Polaris Inc (PII) 2009 Q2 法說會逐字稿

Good morning, ladies and gentlemen. My name is Lori and I will be your conference operator today. At this time, I would like to welcome everyone to the Polaris second quarter earnings results 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)

At this time it is my pleasure to turn the conference over to Richard Edwards. Please go ahead, sir.

Thank you, Lori, and good morning and thank you for joining us for our second quarter 2009 earnings conference call. As in past quarters we will be showing a slide presentation that is accessible at our website at www.polarisindustries.com/irhome which has additional information for this morning's call. The speakers today are Scott Wine, our Chief Executive Officer, Bennett Morgan, our President and Chief Operating Officer, and Mike Malone, our Chief Financial Officer.

During the call today 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. Additional information regarding factors that may influence results can be found in Polaris's 2008 annual reports and in the 2008 Form 10-K, which are on file with the SEC.

Now I will turn it over to Scott. Scott?

Thanks, Richard. Good morning. Thank you for joining us and for your interest in Polaris. Earlier today we reported results for the second quarter 2009 that slightly exceeded our expectations. The results were primarily driven by the strong performance of the Polaris team and our dealer network as we continue to face significant headwinds in nearly every market we serve. Earnings per share came in at $0.53, down 26% from the prior year period. Sales for the quarter were down 24% to $345.9 million from the second quarter 2008. We saw weak demand across almost all regions and markets, with Canada being the one bright spot with sales to dealers down only 8%. Retail credit availability metrics actually improved in the quarter but dealer floor traffic continues to be weak. Creating demand is one of our key priorities for the remainder of the year and our dealer show next week here in St. Paul will feature a great deal of product news that we expect will once again lead the industry.

I will go ahead and cover one bit of product news that we announced this morning with the press release, which is our entry into the low emission vehicle space with our first electric neighborhood vehicle. This is the initial new product launch by our on-road division and is yet another example of Polaris innovation and product development capability. This product puts us into a small but growing market, and also provides technology expertise that has many potential applications across our business. We will launch the new product, which will be named the Polaris Breeze, with a small sample of unique dealers that have prime access to the important master planned communities where these products will be used. This is an attractive market expansion for Polaris providing access to a new and growing customer base. It also provides the opportunity to participate in the growing demand for low emission vehicles in what we believe is an underserved and fragmented market with few purpose-built vehicles. We do not anticipate a significant impact on our financials in the near term but see this as a start in the low-emission vehicle space which we fully expect to evolve into a growth business for Polaris.

The press release provides additional information on the product, but I will quickly highlight the key features of the Breeze. The vehicle is designed for multiple customer uses. It offers the type of innovative and utilitarian neighborhood vehicle that you would expect from Polaris with our renowned ride and handling capability that will immediately be a market leading feature. Many other key differentiators for this vehicle were designed with residents in master planned communities in mind. Primary among these is an industry first, three-in-one rear seat conversion which can be performed with ease and speed. The conversion feature allows for the vehicle to be quickly and easily changed for use as a golf car, a four-passenger vehicle, or for carrying cargo. We are excited about bringing this product to market and this technology to our other applications in our business and look forward to sharing our future growth plans in more details in the weeks and months ahead.

While it would be nice to spend the next hour talk talking about the rest of our product news we do have important results to share. But it is product advantages that are enabling Polaris to gain share and outperform in our power sports space. Looking more closely at second quarter sales which were slightly better than our expectations, off-road vehicles were the big volume driver in the sales decline. Although we continue to gain share in both ATVs and side-by-sides in the quarter. On a percentage basis, it was our Victory motorcycle business that was down the most, off 55% versus the prior quarter of 2008. Our international sales were down 30% with nearly half of that coming from currency impact. We continue to benefit from product mix and price, but these only partially offset the volume weakness. Currency remained a headwind in the quarter with a 4% negative impact on total sales. With the exception of Victory, sales across the business are in line with our expectations through the first half 2009.

