Standard 123-R and as a result, each of our financial statements have been adjusted as if this change was made for the entire 2005 year as well.

I will begin my comments with a review of our overall guidance for the full year 2006 and will then move on to more specific guidance for the third quarter, full year guidance for specific metrics, and a brief review of certain aspects of our actual second quarter results.

For the full year 2006, we are narrowing the range of continuing operations earnings guidance, and now expect diluted earnings per share from continuing operations to be between $3.10 and $3.20, which is a range of -2% to +2% compared to the adjusted $3.15 per share earned for the full year 2005. Total Company sales for the full year 2006 are now expected to be in the range of down 3% to down 5%, slightly lower than previously issued guidance. Third quarter 2006 total Company sales are expected to decrease 3% to 5% from 2005, with earnings from continuing operations expected to be in the range of $1.03 to $1.08 per diluted share, compared to adjusted earnings per diluted share of $1.11 in the third quarter of last year.

As we discussed in our first quarter call, due to the high level of season ending snowmobile dealer inventories, and weakening overall dealer confidence due to the string of poor snowfall winters, our dealers have ordered significantly less new model year 2007 snowmobiles per shipment this calendar year. Our snowmobile sales guidance remains unchanged from 90 days ago. We continue to expect revenues from snowmobiles for the full year 2006 to be down in the range of 30 to 40% compared to 2005 sales levels.

Due to the high dealer inventories and the significant reduction in the build, shipment of most of the snowmobiles was delayed until the second half of the calendar year, in order to ease the burden on our dealers. As a result, snowmobile sales in the second quarter were minimal at just 5.3 million, down 90% from the second quarter of last year.

As has been the case for the last few quarters, the sales of ATVs in the second quarter were once again lower than the prior year quarter, as we cooperate with our dealers to assist them in reducing their ATV inventory. As Tom indicated, good progress has been made in reducing dealer inventories, but we expect to continue moderating shipments of our base North American ATVs during the third quarter.

However, offsetting some of the lower shipments of ATVs is continued acceleration of new product development. Some of which you will hear about in a few weeks, also continued growth in our RANGER utility business, and an increase in the average selling price of units, due to the mix and currency benefits. Sales of Polaris ATVs for the full year 2006 are now expected to be about flat with last year, which is slightly lower than our previous sales guidance. At this point, we do, however, expect ATV sales growth to resume in the fourth quarter of this year.

Sales for Victory motorcycles are now expected to grow in the low 20% range for the full year 2006, which is a slight improvement from prior sales guidance. A number of models continue to go well including the Hammer and Vegas Jackpot, as well as the Kingpin and Vegas models, which have a more powerful engine, and a 6-speed transmission this year. Additionally our dealer network continues to expand and gain strength.

Related to Parts, Garments and Accessories, we expect our change in the PG&A sales to be at a slightly better rate than the overall Company for the full year 2006. We expect strong growth from our RANGER accessories, and increased garments and accessory sales for Victory motorcycles, but weaker snowmobile and ATV-related PG&A sales. Total PG&A sales for the full year '06 are expected to be about flat with last year's full year sales.

Now, moving down the income statement, we were able to improve our gross profit margin by 27 basis points during the second quarter, and we expect to continue to expand gross margins in the second half of '06, particularly in the fourth quarter. Our full year 2006 guidance is unchanged. We continue to expect the gross profit margin to improve in the 70 to 100 basis points range for the full year '06 over the adjusted 2005 gross margin percentage of 22.0%.

We continue to expect gross margin benefits in the full year from cost reduction efforts, and savings from more effective sourcing of component parts, as well as improved product quality resulting in lower warranty expenses, favorable currency effects, and improved product mix. These benefits are offset somewhat by continued commodity cost pressures, particularly aluminum and diesel fuel costs, and additionally we're experiencing higher floor plan financing costs this year, due to both higher inventory levels and higher interest rates.

Operating expenses in dollars are expected to be approximately flat for the full year '06 compared to last year. Expressed as a percentage of sales, operating expenses for the full year are expected to be somewhat higher compared to last year, due to the lower sales levels. However, we will continue to invest in Research and Development efforts, to drive future growth through new products, and also we're including this year a full year of expense related to our new R&D facility, which opened up mid last year.

Income from financial services for the full year '06 is now expected to increase in the mid-single digit range, reflecting higher profitability from both our wholesale credit and retail credit portfolios. For the retail credit portfolio, in the second quarter of 2006, we financed through HSBC about 35% of our products sold to consumers in the United States, which is down slightly from the 38% in the second quarter of last year.

