Polaris Inc (PII) 2006 Q4 法說會逐字稿

Good morning. My name is Bradley, and I will be your conference operator today. At this time I would like to welcome everyone to the fourth quarter full-year 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) Mr. Edwards, you may now begin your conference.

Thank you, Bradley, and good morning and thank you for joining us for our fourth quarter 2006 earnings conference call. Mike Malone, our Chief Financial Officer and Tom Tiller, our Chief Executive Officer will be participating in the call today. Bennett Morgan our President and Chief Operating Officer is also here and is available to answer questions. As before we will be discussing certain topics including product demand and shipments, sales and margin trends, income and profitability levels and other matters including more specific guidance on our expectations for future periods which should be considered forward looking for the purposes of the Private Securities Reform Act of 1995. Actual results could differ from those projected in any forward-looking statements, which by their nature involve risk and 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 we will turn it over to Tom.

Thank you, Richard, and good morning everyone, and thank you for your interest in Polaris. Earlier this morning we reported both fourth quarter and full-year 2006 results for Polaris. The fourth quarter the operating results met our expectations. Sales were $448 million, down 15% from last year, and earnings per share from continuing operations were $0.93 per share, down 6% from last year. These results are near the high end of the range that we discussed in the third quarter call. The full-year results earnings per share from continuing operations of $2.72 per share, down 14% on an 11% decline in sales.

2006 was a disappointing year for the company. The negatives outweighed the positives. For the first time in the last 25 years we did not produce record earnings per share results. Both the ATV and snowmobile industries declined, and we lost market share in each. We did not do a good job managing dealer inventory. We were not successful in completing the KTM transaction, and our gross margins eroded. So it was a tough year for us. But there were also some positives in 2006. We had an excellent year in our Ranger utility vehicle business. The Victory motorcycle division performed well, and we had another terrific year in financial services. Our product quality got better, and although the results were well below our expectations, this was still the third best year in our 53-year history.

Finally and perhaps most importantly, we learned some important lessons from our mistakes in 2006, and we've incorporated that thinking into our plans for the next three years. That plan follows the same outline that we discussed in the third quarter call, and I'm happy to report that we've made some good progress over the last 90 days. At that time we talked about the need to improve dealer inventory and to get our ATV business more competitive. North American dealer inventory of ATVs is down substantially from a year ago, and we are on track to have the dealer inventory back where we want it to be by this summer.

We also said then that we would announce our entry into two new market segments and accelerate growth in adjacent markets. That work is progressing well, and I will talk more about it in just a few minutes. All in we believe that 2007 will be a year of getting the business back on track. We should see better results than 2006, but frankly still nothing spectacular. Based on some of the growth initiatives that we will discuss, we think that 2008 and 2009 have the potential to be very good years for Polaris.

With that overview let's turn to the individual business segments, starting with the all-terrain vehicle division. The ATV division representing about two-thirds of the revenue of the company, had a decent fourth quarter. To cap it was a tough year. As expected, ATV shipments were down 13% for the quarter as we drove dealer inventory down substantially from year ago levels. Many of you are aware that the core North American ATV industry has declined somewhat over the last couple of years. For 2006 in the United States retail sales of ATVs were about 750,000 units, down approximately 5% from 2005. You may recall that in '05 the industry decreased by 4% and in '04 the ATV industry grew by about 2%. As I have mentioned previously, we lost the competitive battle in '06 as our ATV retail sales declined faster than the industries.

Promotions in the ATV category continue to be at a high level but are relatively stable for the most part. This is an area that we continue to monitor closely as most of our competitors are all dealing with the same basic issues that we are. As has been the case for many quarters now, the Ranger line of utility vehicles is dramatically outperforming both ours and the industries core ATV performance. Rangers continue to grow very nicely, and we believe that we are gaining market share in this category primarily based on the strength of our product offering. Rangers now account for about 25% of our ATV business, and Ranger retail sales are not included in the industry retail sales data that is commonly referenced.

In terms of 2007 job one is getting Polaris's core ATV business back in a healthy, competitive position. We have an integrated plan to do just that, to become more competitive in a slower industry. That means fighting harder with product, advertising, marketing and getting our dealers' inventory situation fixed. You should expect a slower first half of shipments and a stronger second half. We have a good productline, and it will get better throughout the year. In the first half we expect success from the new line of high-performance sport quads powered by KTM engines. As we get to the middle of the year look for the recently announced Ranger RZR to make a very positive impact. For the full year we expect the core ATV industry to be down again, perhaps at a similar rate to 2006. We expect to outperform the industry in 2007.

Snowmobiles. The snowmobile division had a generally disappointing '06, '07 season thus far, largely driven by the weather. On the other hand, the factors within our control like product performance, durability, quality and inventory have been positives this season. The snowfall thus far this winter has been very disappointing in the East and the Midwest. Most observers have labeled it the most unfavorable weather conditions for winter sports of the last 25 years. On the other hand, the western part of North America has had good to very good snowfall. Season todate retail sales of snowmobiles across the industry are down double digits from a year ago, and dealers from all manufacturers, particularly in the East, are experiencing substantial stress. Fortunately, we have built a very conservative plan coming into this season.

