Polaris Inc (PII) 2006 Q3 法說會逐字稿

At this time, I would like to welcome everyone to the Polaris 2006 Q3 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS) Thank you. Mr. Edwards, you may begin your conference.

Good morning and thank you for joining us for our third-quarter 2006 earnings conference call. Mike Malone, our Chief Financial Officer, and Tom Tiller, our Chief Executive Officer, will be participating in the call. Bennett Morgan, our President and Chief Operating Officer, is also here and is 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 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 10-K, which are on file with the SEC. Now, I will turn it over to Tom. Tom?

Good morning. Thanks, Richard, and thanks, everyone, for being on the call. For the third quarter, earnings were $1.04 per share, down from $1.11 per share last year or 6% on a 10% decline in sales. The results for the quarter were in the range of our expectations.

But the third quarter was tougher than we expected in terms of lower retail sales and dealer orders, particularly of ATVs. So we have made the decision to aggressively reduce our ATV production and shipments in both the fourth quarter and into 2007. As most of you know, we have been working to reduce dealer inventory of ATVs over the last several quarters by reducing production and increasing retail sales. But it is clear that we need to be more even more aggressive with our actions.

This decision will have a significant impact on our shipments, revenue, and earnings in the fourth quarter. As such, we're reducing our earnings expectations for Q4 by approximately $0.45 per share, versus our prior guidance.

In my portion of the call this morning, I will discuss what is going on, why we're making the changes now, what we're doing to specifically address the situation, and what you should expect as investors going forward. As we typically do the third-quarter call, we will also give you some early qualitative thoughts about next year. In Mike Malone's part of the call, you will give you some more detailed guidance for Q4.

With that overview, let's turn to the individual business segments, starting with the all-terrain vehicle division. The same trends that we have seen all year in ATVs continued into Q3. Namely, a sluggish industry, a competitive environment, and the continuing concern about high levels of dealer inventories.

In terms of the industry, on a year-to-date basis, the core North American ATV industry is down about 3% versus last year. The third quarter was quite weak, down about 6% from last year's relatively weak levels.

We believe the drivers are the same -- consumers' concern about increasing interest rates and relatively high energy costs. Although gas prices have eased over the last few weeks and interest rates have stopped rising, both of which are helpful developments, we expect the industry will be down single digits in both Q4 and for the full-year 2006.

In terms of our performance relative to the industry, we have been modestly weaker. On a year-to-date basis, our market share for core North American ATVs is down about half a point, which is disappointing. That means we are losing the competitive battle.

While it is a positive that dealer inventory has been reduced versus the same time last year, the inventory levels remain too high. We had our dealer meeting in Orlando during the quarter. While dealers were pleased with both the new product offerings and our overall product quality, they were clearly concerned with the high level of dealer inventory. They want to see that inventory reduced quickly and significantly.

Their orders, which were below our expectations, reflected that concern. From a positive perspective, they were particularly excited about some of the new sport quads, like the Outlaw 525, the improvements to the RANGER line, and the all-new Sportsman 800 X2.

Promotions in North America have remained relatively stable through the quarter, although it is possible we will see an upward trend, as we believe that other competitors also have excess inventory at the dealer level.

As we saw in both the first and second quarters, our international business during the third quarter was weaker than expected, particularly in southern Europe. I will expand more on that subject later.

Certainly, the bright spot for our ATV business continues to be the RANGER line of utility vehicles. The third quarter was our best quarter ever, and we are continuing to enjoy double-digit growth in both retail and wholesale sales. The dealers' orders of RANGERs met our expectations. Overall, we do not have significant concerns about the utility vehicle portion of our ATV business.

So against that backdrop, it is clear to me that we need to take the following actions with respect to our core ATV business. First, we need to significantly reduce shipments to dealers. Over the next 15 months, we need to cut our dealer inventory significantly. About half of that reduction needs to come in the fourth quarter.

Second, we need to become more competitive in ATVs. The ATV business has been the heart of Polaris for a number of years, and we need to redouble our efforts to win the competitive battle. A strong, healthy, profitable ATV business and a good dealer network are absolutely vital to our long-term future. The effort to improve our competitiveness will involve a series of actions over the coming months, many of which we will not discuss on this call for competitive reasons.

For 2007, after factoring in additional inventory reductions, we are expecting our ATV business to be about flat to perhaps up a little bit, with the growth being driven by utility vehicles.

Snowmobiles. While the recent focus has certainly been on ATVs, we're now entering the start of the fall snowmobile selling season. The next 120 days will be very important in terms of demonstrating progress in inventory reduction and building dealer and consumer confidence. So far, things have gone according to plan, but it's very early.