However, the volume of retail credit contracts written in the second quarter this year, was a little over over $200 million, which is a 44% increase over the second quarter last year. A large portion of the increased volume is being generated by an additional program, related to used and non-Polaris products, financed through our HSBC relationship at our Polaris dealerships.

At the end of the quarter, June 2006, the wholesale portfolio related to floor plan financing for dealers in the United States was approximately $673 million, up 7% from $629 million at the end of the second quarter last year; however, because of a significant mix change, to higher-priced Victory and RANGER inventory outstanding, and an average selling price increase across all of our product lines, the actual units outstanding in the portfolio are comparable to last year. Credit losses in this dealer portfolio remain very reasonable, averaging less than 1% of the portfolio.

Our equity in income of manufacturing affiliates totaled a negative 0.2 million for the second quarter of '06, nearly all of which relates to our investment in KTM. This modest loss represents our share of KTM's fiscal third quarter operating results, which historically are seasonally weak during this quarter. We expect the income from KTM in the second half of 2006 to be somewhat higher than the second half of 2005, from growth in the base KTM business.

The income tax provision was recorded at a rate of approximately 33.8% of pre-tax income for the second quarter, up from an adjusted 32.2% recorded in the second quarter of last year. For the full year, 2006, our expectations remains the same, and continues to be that the income tax provision rate will be in the range of 33 to 34% of pre-tax income.

Let me take a moment to update you on the expected impact of currency fluctuations on our operating results this year. As you know, our foreign currency hedging strategy is to protect our downside risk, yet preserve some upside opportunity if economically feasible. For the second quarter and year-to-date periods of this year , the currency fluctuation of each of the Canadian dollar and the Japanese yen, have had a positive impact on our sales, gross margins, and net income.

We currently have foreign currency hedges in place through essentially the end of the calendar year, for both the yen and the Canadian dollar, which average approximately 112 yen to the dollar, and about $0.865 for the Canadian dollar. We currently do not have euro hedging contracts in place, as we are approximating a natural hedge. Based on these hedge contracts we have in place, and the current exchange rate, our expectation is that we will have a positive impact on profits from each of the Canadian dollar and the yen for the balance of this year, compared to last year.

In response to requests from our investors, we have now attached a full balance sheet and cash flow statement to our quarterly earnings press release. So I will not repeat a lot of the numbers here but rather just hit some highlights. During the second quarter of '06, we were buying aggressively and repurchased 927,000 shares under our share repurchase program at a cost of $41.8 million. We continue to repurchase, we expect to continue to re purchase shares throughout the second half of 2006 under our existing Board authorization, which has approximately 3.4 million shares remaining.

For the first half of 2006, we have made investments in the business through capital expenditures totaling $28 million, which is lower than a year ago due to the completion of our R&D facility in the first half of last year. Full year 2006 capital expenditures are now expected to be in the range of 63 to $68 million, and we continue to expect depreciation for the full year 2006 to be in the range of 70 to 75 million.

Net cash flow provided by continuing operating activities was $9 million for the first half of 2006, an improvement of 16 million, compared to the use of $7 million in the adjusted prior year-to-date period. This improvement in cash flow relates primarily to lower growth of factory inventories compared to last year.

Inventories on Polaris's books at the end of June 2006 were $241 million, up slightly compared to a year ago. The inventory increase is entirely attributable to the delivery of snowmobiles to dealers later in the year this year, and in fact ATV factory inventories are down 13% compared to June a year ago.

At this time, we would like to take any questions that the analysts may have. Lakesha, would you please open the line for questions?

Yes, sir. [OPERATOR INSTRUCTIONS] We'll pause for just a moment to compile the Q&A roster.

Okay, we're ready to go.

And your first question comes from Greg Badishkanian with Citigroup. Your next question comes from James Hardiman with FTN Midwest Research.

Good morning. You said the results essentially met your expectations in the quarter, although sales were down 13% versus your guidance of 9 to 12, so it seems like sales are a little bit worse. Margins were a little better. Can you give us more granularity on what was a little bit better than what you thought, and what was a little bit worse?