Earnings also slightly beat expectations with net income down 28% to $17.5 million. This is a more than 100% improvement from our first quarter results which included the KTM impairment charge. But we also made several tough calls in the second quarter as well to support our customers and our dealers. Gross margin percentage expansion of 40 basis points was somewhat below our expectations, in part because we took a charge for snowmobile warranties to provide customer assurance for snowmobiles on our high-performance 800cc sleds. We also increased our Victory promotional reserves to provide additional support to our Victory dealers as we deal with what we like to call a brutal motorcycle market. On a positive note, we continue to aggressively execute our cost down plan, yielding a 17% year-over-year decrease in operating expenses and another strong quarter of product cost reductions.

Retail sales are the most closely watched metric within Polaris. We have stabilized over the last nine months in a down 20% to 23% range. Retail within the quarter was again choppy but almost every region of the country is down significantly. Throughout North America, side-by-side sales continue to perform better than core ATVs. As previously mentioned, Victory retail got worse in the quarter, down in the mid 30% range compared to last year, similar to the 1400cc and above segment of the motorcycle market where we compete.

Overall we have moderate expectations for retail improvement in the second half, which will primarily be driven by exciting new model year 2010 products and easier comparables in the fourth quarter. We have no illusions of a strong market recovery in the near future, and have factored this into our very reasonable assumptions for the second half order period.

Closely tied to retail performance is the health of our dealer network. Maintaining the strength of our dealers is a top priority for Polaris. Our Max Velocity program continues to go well with strong support from almost all dealers who are participating. Bennett will provide more color on MVP when he discusses operational excellence. We continue to drive down dealer inventory with a 10% reduction from the previous quarter and an 8% reduction from the second quarter of 2008. Victory dealer inventory improved the most, down 24%, although the weak market requires significantly more reductions in our dealer motorcycle inventory.

Inventory reduction is not the only area where we are working closely with our dealers. We are reducing the overall floor plan receivables and have even accelerated their holdback payments in the quarter to help with our cash flow. Access to wholesale financing remains solid, and Mike will update you on our Polaris success in joint venture with GE. Losses across our network remain low, both in receivables and actual dealer count. We have seen dealer repossessions drop from the spike we saw in the fourth quarter of last year and still expect the overall decrease in dealers in 2009 to be approximately 5%, which is in line with our historical annual turnover. We are watching our dealer health closely, particularly in Victory so that we can respond as appropriate.

With that, I'll turn it over to our Chief Operating Officer, Bennett Morgan, who will provide additional insights into our operations and business unit performance.

Thanks, Scott. I want to begin with operational excellence. Our focus on quality costs and speed continue to pay dividends. Despite the challenging retail industry environment our speed has allowed us to reduce both dealer and factory inventory significantly throughout the second quarter. Scott has already reported on the positive dealer inventory results but in addition factory inventory decreased year-over-year by $59 million or 21%. We were also able to further reduce supply chain lead times in our ORV business by another 13% this quarter, and made even more significant reductions in snowmobile and Victory supply chain lead times. We expect to continue to reduce our factory and dealer inventory levels using our speed and flexible manufacturing capability to run Polaris at more efficient levels of systemwide inventory as we move into the future.

Our improved speed and cost reduction focus continue to drive gross margin percentage expansion, up 40 basis points in the second quarter of 2009. We're having good success in this environment in finding opportunities to reduce our costs and improve our quality simultaneously through the efforts of our engineering and supply chain partners. Commodity costs remain stable and improved from 2008. We remain confident in our guidance on gross margin expansion for full-year 2009. As Scott noted, our focus on reducing waste resulted in operating expense reductions of 17% in the second quarter.

We also continue to improve our speed to market in new product development. We are now 22% faster to market in new product development versus 2008, and we are over 40% faster than we were just three years ago. Our upcoming dealer meeting in St. Paul will showcase our again industry leading model year 2010 new product news and innovation. While most of our competitors have canceled their annual dealer meetings and cut back on virtually all new product releases, Polaris remains on the gas. Almost every new model year 2010 product announced at our show in St. Paul would not have been ready for another year or more without our enhanced product development speed that we've undertaken over the past couple of years. We believe we have begun to build legitimate and significant competitive advantage in power sports product development.