Our dealer inventory, as a result of the significant reductions in production this year, is down nicely. We have made modest changes to the model line this year and are concentrating our efforts on quality and consistent execution. The new management team that we put in place earlier this year appears to be off to a good start.

But like it does every year in snowmobiles, it comes down to the weather and to the competition. We will know more at the end of the fourth quarter, but flattish would be my best forecast at this point in time for snowmobile sales in 2007.

Victory motorcycles. Victory motorcycles are continuing to do well. The progress of the last few years has continued. The business is showing strength in product quality, product appeal, retail sales, dealer network improvement, and brand momentum. Shipments of Victory motorcycles were up 60% for the quarter. More importantly, retail sales continued to be strong. The U.S. motorcycle industry as a whole is growing over last year's record level and is up about 4% year-to-date.

Victory continues to significantly outperform the industry and has maintained momentum through the heart of the riding and selling season. The dealer meeting went well for Victory. Dealers were positive about the new models, and their orders met our expectations.

Our Victory dealer network continues to grow. We expanded the dealer base by 22 dealers in the quarter.

One of the most exciting developments in the history of Victory was announced at the dealer meeting. The news is that Victory has made a firm commitment to enter the luxury touring market segment in 2007. This segment, which is one of the largest, fastest-growing, and potentially most profitable segments in the motorcycle industry, will be a new opportunity for Victory. Luxury touring motorcycles are machines designed for long-distance riding and are among the largest, most expensive, and most demanding machines on the road.

We currently do not offer a product within that category. The investment required for this product family is significant, and this commitment truly represents the next level in our long-term effort to build a viable motorcycle business.

Details about the market opportunity, product, timing, distribution, marketing, and financial impact of this new product will be made available over the next several months. Suffice it to say for now that we are excited about the opportunity.

For the full-year 2006, we expect Victory to be solidly profitable, our first full year of profitability. I would anticipate another solid year of improvement for Victory in 2007 as we enter our 10th model year of production. Long-term, we continue to see Victory as a significant growth engine for the company.

Parts, Garments, and Accessories. The PG&A division had a decent third quarter given the reduced shipments of both ATVs and snowmobiles. PG&A sales were down 4% compared to a 10% decline for the total Company. We continue to expect sales of PG&A to continue to grow a little faster than the Company's sales and that that trend will continue into 2007.

Our innovation in the PG&A category continues, as we have introduced dozens of new items to the line at the dealer meeting. Of particular interest were new cab systems for the utility product line, new plow offerings for ATVs, and an all-new Polaris-branded winch system.

International. International sales were 11% lower for the third quarter, which is weaker than we had expected. As we discussed in prior calls, 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 about riding restrictions and face competitive pricing pressures in Spain. These are the same issues that we have been facing in Europe all year.

Additionally, we're seeing some of the same macro factors that have been influencing the North American ATV market -- higher gas prices and higher interest rates, along with some product mix shifts.

For the full-year 2006, however, we now expect international sales to decrease slightly from 2005. It is too early to tell yet what 2007 will bring.

KTM. We announced during the quarter that, for internal reasons, KTM has made the decision to remain independent and not proceed with Phase II of our proposed strategic partnership. KTM continues to distribute products for Polaris in Germany, and we anticipate purchasing engines from KTM, including the engine for the new 525 Outlaw, which is the fastest production ATV in the world. We will continue to work together with KTM on a project basis.

In terms of our share ownership in KTM, we have maintained a 25% ownership stake in the company. Over the coming months, we will hold discussions with KTM management to determine our long-term ownership position in the company. KTM continues to perform well.

While we were disappointed in their decision, we certainly respect their wishes to remain independent and look forward to a mutually beneficial relationship into the future.

Speaking of the future, I would like to conclude my remarks by briefly laying out for our investors what they can expect from Polaris over the next several quarters and, ultimately, over the next several years. 2006 has been a very challenging and at times a very disappointing year for all of us, both as employees and as shareholders.

We had a very rough start to the year with the problems involving the Snowmobile division. We were disappointed in the KTM Phase II decision. And now, because of the weaker than expected ATV industry, we have had to significantly reduce our earnings guidance for the year. Importantly, after 24 consecutive years of earnings per share growth, our track record of year-over-year increases in earnings per share will apparently come to an end. So we're disappointed.

But more importantly, what are we going to do about these issues? In the immediate term, for the next few months, we have to get the ATV business healthier and more competitive. That means further reducing dealer inventory, improving our cost position, and accelerating retail sales. That is our focus.

We're looking at whether a significant stock buyback would be helpful. I would not rule that out.