I think in terms of the sales departure from the earlier guidance, we shipped fewer snowmobiles than we originally expected to ship. I don't know what the exact number was, but we shipped $5 million of snowmobiles, I know if the original guidance was 10 or 15 million, whatever it was, but we expected snowmobiles shipments would be way down, and they were down even further than we expected. I don't know that there was anything materially in the margins that was tremendously different. I think we expected it was going to be a difficult quarter, and it was a difficult quarter. That would be my 100,000' view of it. I don't know, Mike? You want to expand on that?

As you know we don't give a lot of specific guidance for the different line items during the quarter. One thing that I would indicate is I think our income from Financial Services is very attractive for the quarter, and I don't know that we predicted that quite accurately 90 days ago, but those would be the primary changes.

Okay. And just to clarify, it looks like ATV sales were down about 7% through the first half of the year. You're guiding them to be flat, and I think you said that you probably don't expect them to be up again until the fourth quarter. You kind of run the math it seems like they would have to be up about 6% in the back half of the year, and if it's not really going to be up until the fourth quarter, it would seem like the fourth quarter would be up a really big number. Is that kind of how I should look at that?

It seems like inventory levels are about comparable to where they were last year, momentum if a little bit worse. You're saying that retail is probably going to be up low-single digits, but that your numbers are going to be a lot better than that. Is that a fair way to look at things?

Generally, I think that's fair. When we made the comment that third quarter we'll keep reducing shipments, that's again our base ATVs in North America that we're referring to there, but generally, I would say that you're right. Fourth quarter, we do expect to be an up quarter for our ATVs in total, including our base ATV business in North America. We expect to resume growth in the fourth quarter. We have a number of new models that will be introduced at our Orlando show, which will ramp up in the fourth quarter, and we're coming off a relatively weak comparable in the fourth quarter a year ago.

Okay. So is it safe to say, I mean you're talking about low-single digit growth for retail, is it safe to say that you think you're going to gain some pretty meaningful share in the back half of the year from a retail standpoint?

Well, I would caution you to not necessarily mix wholesale shipments with what our expected retail sales will be. We have been adjusting significantly our wholesale shipments through the year, and that's what we're giving guidance to. We're not necessarily giving guidance to retail sales rates.

Okay, great. And just one more question. Can you give what the warranty expense was for the second quarter? It seemed like there was a pretty big hit to the number last year. Do you know what the number was for second quarter this year?

Yes. I can give you those numbers. For the second quarter of this year, our expense charge was about $5.9 million compared to a year ago, which as you say was much higher, it was $10.6 million a year ago. Our actual claims paid during the quarter are also down significantly. This year it was 5.9 million, and a year ago it was 8.9 million, so down 34% from a year ago.

Okay, so it seems like that 5.9 million is about 1.5% of sales, which is essentially in-line with historical numbers. It seems like it was up pretty high in the first quarter. Do you feel like all of the warranty issues with the snowmobiles are pretty much behind you at this point?

Yes. I think that's a fair statement. I think one of the things I talked about in my speech, was that there's a number of factors that are going to drive the gross margin improvement, and one of those of course is quality improvement, lower warranty expense.

Great. Thanks, guys.

Your next question comes from Ed Aaron with RBC Capital Markets.

Are you there, Ed?

Sir, your line is open.

Go to the next question.

We apparently are having some difficulties here. We're not hearing Ed, anyway. I don't know if you are, but we're not.

Okay. One moment, sir.

Maybe we should just go to the next person in the line?

Yes, let's go to the next person, Lakisha. Can you hear me?

Okay, yes, sir, one moment.

Well, Mike, if you want I could ask you a few questions, and you could ask me a few questions!

I have no further questions!

Lakesha, are we having difficulties on your end?

Yes, sir, please stand by.

Sorry, folks. Just bear with us here as we try to sort through these technical difficulties. If we need to, we'll just run the call here an extra few minutes to make sure that we get to the critical questions.

And your next question comes from Ed Aaron, and sir, your line is open.

Thank you, can you guys hear me?

We can, Ed.

Yes!

Wow! All right then. I've got a couple questions for you. First could you elaborate on your comment about some changes that are taking place in terms of the ordering, and the programs at your dealer meeting?

A little bit, Ed. Of course, you know, as with new products and the specific changes, we'll want to make those with the dealers themselves, before we would announce those kind of to the financial community, as I'm sure you can understand, but you've done dealer surveys, and a number of the other analysts have done it, and there is some frustration in the dealer network, ours, and I think some of our competitors as well. It's a fairly challenging time out there to be a dealer right now, with gas prices and interest rates, and they are fighting pretty hard for every sale.