Our MVP, or Max Velocity Program, tests with our dealer network, which is essentially a whole new way of doing business in power sports, continues to perform to our expectations. The objective of the test group of dealers is to continue to grow market share while operating with lower levels of inventory. Based on our success and our learnings, we are going to expand the MVP program significantly on a geographic and dealer criteria basis to 50% approximately of our off-road vehicle North American retail volume beginning with this upcoming order period. Also for those dealers not yet eligible for MVP, we are making significant improvements to help drive out inventory waste and reduce dealer order risk using improved speed and manufacturing flexibility.

Off-road vehicles. Our ORV business performed to our expectations in the second quarter with sales down 25%. The ORV industries remain weak. North American ATV industry was down about 30%, and while we don't have clear industry data for side-by-sides, we believe it was down mid to upper teens percent for the second quarter. Our innovation continues to drive market share gains year-over-year in both ATVs and side-by-sides. North American ATV dealer inventories continue to improve both year-over-year and sequentially from the first quarter with inventory down 19% year-over-year. Side-by-side dealer inventories, while higher than 2008, are down sequentially from the first quarter and remain at appropriate levels.

Industry ORV promotion levels are up year-over-year but remain within our expectations. Polaris continues to have success moderating ATV promotion spending, and we expect to continue this trend going forward thanks to lower inventory levels, improved age and mix of that inventory, and newer, more innovative products in the marketplace. We are making good progress on ORV cost improvements in both operating and product cost areas which is helping offset the lower demand environment. And as I mentioned earlier, we remain on the gas in new product development in off-road vehicles and will announce a number of new models next week and expect to continue to outperform the overall ORV market based on these introductions and innovations. We are narrowing our full year 2009 sales guidance for ORVs to down 21% to 25%.

Snowmobiles. Due to the time of year there's not a lot to report about snowmobiles, and not a lot has changed from 90 days ago. Model year 10 North American dealer orders were within expectations while international orders were slightly lower than our expectations largely due to pressures in the Russian market. Dealer inventory are at acceptable levels, and we are excited to bring our new RUSH Snowmobile with PRO-RIDE suspension, the industry's first and only progressive rate rear suspension, into the marketplace later this fall. With dealer orders complete, we are narrowing our sales guidance to down 15% to 20% for full-year 2009.

Victory motorcycles. The overall motorcycle industry in Victory had a very disappointing second quarter. Total North American motorcycle industry retail sales were down in excess of 50% with the segments that Victory competes in, heavyweight cruiser and touring segments performing better but still down mid-30s percent. Victory retail sales declined at a similar pace to our segments in the second quarter which was below our expectations. Second quarter sales to dealers declined 55% as we continue to aggressively reduce shipments, as we had previously communicated to you, to assist dealers in reducing their inventories. Dealer inventories continue to come down. They're down 24% from a year ago but remain higher than we and our dealers would like.

In light of the motorcycle industry weakness, we are making significant reductions to our expectations for the Victory business for 2009. We now expect full year 2009 sales to be down 40% to 50% as we make additional build reductions for model year 2010 to assist in inventory reductions and additional investments to improve our dealers' competitiveness during this market slowdown. We remain committed and excited about the Victory business. Next week we will announce key new models at our dealer show that will allow us to reach a broader motorcycle audience and segments with heavyweight cruisers and touring. We also announced recently the formation of our new on-road division designed specifically to get more resources focused on our Victory business and other on-road opportunities. No doubt this is a challenging time in motorcycles, but facing up to the industry realities, getting more resources dedicated to the business, and continuing to invest in new product have us optimistic our Victory business will be stronger as a result in the long run.

Parts, garments, and accessories. PG&A sales declined 13% in the second quarter due primarily to lower retail sales in all product lines. Our PG&A business continues to expand its gross margins impressively in a lower volume environment, and as we expected, continues to outperform our overall Polaris business. Our focus on innovation continues, and we will launch almost 200 new accessory products next week at our show. We are lowering our sales guidance for 2009 to down 13% to 17% and continue to expect our PG&A business will modestly outperform our overall Polaris business.