As we go into 2007, we will continue to focus on getting the ATV dealer inventory down and improving our competitiveness. We will also look to enter two new market segments. I mentioned one, the luxury touring segment of the motorcycle business. The other opportunity will be announced in early 2007, and it too will be exciting and material.

Bottom-line for the full year, I anticipate that earnings per share will be better in 2007 than it will be in 2006. Cost reduction, consistent execution, and product extensions into new markets will be the main themes during 2007.

In 2008 and beyond, with the inventory situation hopefully behind us, we believe that not only will our existing businesses grow, there are attractive, adjacent markets that offer growth opportunities for the Company.

If you look at how Polaris has grown over the years, like when we entered the ATV, motorcycle, or utility vehicle markets, it has been by applying our brand, technology, and innovation to new, adjacent market opportunities. We believe such opportunities exist and are working on potential solutions for new customers already. So in addition to our fast-growing utility and motorcycle businesses, we can accelerate growth by pursuing adjacent markets in 2008 and beyond.

With that report, I will 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. Also as before, our 2006 results include the expensing of stock options in accordance with Statement of Financial Accounting Standard 123(R); and because we chose to account for stock options using the retrospective method provided by the Accounting Standard, we have adjusted our 2005 financial statements, as this change was made for the entire 2005 year.

I will begin my comments with a review of our guidance for the full-year 2006 and we will then move on to the more specific guidance for the fourth quarter, full-year guidance for specific metrics, and a brief review of certain aspects of our third-quarter results; and then wrap up with some comments about the upcoming 2007 year.

As Tom discussed, the current ATV business issues has resulted in a need to reduce our sales and EPS guidance for the full-year 2006. We now expect diluted earnings per share from continuing operations to be between $2.68 and $2.73 for the full-year 2006, which is down 13 to 15% compared to the adjusted $3.15 per share earned for the full year last year.

Total Company sales for the full-year 2006 are now expected to be in the range of down 11% to down 12% for the full year.

Fourth-quarter 2006 total Company sales are expected to decrease 13 to 16% from 2005, with earnings from continuing operations expected to be in the range of $0.89 to $0.94 per diluted share compared to the adjusted earnings per diluted share of $0.99 in the fourth quarter of last year.

Now let's move on to the product line full-year 2006 sales expectations. For sales of ATVs, we are revising downward our full-year 2006 guidance and now expect sales to be down 10 to 11% compared to last year.

Our prior guidance suggested that the Q4 ATV sales would actually increase low double digits. However, our new guidance suggests Q4 ATV sales will decrease in the low double digits compared to last year's fourth quarter.

Our Snowmobile sales guidance remains unchanged from the prior quarter's guidance. We continue to expect revenues from snowmobiles for the full year to be down in the range of 30 to 40%, compared to 2005 sales levels, most likely in the upper end of that range.

Sales for Victory motorcycles are expected to continue to grow in the low 20% range for the full-year 2006, for all the reasons we have discussed in past calls. The Hammer and Vegas Jackpot models continue to gain share, along with increasing sales for the improved Kingpin and Vegas models with the more powerful 100 cubic inch engine and the six-speed transmission. The significant 60% growth in Q3 sales is due somewhat to an earlier conversion to the new model year this summer.

PG&A sales are somewhat dependent on how our whole group's business is performing. Given the softness in ATVs and Snowmobiles, sales in the PG&A business for the full-year 2006 will be slightly lower than last year, but will have somewhat better comparisons than the overall Company's sales performance for 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.

Now moving down the income statement, the gross profit margin in the third quarter was negatively impacted by the lower sales volumes we experienced in ATVs and snowmobiles during the quarter, and its impact on our manufacturing and logistics efficiencies, as well as higher ATV sales promotions, floor plan financing, and incentive costs. These factors all combined to generate about 205 basis points of gross margin erosion in the third quarter.

We do, however, expect this trend to reverse in the fourth quarter, when we should see gross margin expansion as a result of increased cost reduction efforts, and savings from more effective sourcing of component parts, as well as improved product quality, resulting in lower snowmobile warranty expenses, and favorable currency effects. However, these benefits will be offset somewhat by continued higher promotions and incentives and the impact of the lower volume on our manufacturing costs.

Gross margins for the full-year 2006 are now expected to be about flat with the adjusted full-year 2005 gross margin percentage of 22.0%.

One other item to note in margins is that we received a favorable ruling in the European Union, which eliminates import duties for certain ATV models sold into Europe. The refund of these duty charges benefits our gross margins in both the third and the fourth quarters of '06.

Operating expenses in dollars are expected to be down for the full-year 2006 compared to last year, resulting from cost control initiatives as well as lower compensation plan expenses, resulting from the lower operating performance of the overall Company and the lower stock price. Expressed as a percentage of sales, operating expenses for the full-year 2006 are expected to be somewhat higher compared to 2005 due to the lower sales levels.