We are going to introduce some changes that we think will be more friendly to the dealer, in terms of how they would order product from us. We've been working with our dealer counsel in developing these new programs, and hopefully, they're representative of the overall dealer body, in terms of they've had a positive reception of these changes so hopefully the dealers as a group will appreciate those, but in terms of the specifics of those changes, Ed, we'll wait to announce those with the dealers.

Okay. Along those lines, just can you talk about the level of consistency out there? It seems like generally speaking the larger dealers seem to be fairing better than some of the smaller dealers, and I know that's kind of always the case, but that gap sort of seems to be widening. Can you comment on that?

You know, I guess from our perspective, I'm not sure I would portray things quite that way, Ed. I think that there are certainly geographic differences. I think that it's been tougher for the northern dealers, generally speaking, particularly those that have had big snowmobile exposures. It's been a tough, tough year in the snowmobile business, and I think that's probably been the single biggest factor. I'd say that Victory dealers as a group tend to be quite a bit more positive, because of the success they're enjoying with the motorcycle, but in terms of big/small, rural/urban, I'm not sure I could point to something that consistently is true there.

Okay. And then Mike, on the finance side, maybe you can just expand upon the additional business there from the used and the non-Polaris stuff. How did that materialize? Is it a one quarter thing, or is it going to be an ongoing benefit?

No, it's not a one quarter program. It's something that we've been working on, and I would say it's been around six or so months, maybe a little longer. I think it's becoming more prevalent and more popular with the dealers, as a way for them to incrementally improve their profitability. So we think that it's a good program. It's a constant program, and we would expect it to continue.

Just for the people that aren't familiar specifically with what the program is, just like we have for several years offered consumer financing on new Polaris products, we now have the opportunity for the dealer to offer consumer financing for used Polaris ATVs, snowmobiles, whatever, and also non-Polaris products at the dealership. There's no risk to Polaris, just like the retail program is generally, it's a fee-based program, so there's no additional risk, and there's significantly higher upside volume and profitability for us, so it's been a very successful effort.

One last question and then I will open it up, back to the guidance, kind of the split between Q3 and then what's implied in Q4, and I understand that you have kind of easier comps in the fourth quarter on both the sales and the earnings side, but even if you kind of back that out, even relative to say the fourth quarter of 2004, the earnings number is expected to be nicely higher than that. Are there any factors that are driving that, that might not be clear from our seat, but that are going to be benefiting the numbers in the fourth quarter?

Let me try to explain that a little bit. It is dramatic there's no doubt about it, and when you do your modeling, you're right. Remember a year ago, we lost over 300 basis points in our gross margins in the fourth quarter, so that's what I was talking about when I said the comparables are a little different. So we are starting from a much different position. There are some specifics though that will help us grow gross margins in the fourth quarter.

We have, you know, Tom has talked about this for a number of quarters, but we've been working pretty diligently on some product cost reduction efforts, and a lot of those will show up in our new model year '07 production, that starts in the second half of the year, and will ship significantly in the fourth quarter, and that will help our margin growth.

We've already talked about warranty. Warranty was a significant charge a year ago, and our product quality is much improved this year, and we expect that to help us in the second half of the year. I mentioned currencies earlier. Currencies are favorable, and we expect them to continue to be favorable in the second half.

Thank you.

[OPERATOR INSTRUCTIONS] Your next question comes from Craig Kennison with Robert W. Baird.

Good morning.

Good morning, Craig.

Good morning. Just to pursue the financial services strength once again, are you guiding to something in the neighborhood of 11 to 12 million, as you did in the second quarter, for the final two quarters?

Our guidance as I indicated was the full year would be up mid-single digits over a year ago.

Okay.

For the full year.

That's helpful. And then relative to the seasonality of KTM, could you give us a better education for how the remainder of the year should fall out?

I think as Mike said, we expect compared to the second half of '05 that KTM will be up a little bit in the second half.

In terms of the details of the KTM financial performance though, Craig, we're going to have to defer to them a little bit. They have actually not announced their earnings yet for what would be their third quarter. So they will be doing that here in a little bit, and so what I would refer you to would be their earnings announcement, which will be coming here in a few weeks, in terms of the specifics of movement quarter to quarter, and that kind of thing.

I would tell you overall though as I mentioned in my prepared remarks, their business is doing relatively well. We do expect that it will grow year-over-year. They've got some terrific new products that they've just introduced, but in terms of the specific numbers and stuff, we'll leave that for them.