You will recall that we took shipments down approximately 40% in 2006, and as a result dealer inventory of Polaris snowmobiles is actually substantially lower than a year ago. On the other hand, the rest of the industry has seen a substantial increase in dealer inventory. So we are in relatively better shape in this important area. Our products, where there has been rideable snow, have performed very well this season. Customers are pleased with the performance and reliability of our model year '07 lineup. As a result, we expect the results from the snowmobile business during '07 to be down a little bit from 2006. Given the weather, things could have been much worse had we not built a conservative plan. So we expect them to be down some, but we don't anticipate a big swing despite the unfavorable weather conditions. In the next quarterly conference call following the end of the riding season and after our annual dealer meeting we will be more specific about the new model year '08 products in our future guidance.

Victory motorcycles. The fourth quarter closed what was another strong year for the victory motorcycles division. Victory shipments were down 10% for the quarter, but up 13% for the full year. Consumer and dealer interest in victory motorcycles continues to grow rapidly, as we've seen throughout the fall and winter motorcycle shows, including the most recent international motorcycle show in New York City. The overall motorcycle market had another all-time record year in 2006 with a 1.3% increase in U.S. retail registrations to just over one million units. Victory's retail sales pace dramatically outperforming industry in 2006 and for the second consecutive year grew by more than ten times the overall market. So we've accomplished a lot since entering the motorcycle market just nine years ago. We are now the second-largest American manufacturer of motorcycles. 2006 was the first full year of profitability for Victory, and that profitability should accelerate with time and volume. We are growing retail sales at ten times the rate of a growing market. We are building literally the finest motorcycles in the world as measured by credible third parties and our own internal data.

We have created a unique brand positioning Victory, the new American motorcycle that is both relevant and sustainable and awareness of the Victory brand is growing fast. We've expanded our dealer network in 2006 by 12% to 362 dealers, and we expect the network to continue to grow. And finally, we are poised to enter another large and profitable segment, the luxury touring segment. So 2007 should bring more good news for Victory with the recently announced luxury touring model, the Victory Vision we are preparing to take the business to the next level of performance in terms of styling, product appeal, quality, technological sophistication and brand awareness. We couldn't be more excited about the victory motorcycle business.

Parts, garments and accessories. Considering the environment, we have had a relatively good close to the year in PG&A with sales down just 1% for the quarter. Considering the lack of snowfall and riding along with a sluggishness of the ATV industry, PG&A delivered good results. Innovation continues to be the story with new lock and ride cab designs for Rangers, easy to install ATV and utility vehicle accessories and the introduction of all new products like the Polaris VersaWinch.

International. International sales were up by 6% for the quarter, driven by ATVs, and were flat for the year. Like in North America, we successfully reduced inventories in the international market. We expect some modest growth in '07 outside of North America. If you were at our investor day last week in New York, you undoubtedly sensed our optimism about the future. Part of that optimism was driven by what we've accomplished very recently. Over the last 90 days our team has taken some aggressive steps to improve the long-term performance of our business. First, we delivered the fourth quarter to plan. We've reduced our cost structure to better compete in a declining ATV and snowmobile markets. This was a tough but necessary step. We've resolved the KTM share ownership issue on terms acceptable to both us and KTM. We maintain a positive relationship with KTM, and they will continue to supply us engines for our sport ATVs. We've significantly reduced ATV dealer inventory, and we will execute a plan to have that issue behind us in six months. We've developed, and we've begun to implement a plan to improve the overall competitiveness of our core ATV business.

We expect to gain market share in 2007. We have completed a substantial stock buyback. Including the ongoing share repurchases, we've bought back nearly 17% of the company in 2006. Suffice it to say that we believe in the future of this enterprise. We've recently announced two very important new products, our entry into the recreational side-by-side market with the new Ranger RZR and our offering in the luxury touring segment of the motorcycle business with the Victory Vision. Both these new products have been very well-received by the press, Polaris and Victory dealers and consumers. We've developed an achievable operating plan for 2007 and perhaps most importantly, we've developed a clear, long-term strategy to grow the business, and I will talk about that next.

Our new three-year plan has three clear measurable goals. First, $2.2 billion in sales by 2009. Second, $150 million in net income and third, $4.25 per share in earnings per share. To achieve these financial objectives we will employ three strategies. Winning in the core, delivering operational excellence and growing $500 million of new business by entering both new segments of our existing businesses and by entering two adjacent markets. I will outline each of the three parts of the plan very briefly.

Winning in the core means strengthening our ATV and snowmobile businesses. It means gaining share in a declining market with better products, more and better advertising and more effective marketing. It means fighting harder and winning. Delivering operational excellence means becoming the Toyota of the power sports business. While we have always had strong manufacturing operations, we believe we can find an entirely new level of performance. And just like Toyota is using the back end of their business to their competitive advantage, we think we can find new levels of quality and productivity to help us win in a tough market.

Finally, we can grow this business by $500 million between now and 2009. Both Ranger and Victory have been growing rapidly and should continue to grow. Fueled by new products and account for between $100 million and $150 million of growth each over the next three years. The International opportunity should drive $50 million of incremental growth, and the military opportunity is both real and significant for Polaris. It alone represents $50 million to $75 million of growth between now and 2009. Finally, we will announce one other significant new market opportunity at some point in the future. And each of these three strategies are supported by investments in our people, our technology and the Polaris and Victory brands. All in, we are about delivering awesome products, products like the new Victory Vision and Ranger RZR, being customer focused and delivering outstanding results that both you and we expect from Polaris.