However, we will continue to invest in research and development efforts to drive future growth through new products, including a full year of expense in this year related to the new R&D facility opened up in mid 2005.

The income from financial services continues to improve nicely due to higher interest rates and higher receivable balances in the wholesale portfolio, as well as higher retail credit income generated by an additional program related to used and non-Polaris products financed through our HSBC relationship. Income from our finance services business for the full-year 2006 is now expected to increase in the mid-teens percent range.

For the year to date period, so far in 2006 we have financed through HSBC about 36% of our products sold to consumers in the United States, similar to the penetration rate for the first nine months of last year. The volume of retail credit contracts written in a first nine months of this year was about $500 million, a 39% increased over year-to-date in 2005.

At the end of September 2006, the wholesale portfolio related to floor plan financing for dealers in the United States was approximately $768 million, up just 1% from $757 million at the end of the third quarter last year. However, because of a significant mix change to the higher-priced Victory and RANGER inventory outstanding, and an average selling price increase across each product line, the actual units outstanding in the portfolio are down from last year.

Credit losses in this dealer portfolio remain very reasonable, averaging well less than 1% of the wholesale portfolio.

Our equity in income of manufacturing affiliates totaled $2.7 million for the third quarter of 2006, nearly all of which relates to our 25% investment in KTM. KTM's fourth quarter, which ends August 31, is historically their highest earnings quarter of the year.

The income tax provision was recorded at a rate of approximately 28.4% of pre-tax income for the third quarter this year, slightly less than the adjusted 29.3% recorded in the third quarter last year due to the favorable resolution of certain income tax events. For the full-year 2006, our current expectation is for the income tax provision rate to be approximately 32% of pre-tax income.

Let me take a moment to update you on the expected impact of currency fluctuations on our operating results for 2006. As you know, our foreign currency hedging strategy is to protect the downside risk yet preserve some upside opportunity if economically feasible. For the third quarter and year-to-date periods of 2006, the currency fluctuations of each of the Canadian dollar and the Japanese yen had positive impact on sales, gross margins, and net income.

We currently have foreign currency hedges in place through the end of this calendar year for the Canadian dollar at an exchange rate of about $0.90 per dollar. Currency hedges are in place for the Japanese yen through the first half of 2007 at an average rate of approximately 113 yen to the dollar. We currently do not have euro currency hedging contracts in place, as we are approximating a natural hedge.

Based on the foreign currency hedges we have in place and the current exchange rates, we expect a positive impact on profits from the Canadian dollar hedging activities for the balance of this year, and a neutral impact from the yen hedges in place for the balance of 2006 and into 2007 compared to the prior-year period.

During the third quarter, we were buying our stock aggressively and repurchased 1,323,000 shares under our share repurchase program at a cost of $51 million, bringing our total repurchases for the 2006 year-to-date period to about 2.6 million shares and $109 million. We expect to continue to repurchases shares in the remainder of 2006 under our existing Board authorization, which has about 2.1 million shares remaining.

In addition, together with our Board of Directors, we may consider alternative strategies to our existing open market share repurchase program in the future.

During the first nine months of 2006, we made investments in the business through capital expenditures totaling $38 million, which is lower than a year ago, due to the completion of our R&D facility last year. We now expect full-year 2006 capital expenditures to be in the range of $58 million to $63 million. 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 $92.5 million for the nine months ended in September, or about 9% lower than the cash flow generated in the same period last year. The decline in cash flow relates primarily to the lower net income generated in the first nine months of 2006.

Before we take questions, I want to make a few comments about our expectations for 2007. As Tom stated, we have taken some significant steps this year to bring dealer ATVs and dealer snowmobile inventories down to more acceptable levels and to become more competitive in our industries. We will continue to make adjustments in the fourth quarter as our revised guidance suggests.

At the same time, we're taking steps to streamline our business through ongoing efficiency improvements, low-cost sourcing, and overall expense management. We feel these steps are necessary to prepare the Company for a better 2007 and beyond. Our balance sheet and cash flows remain strong, and we have options to leverage our strengths to improve shareholder value, which we are exploring.

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

(OPERATOR INSTRUCTIONS) Greg Badishkanian, Citigroup.

Hey, just a few quick questions here. With respect to the ATVs and snowmobile inventories, when would you expect that to be -- I know you have made some good progress; you have been talking to dealers. But when would you expect it to be at levels that you're comfortable with?