International. International sales were down 30% in the second quarter as Europe and the rest of our international markets continue to deal with difficult macro economic conditions. Unfavorable currency movement accounted for about 12% of this sales decline. The European off-road vehicle industry continued to be soft, down low 20s percent, but Polaris continues to gain market share versus our competition. There are a number of bright spots in our international business. Our subsidiaries continue to outperform their markets from both a market share and profitability perspective. Our Victory business, which has seen significant retail sales growth and market share expansion in every country in which we are currently selling Victory, and our international factory inventories are down significantly year-over-year. We also continue to invest and make progress on our global new market development initiatives.

Adjacencies. Scott has already discussed our newest adjacency, our neighborhood vehicle, for master planned communities, which is our first entry into an exciting low emission vehicle space. Beyond that we remain pleased with our progress and success in our other adjacencies. The military business continues to grow nicely. The new Bobcat alliance and product development effort is off to a great start, and we have a number of other ideas in our funnel. While these will not drive significant sales growth and profitability in 2009, we are very excited about the sales and earning growth potential these adjacencies provide and how they fit into Polaris's growing portfolio of businesses.

With that I'm going to turn it over to Mike, our CFO.

Thanks, Bennett. And good morning to everyone. I will begin with our financial services business. Income from financial services for the full year 2009 is expected to decline 20% to 30% from the full year 2008. This guidance has improved somewhat from the previously issued guidance expectations for financial services income. As discussed in previous calls, the decline in income for 2009 is primarily due to our revolving retail credit provider, HSBC, eliminating the volume based fee income payment to Polaris in the first quarter of last year. No income is expected in 2009 from HSBC.

For the full year 2009, our expectation for the wholesale financing income generated from Polaris Acceptance has improved from prior guidance issued. I will talk more about that a bit later.

For the second quarter 2009, we financed through our retail credit programs, HSBC, GE, and Sheffield combined, about 33% of Polaris products sold to consumers in the United States, which is slightly better than the penetration rate we experienced the last few quarters. The approval rate in the second quarter 2009 increased to 48% compared to 44% for the first quarter. Both the penetration rate and the approval rate are somewhat lower than historical levels, and somewhat weaker than desirable due to the credit tightening by our retail credit providers. And is obviously having some dampening impact on our retail sales levels. We continue to feel our retail credit relationships are relatively stable, given the overall uncertainty in the consumer retail credit markets. Our recently added retail installment credit provider, Sheffield Financial, continues to increase its share of the installment financing provided to our consumers, and GE has recently relaxed their down payment requirements.

For the second quarter 2009, the wholesale portfolio related to floor plan financing for dealers in the United States was approximately $574 million, a decrease of 5% from the end of the second quarter last year, reflecting the decline in the dollar amount of dealer inventories. This 5% decline is in dollars. The units outstanding in the portfolio in the United States are actually down 12% compared to last year, due to the mix change of the higher priced side-by-side inventory. Credit losses in the dealer wholesale portfolio remain very reasonable, averaging well less than 1%.

During the second quarter 2009 we continued to see a modest number of dealer failures, repossessions of inventory, and credit losses, similar to the first quarter, but these issues were well within our expectations, as Scott mentioned earlier. Additionally, during the second quarter we had conversations with our wholesale credit joint venture partner GE, which resulted in increases in the interest rate paid to Polaris Acceptance by both Polaris and our dealers in the second half of 2009. These interest rate increases were agreed to, recognizing the increasing funding cost environment for GE's debt that finances a portfolio and GE's desire to maintain an acceptable level of return from the Polaris Acceptance joint venture. Overall, we are very pleased with our stable, long-term wholesale financing partnership with GE and our joint venture structure of Polaris Acceptance, and do not expect any dealer credit capacity issues to materialize.

The actual gross profit margin percentage generated in the second quarter was 24.1% compared to 23.7% in the second quarter of a year ago, a 40-basis-point improvement. During the quarter we continued to adjust our manufacturing capacity and cost structures to help minimize the fixed cost absorption impact of the lower production volumes, and have been successful in reducing these manufacturing related costs at a similar pace to the second quarter sales decline. Gross margin percentage in the second quarter continued to benefit from commodity and transportation cost decreases, higher selling prices, lower ATV sales promotion costs, and positive product mix change. These gross margin benefits were somewhat offset by the unfavorable currency movements in Canada, Japan, and Europe compared to a year ago, which created some headwinds for us in the second quarter, and will likely continue through the third quarter. But are expected to actually turn favorable in the fourth quarter of this year given the dramatic move in the currencies a year ago.