Before I turn it over to Mike, let me close by summarizing our expectations for 2007. '07 will be stronger than '06. For the full-year we expect revenue to grow modestly, up 1 to 3%. We anticipate that revenue will be down in the first half of the year as we adjust inventory levels and improve in the second half. The environment will remain tough with a down North American ATV industry and a down snowmobile industry. I expect us to outperform our competitors at retail. Gross margins are expected to improve in excess of 100 basis points. Earnings per share should grow 3 to 7% or in a range of $2.82 to $2.90 per share.

We are confident that with the plans we have in place 2007 should be a better year for us, and we will get the business back on track and position us for growth in '08 and beyond. At this time I would like to turn it over to our Chief Financial Officer, Mike Malone.

Thanks, Tom, and good morning to everyone. As Tom stated, 2006 was a difficult and disappointing year for Polaris. For the first time in many years our sales and earnings are below the prior year. We are not happy with these results. However, 2006 is behind us, and we have taken and continue to take steps that should make 2007 a better year in both sales and earnings per share growth for the company. As before my comments and guidance today relate only to the results from continuing operations of the company unless otherwise noted.

I will begin my comments with a review of our guidance for the full-year 2007, and then we will move on to more specific guidance for the first quarter and a brief review of certain aspects of our fourth quarter 2006 results. Total company sales for the full-year 2007 are expected to increase in the 1 to 3% range for the full-year 2007. Although operating income is expected to increase, net income is expected to decrease somewhat for the full-year 2007, as a result of higher interest expense and no KTM income benefit in 2007.

For the full-year 2007 we expect diluted earnings per share from continuing operations to be between $2.80 and $2.92 per share, which is an increase of 3 to 7% compared to the $2.72 per share earned for the full-year in 2006.

Expectations for sales growth for the full-year 2007 by productline is as follows. ATV sales are expected to be flat to up 3% with our core ATV shipments down for the year as we continue to help our dealers make corrections in their inventory levels while we expect the side-by-side utility vehicle shipments to grow strong double-digit percentage growth for the full-year 2007 as the market continues to grow. As you know, we cut our snowmobile build and shipments drastically in calendar 2006, which has had the effect of lowering snowmobile dealer inventories from last year. That's the good news. The bad news is the retail selling season has gotten off to a slow start. Although the selling season is still in progress, and we have not yet taken dealer orders, based on the current available information we expect our snowmobile sales to be down single digits percent for the full-year 2007 compared to '06.

Victory motorcycle sales are expected to increase in the mid teens percent range, continuing its positive trend of recent years and PG&E sales are expected to grow at similar growth rates of the overall company sales. For the first quarter of 2007 total company sales are expected to decrease 6 to 8% from the first quarter of 2006 as we continue to work with the dealers to reduce core ATV dealer inventory levels. With earnings from continuing operations expected to be in the range of $0.23 to $0.25 per diluted share compared to earnings per diluted share of $0.26 in the first quarter of 2006.

I would like to briefly comment on the actual fourth quarter 2006 Victory sales, which were down 10% for the quarter and were somewhat less than our expectation. Our Victory production and shipment rates were less than desired during the fourth quarter as we worked through a supplier delivery issue, which has now been resolved. The gross profit margin percentage expansion of 290 basis points in the fourth quarter of 2006 was positively impacted by the sale of higher gross margin products, a recovery for ATV duties previously paid in the EU, favorable currency FX and savings from various cost reduction initiatives, all of which were partially offset by higher promotional and dealer floor plan interest assistance expenses, primarily for snowmobiles.

The gross profit margin percentage for the full-year 2007 is expected to expand in the range of 100 to 130 basis points compared to the full-year 2006 percentage of 21.7%. Due to manufacturing efficiencies and cost reduction efforts along with lower snowmobile warranty expense as a result of improved quality. Offset somewhat by the expected increases in ATV promotions and incentives to improve our competitive position. Operating expenses are expected to increase both in dollar terms and as a percentage of sales for the full-year 2007 primarily due to increased advertising expenses to support the launch of our new products and an anticipated higher, more normalized incentive compensation cost as the company's financial performance improves.

Income from financial services is expected to decline somewhat for the full-year 2007 after several years of increases. The income from the wholesale credit portfolio is expected to decrease in '07 as dealers lower their inventory levels and their related interest payments to Polaris acceptance. The income generated from the retail credit portfolio in 2007 is expected to be about flat with that in 2006. For the full-year 2006 we financed through the retail credit program with HSBC about 36% of our products sold to consumers in the United States. Similar to the penetration rate for last year. The volume of revolving and installment retail credit contracts written in 2006 was $784 million, a 40% increase over 2005 due in large part to the success of an additional program related to use and non Polaris products financed through our HSBC relationship.