I think, assuming a normal winter, Greg, where we don't have crushing snowfall but we don't have no snowfall -- you know, sort of a normal snowfall pattern -- I would expect at the end of this riding season we will be in relatively good shape in terms of snowmobile inventory. We took some very tough medicine in terms of production reductions this year. So, as we work through the retail sales of that, assuming we get halfway decent snowfall, we should be in good shape there.

As I mentioned, in my prepared remarks in ATVs, we view this as about a 15-month process; but we are going to frontload the plan. So about half of the reductions should come in the fourth quarter of 2006, and then the remaining reductions more evenly spaced throughout 2007.

Any expectation for retail sales for normalized inventory levels at the end of that period?

I don't know that retail sales will be significantly affected by the inventory reduction one way or the other.

What is your assumption behind ATV retail to get to normalized inventories?

Not major changes, but some modest improvements in terms of our competitiveness, as I talked about. We anticipate that the market, the industry, for the fourth quarter will be down single digits. It is down 3% year-to-date. I don't know exactly where that will be in the fourth quarter, Greg, but my guess is you would be in a down 2, 3, 4, 5, somewhere in that range percent in the fourth quarter.

I mentioned that we are down a half point in market share this year. We would like to improve that situation.

In terms of 2007, our models indicate that we would expect the ATV industry to be down modestly in 2007 compared to 2006. Again in, say, low single digit range. Then in 2008, the industry should flatten out.

That is trying to predict the future the same way that you try to predict financial markets and that kind of thing. So you have got a million variables that go in it. But basically the models that we use are econometric models that look at factors like interest rates, disposable income, the macro factors that you might expect.

Sure. The ATV forecast, I'm assuming that excludes RANGER and international; that is just U.S., right?

That is correct. When I talk about the ATV industry and percentages and all that kind of thing, what I am referring to there is what we typically call the core North American ATV market. It does not include utility vehicles and international.

Good. With respect to the promotional environment, are you hearing things in the trade? Or are you just expecting, because everyone has a little bit higher inventory levels, that you're going to see a little bit of a pickup in promotionality?

Yes, I think, as I said again in my prepared remarks, things have been relatively stable during the quarter. I don't know -- I can't predict what the competitors will do, other than typically we have rational people running the companies, and we are seeing indications of a little bit higher inventory. We're not the only people with a high inventory situation. In that instance, there are times where you see competitors react, so I would not be surprised to see that.

So it is just something that is sort of a normal activity when you have a little bit high inventory, but not necessarily something that you are hearing specifically of major promotions coming out of your competitors or anything?

Exactly. They typically don't -- we don't have any advanced information of how they are going to behave. But think of the car companies, right? When a car company has higher than normal inventory, you tend to see higher than normal promotions. I think that is all I am referring to there.

So if everyone has got a little bit higher inventory levels, the fact that you're bringing yours down isn't necessarily going to hurt you from a competitive perspective in losing share. Because everyone has sort of got to bring that down, and you are not going to lose visibility there at the retail level. Right?

Over the long term, let's talk beyond the next three months. If you think about Polaris in 2015, okay? It is really, really important that we have a strong, healthy, ATV business. We have been working on trying to get this dealer inventory down for about the year. Okay? With what I would call sort of a managed process, right? Gradually reducing the production, tactically working model by model, dealer by dealer.

We have made some progress, but we haven't made enough progress. We know that and our dealers certainly told us that at the dealer meeting. So we are going to be more aggressive in reducing our inventory back to a level that we think is comfortable.

Long term, I don't know where the ATV business is going to be in 2015. But whether it is 50% larger or 20% smaller, it will be a very important part of Polaris in 2015. We have to have healthy ATV business, and we have to have a healthy dealer network to do that.

So basically, we are going to keep doing what we are doing, what we have been doing for the last year, Greg. But we're going to be more aggressive in those actions. We are going to try to get this problem behind us, more quickly.

Okay, good. Turning over to Victory, entering the luxury touring, obviously because of the success you have had in the recent year or two, very nice progress. What do you think the financial impact is going to be in '07? Is that going to be accretive in entering that segment if it does as you expect? Or is there sort of initial investment and it is going to take some time to be profitable?

No, I think it will be helpful to us in 2007. We don't -- we haven't provided sort of by-model guidance for that. But we will talk certainly in the fourth-quarter call more about this opportunity and more as we go through the year.

But just to give you a sense, it is a significant market. We believe that the market for the motorcycles is in excess of $0.5 billion. The market opportunity for all competitors, right? When you include PG&A and clothing, it is approaching a $1 billion market opportunity.

It is one of the largest remaining opportunities in the cruiser touring segment, which is a logical segment for us to go after. It also is growing very nicely. Over the last three years, it has grown at about a 12% annual rate.