Can you give us an early read on how your ATVs are selling through their distribution in Germany?

Of course, it's very, very early, right. We've been a couple of months that we've been working with them but I'd say things are going okay, on track, as expected so far. It will be several more months here before we'll have specific quantitative data that we'll be able to share with you.

I think the other kind of exciting thing that I eluded to is, we will have a fairly significant announcement regarding a KTM cooperation project here in the next 30 days or so, so I'd urge you to keep your eyes out for that.

And with respect to your dealer network, are you losing any dealers due to the difficult economic conditions?

No. In total, actually, the dealer network is growing a little bit now. One of the things that we were very concerned with is, that we would lose a whole bunch of snowmobile dealers, guys that would just give up, and one of the reasons that we were very aggressive in reducing build and inventory, and so forth, was to try to maintain that dealer base. We've been successful in doing that. We may have lost a percent, 1%, 2%-type number of our snowmobile dealers. The other dealer, or the other product lines are actually growing a little bit.

ATVs, RANGERs and I think I mentioned Victory was up 10 dealers or so, and they have been interested particularly in that Victory dealer network, so no, I'd say that the dealer base is actually growing a little bit.

And then finally, with respect to your 2009 plan, how do you feel about that?

Still feel good. The 3 billion by 2009 and 9% net margins are goals that we continue to be committed to. To do that, there's a couple of things that have to happen. One is of course Phase 2 of the KTM relationship, it has to come to fruition, that will be decided next year, but we expect that those discussions so far have gone well, and we'll see what next year brings, but the KTM business is performing well, and the relationship is going well so, so far so good. If that happens, our cost reduction efforts continue to grow, and Victory grows and RANGER grows, and our snowmobile business can come back a little bit, we still feel good about reaching those objectives.

Great. Thank you.

Your next question comes from David Anders with Merrill Lynch.

Great. Thank you. Mike, could you comment a little on the general and administrative line item? I know you gave some guidance that absolute dollar expenses will be roughly equivalent on a year-over-year basis. But can you help me understand the G&A movement and the R&D expense movement sequentially from first quarter to second quarter?

Yes. Sequentially, the R&D increased. We continue to invest in new product development efforts. I think traditionally, it's seeing some growth throughout the year. Our guidance for the full year is to be higher on Research and Development expenses this year, than we were a year ago. Part of that is our new R&D facility, which we're absorbing a full year of costs this year versus really only having costs in the second half of last year.

Let me stop you there for a second. I mean, I'm looking at kind of 19 or 17 million as your prior quarterly run rate starting in the second quarter of last year, and you're now jumping up to 20 or 21. Should that be our quarterly run rate then? Is this just headcount?

David, we're not going to give quarterly guidance on each individual line item. I'm not going to comment on run rates. I think that I've given you some broad expectations for directional movements, and I think that will have to be sufficient.

Okay. Any comment on the G&A line?

Yes. On G&A, there has been a decline sequentially. There's impacts on G&A compensation expenses related to our significantly lower share price this year versus last year, and the impact of that on our share base compensation plans, as well as some of our operational metrics that drive our compensation plans, profit-sharing, and stock-related compensation plans as our operating results have been less attractive than they've been in prior year, there's been a reduction of expenses related to those plans as well.

Okay, thank you.

Your next question comes from Kathryn Thompson with Avondale Partners.

Thanks. Just want to dig a little bit deeper into your, I guess better than I definitely expected ATV sales, particularly going into Q4. Could you just comment a little bit more? I know that given the current consumer environment, why you expect to see a little bit better beyond just easier comps year-over-year, and also comment on any pressure you're seeing from your Far East competitors too, and how that may or may not affect sales in Q4. Or the back half of the year.

Sure. Let me take the second half of that first, Kathryn, and then I'll come back to the first. In terms of the Far Eastern, and by that I assume you're primarily talking about Chinese, Taiwanese, Korean, sort of the emerging Asians, as opposed to Honda, Suzuki, Yamaha, Kawasaki, our traditional Japanese competitors.

Yes, to some extent, but also I would very much like some comments on Honda in particular.

Well, Honda is a pretty formidable competitor.

In terms of who we worry about, as I read analyst reports and talk to investors, and so fourth, there's a lot of people that are very, very worried about the Chinese and Taiwanese, and if they are going to come and eat our lunch, and all of that, and I guess where I come from, I'm much, much more concerned about Honda, than I am about Sym, or Dinli, or Kymco, or Aon, or companies like that.