At the end of '06 the wholesale credit portfolio related to floor plan financing for dealers in the United States was approximately $747 million, a decrease of 6% from the end of last year, reflecting the recent decline in dealer inventories. Credit losses in this dealer portfolio remain very reasonable, averaging well less than 1% of the portfolio. You will note that the equity in income of manufacturing affiliates was recorded at nearly zero for the fourth quarter of 2006. During the fourth quarter the Company entered into a share purchase agreement to sell during the first half of 2007 approximately 1.38 million shares of KTM investment, which is about 80% of the shares that we own. The proceeds to be generated from the sale are approximately equal to the amount recorded as an asset on our balance sheet related to the shares. Since the transaction purchase price has been fixed at approximately the asset value, the company no longer will receive a net benefit from its percentage of KTM income in our income statement beginning in the fourth quarter of '06 and continuing into 2007.

The income tax provision was recorded at a rate of approximately 32.2% of pre-tax income for the fourth quarter 2006 and at a rate of about 31.1% of pre-tax income for the full-year '06. For 2007 full-year our current expectation is for the income tax provision rate to be approximately 33% of pre-tax income, reflecting fewer non-recurring tax benefits expected in '07. As Tom mentioned, during the fourth quarter of '06 we were buying our stocks aggressively and repurchased over 4.3 million shares under our share repurchase program at a cost of $198 million bringing our total repurchases for the full-year '06 to about 6.9 million shares and $308 million. As we have previously disclosed, the fourth quarter purchases include 3.55 million shares of common stock repurchased in connection with the accelerated share repurchase agreement entered into in December with Goldman Sachs.

These aggressive 2006 repurchases and the resulting lower share count will obviously help our 2007 earnings per share comparability throughout each quarter in 2007. An additional 4.8 million shares remain available to repurchase under the Board of Directors authorization, although it is unlikely we will be repurchasing any additional shares until the accelerated buyback program has been completed.

Taking a look at some cash flow and balance sheet information for the 2006 year, our net cash flow provided by continuing operating activities was $153 million for 2006 or about 6% lower than that generated last year. The decline in cash flow relates primarily to the lower net income in '06, as well as higher factory inventory levels. We expect cash flow provided by continuing operating activities to increase for the full-year 2007.

Accounts Receivable at December 2006 were $64 million, a 19% decline from last year, reflecting the lower sales volume experienced in the latter part of 2006. Inventories at the end of the year were $230 million, a 14% increase from a year ago. Inventories were up primarily due to model year 2007 ATVs that have not yet been shipped to dealers as of year end. Production levels of ATVs are being reduced for the balance of 2007 model year to compensate for the heavier year end ATV inventory.

For the full-year 2006 we made investments in the business through capital expenditures and new product development tooling, totaling $52.6 million, which is lower than a year ago due to the completion of our R&D facility in 2005. Full-year 2007 capital expenditures are expected to increase to be in the range of $60 to $65 million, and as we invest more heavily in new product development tooling and capital projects to reduce our production costs and improve our product margins.

We expect depreciation for the full-year 2007 to be in the range of $65 to $70 million. On January 18, a week or so ago, we announced that our Board of Directors approved a 10% increase in the regular quarterly cash dividend to $0.34 per share per quarter, which currently represents about a 3% yield. This is our twelfth consecutive year of increasing the dividend paid to shareholders. We are very proud of that record.

Total debt levels finished the year at $250 million primarily as a result of the term loan utilized to complete the accelerated share repurchase transaction. Debt to total capital at the end of the year was 60% compared to just 5% last year, again as the result of the significant impact of the additional debt on the numerator and the accelerated buyback on the denominator of the calculation.

EBITDA from continuing operations was $244.7 million for the full-year 2006, down 10% from a year ago. So to recap our full-year 2007 guidance our total sales for the year are expected to increase in the range of 1 to 3% with EPS from continuing operations growing to $2.80 to $2.92 for the full-year 2007, an increase of 3 to 7% over the $2.72 per share earned in 2006. First quarter 2007 sales are expected to be down 6 to 8% with earnings per share expected to be in the $0.23 to $0.25 per share range compared to $0.26 in the first quarter of 2006.

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

Mike, before we do the questions I want to correct one minor thing that I said in my prepared remarks. I made an error. It was my dyslexia coming through. I think I gave full-year guidance that said $2.82 to $2.90, and the correct guidance should be $2.80 to $2.92, which is what you said in your prepared remarks. I just made an error and just want to make sure there was no confusion out there.

Thanks, Tom. Bradley, we are ready for questions.

(OPERATOR INSTRUCTIONS) Edward Williams, BMO Capital Markets.

Can you give us some color as to how much of the difference between the first half of the year and second half of the year is going to come from the expected improvement is coming from new products coming onto the -- being released, as well as coming from the better dealer inventory levels on existing products?

I think both will be helpful developments. As we said in the prepared remarks, we think that based on our forecasts that dealer inventory should be at a desired level by the summer of this year. And at that point, we have our 2008 model year introduction, which we believe will be a strong introduction of new products. So those two things kind of work together, I think, getting the inventory down. Dealers, obviously, are anxious to do that. And also seeing what is new and exciting coming from Polaris.

In addition to that, the two new products that we introduced last week, you may have seen the new Ranger RZR and the new Victory Vision. Both of those are essentially second half, and in the case of the Vision mostly fourth-quarter introductions. I suspect based on the reaction that we've seen to those products they will be quite popular.