That makes sense as you consider demographic shifts. People are -- as they get older they come off a cruiser and move into kind of their last motorcycle, a big touring bike. So we think it is a very attractive market. We have a unique proposition for that market. We are excited about this being the next big step in Victory's growth and development.

The other thing I would add to that, Tom, is that much of our development effort has been taking place over the past few years. So that that initial investment and cost, obviously, will be behind us as we announce the profit.

When we built the Wyoming development center and we talked about a series of products that would be impactful into the next decade, and this would be an example of one of those.

So you have already been investing and expensing that, basically?

For many years.

Okay, good. Just a final, just to follow up. To put it in context, the current Victory motorcycles that you have now, what is the market size for that? Then, so -- I think you said $1 billion for the new segment that you're entering.

I will have to get that exact number for you, but it would be on the order of $2.5 billion. So this represents a substantial expansion in terms of our served market. I will get you an exact number, Greg; but that is ballpark.

That's fine. Thank you very much.

Ed Aaron with RBC Capital Markets.

A few questions for you. One of the things that I'm trying to get my arms around just with the consumer discretionary base in general is -- how much of the weakness that we have seen is attributable to gasoline prices? We have seen them certainly back off a little bit here over the last couple months.

I don't know how immediate of a benefit there might be there. But you are coming into the hunting season for you, which is a reasonably strong seasonal part of your business. So just wondering if you're seeing anything in terms of your customers' response to the lower gas prices that might give you an indication one way or the other of how much of this we can attribute to gas.

Let me try to answer that, Ed. Certainly, there is no question that over time lower gas prices are very helpful trends. As are seeing interest rate increases moderate. We have had 17 or 18 interest rate increases.

If you look at our customer, which tends to be a successful, blue-collar person, maybe average income around $55,000, $60,000, $3 a gallon gasoline has an immediate and significant impact on their behavior. No question about that.

As we have seen the gas prices moderate -- and I think nationwide we are somewhere around $2.25 a gallon -- that has been a helpful development. So in our case, if you look at our retail sales, we were generally kind of sluggish in the July and August time frame. We were relatively pretty good in September, which correlates with kind of the gas price. We also had promotions in the market, new model changing, and all that sort of stuff. But causally, the two are -- they correlate together.

If you look at the industry, though, the industry was kind of weak in September, which surprised us a little bit. Because you did have the gas prices coming down; and you also were going up against pretty weak comparables.

I mentioned for the quarter the industry was down 6%. If you may remember, I think the hurricanes hit last year around the 28th, 29th of August; and September was a very difficult month for ATVs. It was very strong for motorcycles last year. But it was very weak for ATVs. So it kind of surprised us a little bit.

So our business was good in September; the market was not so good. But clearly, it will be a helpful trend if gasoline prices stay down. There is no question about that. It is a durable purchase. The gas prices have been down now for three or four weeks. People typically go through a 45 to 60-day process when they decide they are going to buy an ATV. I don't think they drive up to the pump on day and say -- okay, well, let's go buy the ATV now. It will take some time for that trend to develop. But that is a very helpful trend.

Fair enough. Then on the inventory side, can you maybe put the dealer inventory situation in the context of inventory turns, and what kind of the range has been since you have been in the business? Where roughly we are now, and where roughly you see as a normal level relative to the demand that you anticipate?

I'm going to stay away from that question, Ed, for competitive reasons. We don't disclose to our competitors specific dealer inventory numbers.

They are higher than we want them to be. We need to reduce them significantly. We think that will take about 15 months. About half of that reduction will come over the next 90 days. That is about as far as I am going to go with that.

But even speaking about just general industry ranges?

You know, we don't have specific industry data on their inventory. We do the same types of things that you do, Ed, and the other analysts do, in terms of -- it is more qualitative. It is dealer surveys. It is visits to dealerships. That kind of thing.

We do not have any type of industry data that tells us that. It is partly anecdotal and partly judgment, based on what we see going on, in terms of promotions and that kind of thing.

Thank you.

Bob Evans, Craig-Hallum Capital.

Can you comment a little bit more in terms of your logic on your ATV reductions? You said you're going to aggressively go after it in Q4, and then kind of be consistent through next year. Why not be aggressive Q4; maybe Q1 next year; and then have it, I guess, rightsized earlier?

We looked at a lot of different alternatives, Bob. That was one of them. We looked at continuing basically what we have been doing, which is a more gradual approach, and several different variations in there.

It is not simply a matter of production and shipments and that kind of thing. Some of this, also, involves the other factors that goes into competitiveness. For any company and any product-based business -- think of a car company -- it is the product offering; it is the cost basis; it is the promotional effort; it is the pricing; it is all that sort of stuff.