Honda is a large formidable competitor that we have competed with, of course, for most of our history. They're 50 times our size, they have tremendous technology, and they're a very, very good company, but they are also a fairly well known entity, and I think we understand where we compete effectively against Honda, and where they compete effectively against us.

In terms of the more emerging competitors, I think that their primary effect has been in low displacement, 50 cc, 90 cc, kids ATVs, and entry level ATVs, largely sold through non-traditional channels of distribution. So things like auto parts stores, Pep Boys for example, will sell a very inexpensive unbranded, non-branded kids ATV, and that's a significant part of their market.

In terms of their ability to penetrate the profitable segments of the core North American ATV business, I think that's going to be a difficult challenge for them, just as it has been for every other competitor that's tried to enter the North American ATV business, whether that's Arctic Cat, us originally, and then Arctic cat and Bombardier, and more recently, John Deere.

There were people a couple years ago that thought John Deere based on the strength of their brand was going to turn the North American ATV industry upside down, and that has hardly been the case, so I think that they're a factor, are they likely to leverage some tremendous cost advantage to their benefit? No, they are not. We think we can be cost competitive with any manufacturer in the world producing ATVs out of our existing facilities, and we have some reason to believe that.

In terms of the second half of the year and what's going on with the ATV business and so fourth, I think in terms of the retail environment, I expect that it will be largely similar to the first half of the year. You've got kind of a skittish consumer driven by $3 a gallon gas, and 17 interest rate increases, or whatever the latest number is here. Dealers are concerned about that, so the first half of the industry was down a percent or two, I think in the second half it will be a little better, largely because we had such a negative impact last year in September and October, because of Hurricane Katrina and Rita, and hopefully, we're assuming that that doesn't repeat itself, and those are big months for retail sales particularly of our products.

A lot of our products are sold into the hunting and outdoor market, the large displacement big bore ATVs, that's in the heart of hunting season and last year, we got murdered in September particularly, as the hurricanes hit, and we're hopeful that that doesn't repeat itself, and that we can have a more normal set of assumptions.

So our retail assumptions for the third and fourth quarter are that probably we don't get back quite to where we were in 2004, but they should be better than they were in 2005. So I think we have reasonably prudent retail assumptions that are underlying this business model.

Okay. And just going back to your Honda comment, I mean I absolutely agree with you, it's a more formidable competitor, and really I guess more to the point, I have spoken to several dealers, maybe even spoken to some Honda dealers who have complained about other Honda dealers that are underpricing in the market, and it's been a lingering issue, I know for at least the past 12 months or so. Does that, how big of a concern is that for you of certain larger Honda dealers stuffing the channel?

In terms of Honda as a Company, and kind of the long run performance of the Company, I think that Honda is a terrific Company. They make a very good product. They have a very good dealer network, and I think they have made a phenomenal name. The world's largest motorcycle company, and I think their success speaks for itself.

Like us, they have a network of independent dealers that I guess I would underline the word independent. Some of the Honda dealers behave irrationally from time to time, and as they get into an inventory situation, they may have some aggressive pricing, and so forth, but I think in terms of long term effects on the overall ATV market, and is it going to lead to systemic share change, or sustained price changes or those kinds of things, I don't see that, Kathryn.

You see local things happening in different markets around the country, but I don't see Honda starting a price war, or doing something like what the auto companies have done, or those type of things. I just don't see that.

I see skirmishes that take place with one brand or another, that go from quarter to quarter, dealer to dealer, region to region, but I don't see any systemic changes. I would describe the promotional environment generally speaking in the second quarter, as pretty stable in compared to the first quarter.

What was your RANGER gross in the second quarter, and where do you see that for the back half of the year?

We actually don't break out the RANGER results individually. I think all I said was it was very, very good. I think people that are familiar with the Company know that RANGERs have for quite some time been growing strong double digits, that strong double-digit growth has continued, and RANGERs are approximately 20% of our North American ATV business.

That's about as much as we've shared with the specifics there. There's not good industry data for utility vehicles, and we're not working hard to provide that data on our own.

And also, are you still in-line for your original target for the number of Victory dealers by the end of the year?

Yes, we are.

Could you remind us what that is?

Between 375 and 400.

Thank you very much.

Yes.

Your next question comes from Tim Conder with A.G. Edwards.