So I think both factors, both reduced dealer inventory and also the new products that we have announced and will announce, I think will work together to make the second half stronger than the first.

Then looking at your cost-cutting initiatives, specifically looking at headcount, are you at the level that you would like to be at this point? Do you anticipate any more moves along those lines to bring costs out of the Company?

With regard to cost-cutting, I think we did not talk a lot about that in the prepared remarks or typically we don't, I guess, in these earnings announcements. But I think we had a very good year in terms of overall improving the efficiency of the operation. We talked about this operational excellence. We're going to continue to work very hard in that direction.

We do not anticipate at this point that would involve additional headcount reductions. We reduced our workforce to the levels that we think were prudent, and nothing has changed at that point. Obviously, if the market makes a change if there is some kind of external factor, we will reevaluate that. But based on what we know right now, we are very comfortable with where we are from a staffing point of view.

Okay, and then last question for you is when should we hear more about the move into the adjacent markets? Another way of asking it is how significant or meaningful could it be in 2008 with regards to your '09 goals?

We talked about at the investor meeting that we had last week in New York City, we talked a little bit about one of the two adjacent markets, that being the military opportunity, and we believe that is a significant market for Polaris. We quantified that as generating revenue growth of somewhere between $50 million and $75 million between 2006 and 2009.

As you may be aware, we are already selling to the military and have, actually, for a number of years on kind of a test basis. Those products have performed very, very well in theater, both in Afghanistan and in Iraq. And we continue to work with a number of customers across the armed services to develop vehicles that meet specific mission applications. It is not just one customer. It is not just one mission. It's a variety of customers and missions, but in aggregate we feel very good about that.

So we will talk more about the military opportunity as the year goes on and as we demonstrate capability and see some success or maybe some setbacks as we go along. So you can expect us to talk a little bit more about that. With regard to the second new market opportunity, we won't say anything about that until we get there. So that is at some indeterminate point in the future, and you're going to just kind of have to bear with us on that. We are working on that, but we are just not from a competitive point of view in a position to announce that. So that will be at some point down the road here.

Okay, great. Thank you very much.

Ed Aaron, RBC Capital Markets.

Good morning, everybody. A couple questions for you. I was actually a little bit surprised to see that your Q1 earnings are expected to decline only positively with a 6 to 8% sales decline. And that would actually seem to suggest that maybe you would see more earnings growth than you are forecasting when sales turn back positively in the second half of the year. Am I missing something from a margin perspective that would mislead me there?

I don't think there is anything -- I don't think you are necessarily missing anything. We expect gross margin expansion for the full year, as I said. We had some significant charges to the first quarter of last year as we got our snowmobile business adjusted that we don't expect to occur again in 2007, which should help our gross margins in the first quarter of the year also.

I think that is the main thing, and it's just the snowmobile situation. While the weather is obviously disappointing for us and for everybody in the industry, the business fundamentally is a heck of a lot healthier than it was a year ago. The product quality is very good. Inventory levels are down. We are seeing increased promotions across the industry. But if you look at our part of that, it is significantly less, perhaps, then some of the others just driven by the inventory situation. So I think that is probably the one most significant factor if you look at Q1 '07 versus '06.

That makes sense. Also wanted to ask you about the finance income that you are benefiting from from the new program in which you are financing the non Polaris products. I am just trying to understand the value that you provide in order to get that income. So in other words, what incentives do your dealers have to use your partnership to finance your competitors products?

We've got a very attractive program that we've established with HSBC that is attractive for us, but it's also very attractive for the dealers that encourages them to utilize this program to sell not only our products, but competitor products or even products that aren't even in our competitive space to the consumer utilizing that program. So it is a program we've developed. It is attractive. We've made it attractive for the dealer, and they are choosing that vehicle rather than alternative financing sources.

The value add is a relationship we have with that dealer. And we've built I think a very successful financial services business across both wholesale and retail side, so it is kind of the next logical step for us. And if we can help that dealer on financing a used vehicle that can help a new vehicle transaction. So it helps our whole good business. And again, it is for us for Polaris there is no risk. It is a fee-based program for us. So it's great for the dealer, it's great for us, it is a profitable business for HSBC. So I think it is a win-win.

Great. One more question if I could quickly. The international business, could you maybe just give us an update on the trends in Europe? You talked about the more aggressive promotional activities seen over the last few quarters. Can you just give us a brief update? Thanks.

Just for time I didn't spend much time on international. International is through '06 is down a little bit there the first three quarters. We saw a nice, positive, modest but positive increase in sales in the fourth quarter. We were kind of cautiously optimistic about that. A lot of the same things, the same themes that you hear about in the North American business; the higher interest rates and until recently the higher fuel prices. While I didn't mention that in my prepared remarks, that is a positive trend for us, and we will see how that develops. But gas at $2 a gallon is a whole lot better for us and our customers than gas at $3 a gallon. So that is a favorable development both here, and of course with the even higher fuel prices in Europe, that can be a helpful development.