We have what we believe to be an integrated, well-developed plan to do that. That is kind of the plan we are going to run.

I can't comment further on why that alternative makes more sense. But when you look at the totality of those factors, in terms of production timing decisions, effects on suppliers' plants, there's a number of factors that go into that. We think that makes the most sense for not only the dealers, not only for Polaris, but for all of the constituencies that make this place go.

Fair enough. You have given us some color on some of the '07 segments that you're looking for. Can you give us a little better sense of what you think from a gross margin or operating expense standpoint? I know it is early, but can you give us some further color there?

I will handle that one, Bob. From the gross margins perspective, we have observed a lot in the current year, in 2006. We expected to be able to grow margins earlier in the year; and as I gave guidance to now, we are expecting them to be about flat on a percentage of sales basis. So we're disappointed in that. But it reflects the tough market that we are in.

Next year, we are not going to give specific guidance, yet. But next year, I would expect them to be a little better. If we have absorbed what we have this year, and we are flat with 2005, I would say next year we should expect some modest gross margin expansion.

How about from an operating expense standpoint?

Operating expenses, we are working real hard on cost management. I think you can see evidence of that in the second half of this year. We are working real hard on that.

Tom mentioned that we need to be more competitive, and that applies to all other areas of our business. Operating expenses is no exception. So we are looking real hard at cost, expense management.

We have made some progress. We will continue to make progress in the fourth quarter; and as we build our budget and plan for next year, we are going to be very prudent with our spending levels.

Okay. Just want to make sure I heard you correctly; but given your plan on the ATVs, you said -- early, but kind of think of next year as kind of a flattish to maybe up slightly type (technical difficulty). Is that right?

That is right.

Okay, all right. Thank you.

Tim Conder with A.G. Edwards.

Gentlemen, a couple clarifications. Mike, you mentioned in your prepared remarks regarding the European duty rebate. How much of that, either basis points or dollars, are you looking at here in '06 benefiting gross margins in the third and fourth quarter; or just collectively?

Then, also, Tom, in your discussion about adjacent markets, is that going to primarily be tilted internal? Or are you seeing some potential opportunities -- and of course you guys have been very disciplined in the past in what you go after -- on the acquisition front?

Okay, on the EU duty, it is about 40 basis points or so benefit in the Q3 period to our gross margins. We don't know yet what it will be for Q4. We haven't got that far yet. But our expectation is that it should be maybe similar to that, maybe approaching that again in Q4.

Okay, okay.

In terms of the adjacent market opportunities, Tim, I guess the way I would answer that is our acquisition thinking, our strategy on acquisitions, we continue to be open and exploring the idea of growth through acquisition with a disciplined approach.

We very much liked the concept of the KTM partnership. It was going after an adjacent market, primarily the off-road and to a certain extent the on-road motorcycle opportunity; and doing it in a disciplined away with a high-quality company.

If we find opportunities like that, we will continue to pursue those. And we are. We are continuously looking for opportunities to grow through acquisition.

But the primary approach that I am talking about here would be on the organic side. It would be more like we have traditionally grown the Company, which is through applying our innovation, our technology, and our brand to an adjacent market.

If you look at how we entered -- we were a snowmobile-only Company, and we went into ATVs, and watercraft, and motorcycles, and utility vehicles. It is that type of opportunity that I am talking about, primarily. If we could get some acceleration, some topspin through some kind of a partnership or acquisition opportunity, certainly we would look at that.

Okay, okay. Talking with dealers and that, as we mentioned in our survey, there appear to be several state litigation issues out there. Texas, California, Montana, Maine, and with Montana potentially being a class action issue.

Any commentary or view that you can mention here? I know again it is litigation, so there is not too much you can say. But any color or thoughts you can give on those issues?

A little bit, Tim. I would say, of course, in terms of the specifics of the four issues that you mentioned, we can't get into those because they do involve the pending litigation. We like most companies don't comment specifically on potential litigation.

But while I would say that generally speaking, the analysts' reports that I have read have broadly characterized the dealer inventory situation correctly -- dealers are frustrated -- I am not sure that this part of the characterization has been quite as accurate, if you will. Okay?

We have approaching 2,000 dealers. We have a lot of dealers. These are small dealers, and from --- in any year at any time, we are involved in a number of what I would term commercial disputes, relatively small lawsuits, or arbitrations, that take place on a relatively consistent basis. Year in, year out. We do have the same thing on the supply base side, and I think most companies our size do.