In addition, as Scott mentioned, our second quarter gross margin percentage was negatively impacted by an increase to the snowmobile warranty reserve to cover a warranty repair for snowmobile models that have the 800cc Liberty engine introduced a few years ago. However, we continue to expect the gross profit margin percentage for the full year 2009 to improve up to 130 basis points over the 22.9% generated a year ago, which is unchanged from our previously issued guidance. The mix of positives and negatives experienced in the first half of the year combined with our aggressive product cost reduction efforts, which will become more evident in our model year 2010 product offerings are expected to continue to generate gross margin percentage expansion throughout the remainder of the 2009 year.

Moving now to our balance sheet and liquidity profile for 2009, our net debt position finished the quarter at $220 million, which is $19 million lower than a year ago. We continue to have ample borrowing capacity under our attractively priced $450 million banking arrangement comprised of a strong and stable corporate banking group. For the year to date period we made investments in the business through capital expenditures and new product development tooling, totaling $25 million, which is 33% lower than a year ago. For the full year, we expect to continue to moderate our appetite for capital expenditure spending and realize a significant decline to be in the $50 million to $55 million range.

We will continue to invest in tooling for innovative new products, some of which we will introduce next week, and targeted investments in capital projects to reduce our production costs and improve efficiencies and product margins. We continue to expect depreciation for the full year 2009 to be in the range of $60 million to $65 million.

Cash flow provided by operating activities was $24.4 million for the second quarter 2009, compared to $53.3 million in the second quarter of last year. During the six months ended June of 2009, $8.7 million in net cash was used for operating activities, compared to $21.7 million of net cash provided during the first half of last year. The decreases in net income and the decreases in the dealer hold -back accrued liability for the 2009 second quarter and year to date periods compared to the same periods last year are the primary reasons for the decline in operating cash flow. We continue to expect cash flow provided by operating activities to decrease for the full year 2009, in line with percentage decline in net income. But notably, operating cash flow generated will remain well above the net income level.

As Bennett mentioned, factory inventories are at $220 million, a 21% decrease from a year ago. We continue to expect factory inventory levels to decline consistently throughout the year, as we have adjusted and will continue to adjust our production capacity and build schedules for the challenging demand environment that we're experiencing.

During the first half of the year we repurchased only a minimal number of shares under our share repurchase program. We still have approximately 3.8 million shares authorized from our board, but as I stated in our last call, we're taking a different approach this year and are being more conservative, given the uncertain overall economic environment. During the second quarter, we once again paid a cash dividend of $0.39 a share which represents a 3% increase over a year ago, and we expect to continue to pay the dividend at that rate for the remainder of 2009.

Guidance for the full year 2009 has been narrowed to reflect the actual results generated during the first half of the year and our current outlook for the remainder of 2009. Total Company sales guidance has been narrowed, and lowered somewhat, and is now expected to decline 20% to 25% in total for the full year, with the individual business as follows. Off-road vehicles down 21% to 25%, snowmobiles down 15% to 20%, Victory motorcycles down 40% to 50%, and PG&A down 13% to 17%. As Bennett mentioned, Victory motorcycle sales expectations have been lowered from previously issued guidance. This is a reflection of the deteriorating industry sales for heavyweight touring and cruisers in the second quarter, and our intention to reduce production levels for model year 2010 to help our dealers adjust their Victory inventory levels. In addition, PG&A sales guidance has been lowered somewhat.

Gross margins are expected to expand up to 130 basis points for the reasons explained earlier. Our operating expenses are expected to decrease significantly in dollar terms, as we continue to aggressively deal with the reality of a lower volume environment. Operating expenses will increase as a percentage of sales for the full year 2009, primarily due to the lower sales. The income tax provision was recorded at a rate of approximately 34.4% of pretax income for the second quarter, which is lower than last year due to the Federal Research and Development tax credit which had not been extend' by the US Congress in the second quarter a year ago. For the full year 2009, our expectation is for the income tax provision rate to be in the range of 34% to 34.5% of pretax income, which is unchanged from our previously issued guidance. In the third quarter, 2009, the income tax provision rate is expected to be higher than the 29.3% rate experienced in the third quarter of a year ago, primarily due to the favorable settlement of certain income tax examinations last year which are not expected to repeat again in 2009.