Generally I would say our business is stronger in northern Europe than southern Europe if you look at markets like Spain and France, which historically have been pretty good markets for us. They are a little slower with really different reasons driving that; France really going through some fairly challenging land access issues. We are seeing some shifts in the market where the lower end of the ATV market is slower. That is probably a positive for us. We tend to sell at the upper end, so we sell Sportsman 800 and Sportsman 500 to larger, more expensive American products. And the more imports, the Chinese, Taiwanese type part of the market is actually slowing. We believe part of it driven by some of the quality issues that perhaps some of our Asian competitors have had. So overall it's not great. It does seem like it is improving. That is helpful. And snowfall in Scandinavia was good early -- kind of weak in the middle and recently been improving a little bit. Maybe that's helpful, a little bit of color.

Thank you.

James Hardiman, FTN Midwest Securities.

Good morning, guys. I was hoping you could give me a little bit more color on what looks like a great gross margin number. You talked about some of the factors. Is there anyway you could quantify the currency impact, as well as maybe some of these other issues?

Are you talking about in the fourth quarter, James?

Yes.

I do not think I am going to get any more specific with the numbers. I indicated the drivers. Currency, as you mentioned, was helpful, both the Canadian dollar and the Euro and other European country currencies have generally all moved in our favor during 2006. So that has been helpful. Our cost reduction activities are really starting to pay off in helping us reduce our base costs of the products that we develop. So that is helping quite a bit. We do have a little bit of -- we talked about this last quarter also, but there has been a change in the duty levy in product that is imported into Europe. So we have received both in the third quarter and the fourth quarter some benefit from that refund, as well. Those are the primary drivers.

I guess the only thing I would add is maybe a little bit of the snowmobile thing we talked about in the first quarter, too, on a year-over-year basis fourth quarter of '06 is substantially better than fourth quarter '05 with some snowmobile issues.

Okay. I mean you did mention that one of the things that you were offsetting was some increase in promotional activity with the snowmobiles. I would have assumed that ATV promotions would have been up as well, given sort of your goals to work down some of that inventory. Was that not really the case in the fourth quarter, and is that more of a first half of '07 event?

I think with regard to ATV promotions we've talked about making the ATV business more competitive. I read some of the stuff that came out of our New York meeting with investors, and I'm not sure maybe we weren't perfectly clear there. Some people have sensed that we are going to go to an automotive style, promotional war, price war, that kind of thing. We are going to make the ATV business more competitive through a variety of factors, product being the most important. In our business you win and lose with product. So when you see things like the Ranger RZR, that is an awesome new product that will as part of our utility vehicle business which obviously we report as ATVs, you can expect us to have more product news. You can expect us to do more and better advertising. I think as I look back at the last couple of years I think we've under advertised some of our new product launches, and Bennett, when he went through his presentation in New York talked a little bit about that. And more and more effective marketing. And I do expect us to be competitive with promotions, but don't anticipate that there is going to be some wild humongous change. I think we had -- we are going to be competitive with what is in the market, but don't expect a major seachange here in terms of at least our promotional activity. And I think you properly characterized that and I think in my prepared remarks I talked a little bit about the promotions are heavy, but relatively stable.

With regard to snowmobiles, promotions have increased. Promotions have increased. As we get towards the end of the season and dealers and other manufacturers are looking at higher levels of inventory and we've taken our promotions up a little bit, in response to that. But because our inventory situation is fundamentally different than our competitors, our piece of that has been relatively muted. So you can talk about promotions. You can talk about floor planning assistance and all those kinds of things that we typically talk about with snowmobiles. And of course we put those snowmobile related costs into the fourth quarter results as best we can estimate given where we are at this point in the season. So Mike, do you want to add to that?

That's perfect.

I guess another way to get at this gross margin question, which of these benefits in the fourth quarter are one time and which are repeatable? When I look at your gross margin guidance of 100 basis points of an increase of 100 basis points in 2007 my initial assumption would be that a lot of that is more second half weighted than first half waited. But then again, I would assume that gross margins would be down in the fourth quarter but they are up 300 basis points in the fourth quarter. Am I looking at this the right way, or is there something I'm missing there?

The things that are going to drive gross margins up in '07, the sustainable parts, we are going to see some nice product mix improvements. If you look at the parts of the business that are growing the fastest, they tend to be a little bit mix heavy. As Mike mentioned and I mentioned, we've had some very nice cost reduction efforts. Those are going to continue. The quality improvements particularly around snowmobiles, we are going to realize a full-year benefit of that. What is not predictable or necessarily repeatable, we don't know what the currency situation is going to be anymore than anybody else does. We also, the duty reductions that we saw in the fourth quarter from the European ATVs, that is a onetime thing. We will see the benefit of it but on a relative basis we won't see improvement in that. Mike, any other --

The only thing I would add is you mentioned currencies are uncertain. When we build a plan and give guidance we expect the currency impact to be flattish, given the uncertainty. So we are not expecting any positive or negative impact in currency in '07.

And just one last thing. Is it safe to say I'm assuming at this point despite the fact that motorcycles are profitable, their margins are below overall company margins. So as you sort of saw the declines in motorcycles, did that help your gross margins sort of beyond where you thought they would be for the fourth quarter?

I would say that is very, very insignificant. Our motorcycle gross margins are actually about at company average now. And being less than 10% of our sales, that really doesn't less than 10% of our total sales it really isn't driving anything.

Bob Evans, Craig-Hallum Capital.