Thank you, operator. A couple of questions, gentlemen. Tom, a clarification on your motorcycle comment. You said that the market overall up about 7% year-to-date. Are you looking at the heavyweight in particular, where Victory competes, or are you looking at just the broader market as a whole?

No, that's all motorcycles, on road, off road, heavyweight, you know, everything.

Okay. And then can you talk a little bit more about what you've changed lately in your component sourcing? That sounds like one of the areas that you're really targeting and expecting some benefits on the gross margin side, not only in the back half of the year, but going forward.

Sure. We've always had I think you know, Tim, we've run the back half of the business I'd say pretty efficiently in our factories, and so fourth, but really about 18 months ago, as we saw this wave of inflation starting, and the slowdown in the market, we really have re-intensified our effort and in our case, cost reduction is going to happen gradually and over time.

We're not like the auto companies, and we close factories, and that kind of thing. We've had a consistent long term committment to our employee base, but we are working very very aggressively with our suppliers to try to figure out ways to reduce waste, and I think many of those efforts to redesign and simplify products have been successful, and as Mike mentioned, you'll see some of that in the 2007 model line up, where you redesign a component and make three into one, you injection mold it instead of welding it, those types of product simplifications, and also we've been working again with our supply base to increase our Asian sourcing of components. Again that takes some time. We don't just nilly-willy move a component from supplier A to supplier B without an extensive amount of testing, but that is coming along quite well.

So I think you're going to see some benefit from that here in the second half of the year, and I suspect into 2007 and beyond, and as I mentioned kind of in the wrap up of my part, one of the reasons I am optimistic is, I think we are going to see some very nice cost reduction as we look in '07 and beyond.

Is there any way, gentlemen, as to sort of in your outlook for the improving gross margins, just in broad percentage terms, how much is due to the reduction and the warranty expense? Maybe just looking in the back half of the year, how much is due to I think you mentioned, obviously mix, and then how much is due to some of this component?

I'll let Mike take that one, Tim!

I'm not going to get real specific with that, Tim. I've given you the pieces of the puzzle, the material pieces of the puzzle, I've given, but I would rather not get into the specific quantifications of specific basis points on each one of those criteria.

Okay, that's fine.

The one that I didn't talk about that is also a factor, is product mix. As our RANGER and Victory business grows significantly faster than our other businesses, that helps both top line, and increasingly helping our gross margin line. So mix of product, as well as even mix within the product lines, so for instance, our base ATV business, particularly in the fourth quarter, we're expecting our mix to be helpful with some of the newer products that we're going to introduce, that should be helpful particularly in the fourth quarter.

Okay. And can you give us an update, KTM looking to do some contract manufacturing for you, is that, Tom, maybe what you're eluding to a little bit, or has that already started to take place, and then also related to KTM, what type of EPS contribution at this point are you looking for in calendar '06 for Polaris?

KTM is not doing any manufacturing for us at this point, Tim. In terms of any future manufacturing, we'll kind of announce that when that becomes time, and in terms of what we're going to announce in the next 30 days or so, I guess we'll have to wait for the next 30 days or so before we announce it, so that's probably not real helpful for you, but you probably knew that when you put the fishing line out there.

In terms of the EPS, you want to take that, Mike? What is the contribution of KTM?

Yes, so in my prepared comments, I gave an indication that our expectation for the second half of the year, income contribution from KTM will be somewhat better than it was a year ago, given the growth of their base business.

Okay. Maybe that's along the line of what Tom said on the fishing line! [laughter]

A few other questions. It sounds like higher promotions coming or overall better packages for the dealers to help clear the inventory in Orlando in a few weeks. Was that already accrued in the second quarter, or you would think at minimum, it's baked in obviously to your projections, but how much did you accrue in the second quarter versus sort of baked in on the promo front?

As you know, we accrue promotional costs, flooring costs, rebates and all of that, when we sell a product, and/or when we change our programs or have anticipated change in our programs, so you're right. The inventory that's in the field in the dealerships today has been accrued for what we anticipate will be the promotional activity, which would include whatever we're going to announce at Orlando for promotional activity for this upcoming season.

There has been an impact, a slight impact in the second quarter of slightly higher promotional activities that impacted our gross margins in the second quarter somewhat negatively. Obviously we were able to offset that with some improvement, so slight impact in the second quarter.

And I wouldn't look for anything dramatically different than things we've done in the past, Tim.