Earnings per share for the full year 2009 are now expected to be in the range of $2.70 to $2.90 per diluted share, which is a decrease of 23% to 17% compared to the $3.50 per share earned for the full year last year. We expect the third quarter 2009 to look a lot like the second quarter did. Guidance for the third quarter 2009 for the Company is as follows. Sales are expected to decrease in the range of down 25% to 30% from the third quarter of a year ago due primarily to the continued weak industry trends in North America and in our international markets in the third quarter. Earnings are expected to be in the range of $0.76 to $0.86 per diluted share in the third quarter 2009 compared to the $1.13 in the third quarter a year ago. As Bennett mentioned, the move to 50% of our ORV retail volume on MVP during the upcoming order session will have a dampening impact on third quarter sales volumes as we make that transition. And I will remind that you the third quarter of last year was the best quarter in the Company's history. As you will note, this third quarter EPS guidance implies very strong earnings per share results in the 2009 fourth quarter, which we are confident we can achieve given the momentum generated to date on our cost reduction efforts and innovative new products when compared to a relatively easier comparable from the fourth quarter 2008.

In conclusion, we feel our plans for 2009 remain achievable in the current challenging external market environment. We continue to proactively implement contingency plans and are confident we can adjust production levels and cost structures appropriately.

At this time I will turn it back over to Scott for some quick concluding comments.

Thanks, Mike. Overall, and hopefully as you gleaned from our comments this morning, we had a solid second quarter, and I feel good about the way this Polaris team has navigated through the first half 2009. We have taken significant costs out of our business but also made investments to support our product innovation and strategic plans. The product news will be on full display next week at our dealer show and we are poised to turn innovation into orders. The results of our operational excellence initiatives will continue to show up across our business, not only in our P&L and balance sheet metrics but also in our dealers as we further expand MVP in the months ahead. We will continue to exploit our flexible manufacturing systems to manage the uncertain demand environment and leverage our strong engineering team and processes to drive product results, cost reductions and product innovations. Both of these initiatives will be part of our Victory turnaround effort.

While we are confident in our ability to return to organic growth in the years ahead, we recently created a new corporate development officer role to lead our non-organic growth efforts. Todd Balan brings significant experience in business and market development and will be a key resource to help us drive our strategic growth initiatives.

Having and executing the right plan is very important. But it is results that matter. As Mike stated, we are narrowing our sales and earnings guidance and feel comfortable with our ability to deliver full-year earnings per share of $2.70 to $2.90 and sales in the down 20% to 25% range. We remain focused on executing in 2009 and positioning the business to emerge from this economic downturn as a stronger, more profitable company. I look forward to speaking with you again next quarter to talk about our progress.

Lori, that concludes our prepared remarks. Can you open up the line for questions.

Absolutely. (Operator Instructions) We'll take our first question today from Ed Aaron with RBC.

Thanks, good morning, guys. On the new adjacency, I understand the thought process behind that business opportunity but I'm a little surprised that a product like that is going to have your brand name on it and be sold through your dealer network. I guess tend to think of the Polaris brand as maybe a little cooler and tougher than that. Can you just help me understand the thought process behind how you're positioning that from a brand and distribution perspective?

Yes, Ed. I used the word "unique" distribution in my prepared remarks. This will not initially be sold through the Polaris dealer network. These products are designed for master planned communities, and there are specific dealers that support those markets. We have a small subset that we've been working with for the initial launch of the product, and we actually feel like the Polaris brand name is a strength that we'd like to leverage and we'll play that out over the next several quarters as we launch the product. But that's the strategy. It's not something -- that's the reason we announced it today. We've got the dealer show next week where we'll announce most of our new product news, but because this is not specifically designed for our current Polaris dealer network, we thought it best to go ahead and announce it on the call today.