Good morning, everyone. Can you comment a little bit on your dealer health and how are your dealers doing particularly in the last few years in the snowmobile market has been difficult. Do you expect dealers to exit that market or what's kind of the overall financial health, if you would?

I think, as I mentioned I think I used the word dealers are under stress. I would say that is particularly true for snowmobile dealers and particularly true for snowmobile dealers in the Northeast, Bob. I believe that we will lose some dealers and I suspect that is true across the industry, not just for Polaris. I think because of our relative inventory situation and the assistance we've been giving the dealers I think that will be a manageable number, but we won't know that for sure until we get to the dealer meeting. We are going to have dealers out west that are frankly on cloud nine for the most part. We've given them some mountain snowmobiles this year that they love, customers love, sales are growing there and we are going to continue to have good news for those guys. So I think the snowmobile dealers out west are feeling good about life, but in the Northeast particularly they are not feeling good about life.

I read a thing the other day I think it was in the New York Times that said it is the worst year for the ski industry in the East in the last 25 years. So it has been a tough, tough year for ski industry, snowmobile dealers particularly in the Northeast. So I'd say snowmobile dealers are under stress in the East, to a certain extent the Midwest and much less so in the western part of the country. With regard to dealers generally I think we have kind of beat this horse to death. I think the primary factor is ATV inventory, and I think as we can give dealers a reason to believe in the future of the Polaris ATV business with new products like the Ranger RZR for example, I think that the dealer situation will significantly improve.

So I think if you track that dealer inventory you can probably track the inverse of that would be dealer morale. So I would say it is dealer morale right now is not great, but I think with the new products it is improving and I think as we bring our inventory down it will improve more. And as we exit the year in '07 I suspect it will be substantially better than what it is right now. And by the way, as I read some of the stuff that is written, I don't see the situation fundamentally different across the power sports industry. If you go look at some of our Japanese competitors and survey their dealers, which we do, you hear a lot of the same things. The consumer spending is down. We've had 17 interest rate increases. The market overall is kind of sluggish for discretionary purchases. And so dealers are conservative. They are watching their bottom lines. They are being cautious about advertising and that kind of thing. It is just as you would expect in kind of a sluggish market.

That's fair. Also can you comment as you look into your '09 goals when do we start to see the operating leverage kind of on the overall expenses? I know for '07 I believe your guidance was in the percentage of sales operating expenses will be up. When do we later in the year do we start to see operating -- this year do we start to see operating leverage or just kind of looking ay as you look at your goals and your leverage, where does that start to happen?

If you look at the '09 goals, Bob, there really isn't operating leverage. We are saying that we are going to grow revenue by 10 and earnings by 10 -- compound annual growth rates at 10% a year in each of those. And then with a buyback the EPS will grow an average of 16, 17% a year over that three-year period. So if you look at the net margin what is implicit in those numbers is really no operating leverage. And we had some discussion and debate about that when we were in New York, and I think that it hopefully is a conservative set of assumptions but basically what we expect to happen is that we will see some operating leverage in the growth parts of the business. If you look at what we call the right side of the chart, the Victory, the Ranger, the international, the military and the other adjacent markets, those are all margin positive events for the company. But until we see signs of growth out of snowmobiles and ATVs we expect that that's going to be a challenge to maintain margin. So net net what we're talking about at the net income margin level is really flat margins over the next three years. Now can we do better than that? Well, it probably depends a little bit on where those markets go, but the assumptions that we have are pretty conservative on the base business. Mike, you want to talk more about that?

I think that's good.

Okay. All right, thank you.

Joe Hovorka, Raymond James.

Just go back on the international one more time. Spain I guess was the area that you had the problem with the competitive pricing. Can you just give a little bit more detail on that country specifically?

Just generally I'll just hit a few of the major regions in Europe, Joe. Spain continues to be sluggish. Market is down, competitive pricing, it is a tough market for us right now. France is also weak as an overall industry really driven by the two factors I mentioned in the previous question. One is land access, which is kind of dampened the overall market and secondly, a mix shift really to the upper end of the ATV category, which is probably beneficial for us. We tend to sell at the high end of the market in Europe maybe like Mercedes sells at the high end of the market in the U.S. car industry. Italy has been good for us, nice growth there. We've seen good growth in across Scandinavia. And starting to see some nice business in Russia, actually, which is a nice growth opportunity for us both in snowmobiles and ATVs and perhaps even motorcycles at some point. So I would say that would be just a general sense -- Germany is still a little sluggish. The UK is a little sluggish. So mix of hot and cold, but all in up about 6% for the quarter, which we will take, and we think some modest growth for '07.

And thoughts on when motorcycles can be sold internationally?

We are selling motorcycles in Canada right now and in some small, selected international markets. We are going to -- you should probably expect we will do a little bit of expansion in that as we go into '07 and '08. We have not announced a major expansion kind of the pan-European part of that, and we are not going to do that today. We are not going to announce that today. So we will see. But you've got to have something left for the second quarter, right?

Right. And if I missed this I apologize but CapEx for '07? And can you give the warranty numbers, the P&L charge-offs and the actual cash warranties in the quarter?