I would not characterize the dealer situation being materially different this year as any other year. I do think that dealers are frustrated. The primary reason, from my experience, that dealers are frustrated is when they are not making money. You hear that frustration expressed in lots and lots of different ways, okay? But generally speaking, if they are making money, the problems are relatively manageable. And if they're not making as much money as they expect, then they are frustrated. They might express that frustration with your product or your program or your advertising or your whatever.

But I think if we can work to reduce the dealer inventory, to improve the overall competitiveness of our offering, I think that the vast, vast majority of Polaris dealers will be happier and more satisfied with their business.

I don't think we will eliminate all commercial disputes in 2007, '08 or '09. I think that is part of doing business. So I guess that is the way I would characterize that, Tim.

Okay, okay. Then, you were alluding to potentially the opportunity to expand a share repurchase. Either that, or a combination of acquisition or whatever you may do, and given the strong cash flow of the Company, where would be the general area, from a maximum debt-to-capital area, that the Company would be comfortable with?

Well, Tim, we have historically been very conservative with our capital structure. As you know, we have carried no long-term debt and have an operating line that generally pays off or close to pays off every year.

So we have maintained a very conservative approach. That is our nature, and I don't think that is going to change a whole bunch.

What is a little different is that without the KTM Phase II opportunity, over the next short term we don't see a huge M&A opportunity. Now something may come up; but it's not quite to be as significant perhaps as the KTM Phase II would have been in the near term.

Given that, there is some thought to levering up modestly, to take advantage of the current situation. So when I say modestly, it is up to maybe 1 times cash flow; or maybe a little more than that, 1.5 times cash flow; something like that. But not anything what I would consider extreme.

Again, Mike, your definition of cash flow being an EBITDA measure?

EBITDA, yes, I'm sorry.

Okay. And --

Tim, let me just add, strategically we want to be in a situation where we can run the Company exactly the way it needs to be run. So if we need to for a quarter make a move like we are making this quarter, with ATV shipments, that we have the flexibility to do that and are unencumbered. We also went to be flexible enough that if we do find an opportunity -- perhaps not of KTM size, okay? Perhaps not that size of a deal. But if we find something a little bit more modest that helps us as we pursue these adjacent market opportunities I talked about, we will have the flexibility to go after that.

So don't expect us to take on, as Mike said, an inappropriate amount of debt, given our strategic direction for the Company. But we do think that certainly at these prices, that this is a terrific buying opportunity.

Okay, thank you, gentlemen.

Casey, we have time for one more question.

James Hardiman, FTN Midwest.

Just a real quick housekeeping item and then a quick question. In terms of the tax rate, the tax rate is about 28%. You compared that to last year's rate. But if I recall correctly, there was about a $0.06 benefit in last year's tax rate.

What is the normalized tax rate for the third quarter that I should expect for next year, for example? What was the earnings impact that you got from that in this year's third quarter?

Okay, James. We have been guiding throughout the year to a -- I don't know what it was -- 33 to 34% tax rate. You're right, last year in Q3 we had some special items that were resolved that gave us some benefit.

The same thing happened in this third quarter, where we had some tax issues that were resolved in the third quarter that gave us some benefit. So our tax rate came down a bit in Q3.

On an ongoing basis, we would expect about a 33.5 to 34% tax rate going forward. When you blend the benefit of what we realized in Q3, I gave guidance for the full year this year at a blended rate of about 32%. But going forward, I think it is appropriate to model in something approaching 34% on an ongoing basis.

Okay. Just on the finance unit, it continues to grow pretty impressively; up 24% this quarter. How much of that is coming from the expansion of some of the credit programs? When do those programs get annualized? I'm assuming -- I am guessing they might be annualized now. So I guess the question is, going forward, what type of growth do you expect to get from that segment?

On the retail credit side, I would say you're right. There is getting to be a little bit of anniversarying of our significant growth. That growth will be tempered next year. We still expect growth in Q4, however.

On the wholesale side of the business, the growth this year is really related to two things. One, the rising interest rates, as well as the continued elevated dealer inventory level. As those both moderate going forward, we will see an impact in the profitability of our wholesale credit business.

So, I would be careful about expecting too much growth on the wholesale part of our financial services business too far into the future.

Okay. So combined, is there a certain growth rate that I should expect for '07? Or is it too early to kind of take a stab at that?

James, at this point, we are not prepared to give specific guidance on the line items for 2007.

Okay, great. Thanks guys.

Thanks. That is all the time we have this morning. I want to thank everyone for participating in the call today. Please remember that our presentation and responses to your questions contain certain statements that could be considered forward-looking for purposes of the Private Securities Reform Act of 1995 and that actual results could differ materially from those projected in any forward-looking statements. Thanks again for listening. Goodbye.

Ladies and gentlemen, this does conclude today's conference. You may disconnect at this time.