Okay, thanks for the clarity on that. And then also, to what extent have you challenged your commitment to the Victory business? The market's been cut in half, and that's not necessarily unique to the motorcycle industry but the share trends had plateaued, even while that was happening. So is there enough demand in that business over the next couple years, as you see it, to really be sufficiently profitable there? And then also, as far as your dealers are concerned, they have to make a pretty big inventory commitment for that product to have the full line in their stores, and perhaps right now the turns aren't quite enough to support that. So have you thought at all about potentially not staying with that business or what would you need to see to change how you're positioned there?

Ed, absolutely. We have taken an incredibly sober look. That's one of the things about being new. You have a chance to look at everything. And while it is a very difficult year, we still feel very good about the long-term potential of Victory in our business. If you have a chance to come to St. Paul next week, I think we'll give you a lot more clarity on both product strategy and execution strategy to see why we have that confidence. But we are not blindly committed to Victory. We are constantly analyzing the business to make sure that we see the potential there. And so far we do.

Okay. Last question. On your current plan for the back half, do you expect that at the end of the year your inventories at the dealer level will be at a level that you would consider to be balanced?

Ed this is Bennett. We feel really good about, in this environment, where we are with dealer inventory. Dealer inventories will continue to come down throughout the second half of the year. When you see industries under the kind of pressure they are under right now, we'd love to move it even a little further, but you've seen us take inventory down consistently over the last three years. We're down almost 45% from where we were three years ago in the channel. We've taken it out each and every year, even in declining markets, and we'll continue to do so. As we move towards MVP, and as we continue to improve our speed and flexibility capability, our ability to drive further inventory reductions, frankly, is enhanced as we go forward. So we are feeling, relatively speaking, very good about our ability to deliver on that promise.

Great, thanks. See you next week.

Next question.

Our next question comes from Greg Badishkanian with Citi.

Just a follow-up question on the electric neighborhood car. I'm not very familiar with that segment, and you might have talked about this in the earlier part of your call, but I apologize, I missed it. Market size, margins of that whole segment. Just looking at it and seeing how much it could actually move the needle.

The market size for this particular type product is about 35,000 units. We are not disclosing or analyzing margins and what we can do there. I will provide a little more clarity next week if you come out, but it's an attractive space for us, and we certainly like the technology applications across the portfolio.

Okay, good. And then maybe just a little bit of color in terms of inventory levels, in terms of promotions, you guys gave some color on what you guys are seeing out there for yourselves, but even just like the competition and have there been any kind of changes in terms of how they're approaching promotions in the marketplace?

Greg, this is Bennett. As we said in the prepared remarks, and I think as we said really for the last couple quarters, promotion levels in most of our industries are up, or elevated. But they're within our expectations. As some of the guys are doing the surveys, they seem to be picking up feedback from dealers, and I think that's just the stress of the marketplace. Frankly, we've seen elevated competitive inventory levels for a number of quarters, frankly going on a number of years, and we've seen aggressive promotion levels. So this phenomena for us is really within our expectations and isn't anything that is beyond our plan, and frankly, as we continue to enhance our inventory levels and our innovation and our product line, we've actually been able to moderate our levels in ATVs and still gain market share which has us very encouraged, even in an elevated promotional environment that the strategy we have is working and will continue to work as we go forward.

Great. Across the board it's more promotional in every segment of leisure.

The other advantage that we have there, Greg, as you look at it, as you come to St. Paul and you see the amount of product news we'll have next week, which I don't want to get into details, but it's good. We're selling new product, and other guys are selling fairly dated moldy products. And that's an advantage for us. Significant advantage.

I was going to ask you, if you look at the product lineup this year versus last year, are you a lot more excited about the new lineup this year than you were going into the dealer show last year?

I'm always excited about that. I would tell you, in our humble opinion, it's an internal view, is we've had industry leading product news in model year '08, we had industry leading product news last year in model year '09. Again, based on the behaviors we're seeing from our competitors, where the vast majority of them aren't having a dealer meeting, and at least the news we're hearing so far is zero to very very minimal product news, we'll clearly have industry leading news. And again, I think if you get a chance to go to our show, you'll be amazed. We feel really good. Greg, I like to joke that somebody forgot to tell our engineers that there's a recession going on. You'll see the results of that next week.

Good, look forward to it.

Our next question comes from Hayley Wolff with Rochdale Securities.