Certainly, Joe. The capital expenditure expectations for 2007 is to be in the range of $60 to $65 million. The warranty reserve at the end of the year ended up at $27.3 million. It started the year at $28.2 million. Our expense charges during the year was $33.2 million, which is down 9% from last year, which is related to the lower sales volume in '06. The actual warranty claims paid out for '06 was $34.0 million, which is about 4% less than the actual claims paid a year ago.

And then just one last question there is a lot of talk about foreign currency. You had about a $4 million shift in the non operating income line from foreign currency. Can you just explain again the difference between what is happening in gross margin and what this is on the non-operating line item?

What is going on in gross margins is more related to the sales activities from the operations. Other income is more the actual cash transactions that occur. Most of what's going on there is transactions related to our subsidiary operations, where we move the cash around. And basically it reflects the change this fourth quarter the dollar was weak, and a year ago relatively speaking the U.S. dollar was stronger.

So those are translation gains coming back from your subsidiaries in international markets?

Right.

Thanks, guys.

Tim Conder, A. G. Edwards.

Bradley, this is going to be our last question. We are out of time here. So go ahead, Tim.

To follow on on Joe's question regarding Victory. Internationally you started shipping a little bit into the UK. What time would you estimate Victory will be part of the international versus domestic sales mix looking out '07 then maybe to '09? And then you didn't mention UK in any of your international comments, and then Germany with a strong economy and KTM distribution is it a market issue there, or is there something with the change in the KTM relationship hurting in Germany?

Okay, let me see if I can take those one at a time, Tim. In terms of Victory internationally it is a small part of our overall international effort right now. I would say we are kind of testing the market more than anything else, Tim. We haven't been in the UK. We are in a few other small markets. You can expect us to enter a few more small markets this year and really just trying to learn in smaller markets, what does it take to establish the motorcycle outside of North America. You've got a brand that while domestically we are just tickled pink about the growth of the Victory brand and awareness and what the Victory brand means among motorcyclists, internationally it is like when we are starting from scratch. Nobody knows who Victory is. So it is a small part, and I think it is going to continue to be a small part. The big question for us, of course, is when do you take the motorcycle to Continental Europe?

The motorcycle market in Continental Europe is larger actually than it is in North America. There is some very different segments that are emphasized. It tends to be more of a sport bike market. Harley obviously has a strong presence there and we've looked at what they've done and tried to figure out what makes sense for us. So we will kind of see how that goes as we go down the road. But we are aware that they sell motorcycles over there, and at some point probably it makes sense. But we will see where that is down the road. I did mention a little bit about the UK; primarily what we sell in the UK is ATVs into the ag market. We do have a handful of Victory dealers. The ATV market is a little sluggish for us in that market right now. The Victory thing is actually going quite well on a relative basis. It is very small, but those handful of dealers that kind of struggled in the first couple of years are finding a little bit better success, so we are pleased with how that overall test market has gone.

I think you asked about Germany, what is going on in Germany. I'd say Germany the economy may be doing well and I saw Harley's international business was terrific. Our business in Germany is not great right now, and we have a plan to try to straighten that out and we will keep that one to ourselves. And as that plan develops, we will share it with you but we are not thrilled with the way things are going in Germany, but we think we do have a plan to get things going better there. The opportunity there, if you look at where the big international markets what is going to drive the growth it is fixing Germany and to a certain extent Spain. Its continuing to do well in the markets that we are doing well. Russia we think may represent a pretty significant long-term growth opportunity for us, and you look way down the road you look at markets like China and India. Those could be interesting, although that's certainly quite a way down the road.

You mentioned R&D as part of the overall plan going forward. Do you anticipate that compared to '06 as a percent of sales that piece going up? And then Mike, maybe more of a little housekeeping here. Any commentary where you are hedged or not, Canadian dollar and yen for '07? And then your ending share count at 12/31/06.

We would have been very disappointed had you not asked the hedging question, by the way. R&D expenses actually probably on a year-over-year basis might be down a little bit '07 to '06. I would describe the pipeline of new products, though, being quite strong. If you look at products like the RZR and the Vision, we are obviously very excited about those products. I think the customer reaction has been extremely strong to both of those. We have more stuff like that coming so I think the whole idea of awesome products and at the end of the day Polaris is a product driven company. And I feel good about where the product pipeline is. I will let Mike either choose or not to choose to answer your remaining questions.

The hedged position on the Canadian dollar and the yen are unchanged from a quarter ago. So we've got some hedges on the yen. We have no hedges on the Canadian dollar at this point. As I said earlier, the Canadian dollar right now is a little bit negative compared to in '07 compared to '06, and the yen is positive. And I think they will roughly offset each other as far as an impact that we expect in 2007.

Your last question was the ending share count at the last day of the year, and Tim, I don't have that number in front of me. What I have is the average counts, which are in the press release.

I will have to follow-up on that, Mike.

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

And then one last clarification question on the EU duty recovery or refund that they are giving. If I heard you right that is basically done and when you were discussing the question regarding the fourth quarter what will continue and what won't. So that is basically done, just to clarify that.

What has happened is the duty has been lifted, so going forward we will no longer pay a duty to import product. So we will get the benefit of that going forward. What we got in both the third and fourth quarter was a refund of some previously paid duties, which obviously won't repeat in '07.

Thank you, gentlemen.

That's all the time we have today. I want to thank everyone for participating. We will talk to you next quarter. Goodbye.

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