Okay. And then again the last question was, second quarter consecutive here now that there are some problems, especially in France and Spain and Tom, you eluded this time and last time also, that a competitor typically when they dump in the European market, they do it in Spain. Dumping, I mean is that continuing on, or is there something changed in the Spanish market, and then also in the French market here?

Well, in the European market generally, it's softer than we expected it was going to be.

Even despite improving business confidence and consumer confidence?

Yes. It's a little weaker. The first half of the year in International was weaker than we expected it to be. I don't know how else to say it, Tim. It's softer than we expected it to be.

I gave a couple of specific examples, I think some of the factors are across Europe, and some of the factors are unique to a specific country. The regulatory issues I mentioned in France. France is a big market for us, and people are concerned about banning off road vehicles, and that's a specific issue there. There are specific issues in Spain that you talked about. You got higher gas prices, which has had an impact, so it's not just one factor.

It's a number of factors, but I do think also that for the full year, we expect that international sales will grow, and so we're going to see some ups and downs internationally, just like we've seen ups and downs domestically, but I think for the full year, we should be up mid-single digits reasonably strong in comparison with where we are domestically.

Okay. So your international again, you're staying up mid-single digits on a full year basis in ATVs or collectively?

It's mostly ATVs, right, Tim?

Right.

Most of our international business is in Europe, 80% or so, and most of our international business is in ATVs.

Got it. Okay, thank you.

We have time for one more question.

Yes, sir. Your final question comes from Bob Evans with Craig-Hallum Capital.

Good morning, gentlemen.

Good morning Bob.

A question back on the operating expenses. I believe, Mike, you had said that you expected the dollars to be flat roughly year-over-year; is that right?

Yes.

And does that include the option expense?

Yes, for both periods.

So you're saying apples-to-apples options expense flat?

Yes.

And to the G&A point, I know you're not giving specific guidance, but can you give us a little bit in terms of how should we view G&A year-over-year? Is a pretty big sequential drop? Can you give us a little bit more sense of magnitude there?

Yes. It's down year-to-date.

Yes.

Quite a bit, it's down year-to-date. We expect it to be down for the full year, perhaps not as many dollars down, as it is year-to-date for the first half.

Okay. I'm kind of getting in a 10-20% range that type down. Is that the right range to think about?

For which period?

For the year, year-over-year.

That sounds to be a little bit heavy.

Okay.

But again, I don't think we need to get into the specific line item.

That's fine. As it relates to the retail sales for Polaris for ATVs, Tom, I think you said there was modest growth, and I believe you said for the industry. Can you give us a little bit more as it just relates to Q2?

I think for the first half, I think what I said was that the industry was down 1 or 2%.

Correct.

That was about what we expected for the industry, and I'd say for Polaris, we were a little bit weaker than that, not much. And about what we expected as well. How about for Q2 relatively speaking, same question, relative to the first half? Directionally the same, Bob.

Okay. And as you look at your retail sales, I know the guidance that you've given as it relates to wholesale shipments, but how do you look at your retail sales relative to industry for the second half?

Maybe a little stronger than the industry in the second half. Again, probably some of it new product driven, some of it driven by the comparables. We took it on the chin a little harder again, because of our product mix, in particularly September of last year, which is a very big month. We tend to sell more of kind of the hunting/outdoors-type ATV, and the Japanese as a group tend to be a little stronger on the more sport-type ATV, so assuming that we don't have another devastating hurricane, which is implicit in our assumptions, and the market is more normal, I would guess that we will do relatively a little better in the third and fourth quarters this year than the overall market.

Okay. And again, on the KTM, I don't know if we have the full detail of last year's second quarter, but you're saying nothing unusual this quarter? This is just pure seasonality?

Right.

For that business?

Yes. There's nothing unusual going on. The business is performing well, and they typically have what they describe as their third quarter, Bob. Of course, they're on an August 31 fiscal year, so it's a little bit different, the nomenclature is a little bit different, but their business is performing well. They had a good dealer meeting here a couple of weeks ago, and we'll leave their financial results and announcement to them.

Okay. Fair enough. Thank you.

At this time, there are no further questions.

Thank you. I just want to thank everyone for participating in the call today, and apologize for the minor technical difficulty we had earlier. Please remember that our presentation and responses to your questions contain certain statements that could be considered forward-looking for the purposes of the Private Securities Reform Act of 1995. In that results could differ materially from those projected in any forward-looking statements. Thank you again for listening and goodbye.

And this concludes today's conference call. You may now disconnect.