Hi, guys. A couple questions. First, can you talk a little bit about the investment you are going to put into the Breeze? And then on distribution into these master planned communities, how does that work in the current real estate environment where you're not seeing many new communities popping up and distressed real estate, and how does that all fit in, in that real estate backdrop?

We're not going to disclose our investment to get into this, although it's certainly moderate in levels compared to our typical product launches. The master planned communities, there's a demographic shift in the US, that while the real-estate markets in those areas are pretty weak, there's still a long-term trend of migration to those areas. And as I said in my remarks, we really believe this is an underserved market. When you see the competitive advantages of our product. And that's why we were able to set up new dealers. If you think about this environment, asking a dealer to take on a new product line, they wouldn't do so if they didn't feel confident in their ability to retail it. And we've done quite well in getting the dealers that we wanted in these key master planned communities.

Where will it be priced, vis-a-vis a golf cart or some other form?

Suggested retail is $7,499. Let me be clear, we are not competing with golf carts. This is an alternative neighborhood vehicle that can be used for golf, but we think the price is very competitive at $7,499.

And it's a street legal vehicle? Can I go to the supermarket with it?

In master planned communities, it's street legal with a top speed less than 20 miles per hour.

This is Mike. The other real key thing to understand about this product news is that it's our first entry into this low-emission category. It's an electric vehicle. It's got different technology than what we've had before. We're excited about the opportunity to learn about the technology and learn about the market, and we see the opportunities in low emission and electric to go far beyond this one product that we're introducing today.

Okay. And then switching gears to motorcycles, why do you think the motorcycle market is so much weaker, on the heavyweight side is so much weaker than some of the other power sport market, with the exception of boats maybe? And when you evaluate Polaris, initially when the product was developed, it was a much larger market and a rapidly growing market, and now you've had significant contraction, smaller market, less growth potential. What are some of the variables you use to consider whether or not you are going to stay with that business, to Ed's point earlier?

First of all, why the market's down, partly because if you go back a year, motorcycles were selling very rapidly with the higher gas prices. So part of the significant downturn is just really tough comparables. Also, it's a high ticket item, and with many of our products, you can very legitimately argue there is a work use for it, a utilitarian use for it. You can't really do that with a motorcycle. It's typically transportation, if it's your only means, but it's a little more discretionary, we think, than some of our other product offerings in the side-by-side space. How we look at the future potential is very clearly do we see profitable growth, and if we see a path, a risk adjusted path to profitable growth, we'll continue to invest and drive the business for it, and that's where we stand today.

Clearly you see that path?

We do.

All right, thank you.

Our next question comes from Bob Evans with Craig-Hallum Capital.

Good morning and thanks for taking my call. Can you give a little bit more granularity in terms of the ORV market in terms of what segments of core ATV and the side-by-side did well and what areas are struggling this quarter? Looking forward to the second half.

Bob, this is Bennett to. Just to give you a little bit of detail, in general, surprisingly, the higher cc segments are performing better for us. So 500 cc's and up are doing well. Our new Sportsman XPs are doing well. Anything in the marketplace where ourselves or our competitors are able to place value, even relative value in the segment is doing well. The Canadian marketplace is generally outperforming the US marketplace. And while we're not thrilled where we are in international, the international marketplace is relatively stronger still in ORVs than North America. And with that said, the side-by-side segment continues to outperform the ATV segment. In general, Ranger is relatively stable, and things like our hot new products, like the RZR-S is still in high demand.

I think you give us market data in terms of core ATV and side-by-side. Can you give us relative to Polaris how trends were this quarter?

We gained market share in both core and side-by-side.

Is there one segment that you're gaining more share in than the other?

As we've talked about, we don't get the same kind of monthly granularity in side-by-sides as we do in ATVs, but you know that we've been able to successfully gain a tremendous amount of market share in side-by-sides over the last couple years. In all honesty, I think that trend is continuing. We're continuing to gain a reasonable amount of share in side-by-side.

And then on the warranty expense impact this quarter, I think you had mentioned it was as a result of the snowmobile side and a little bit on Victory. Can you give us any sense of magnitude there? Just wondering basis point impact or just overall some color.

I'm not going to give specifics on that issue itself. That issue was disappointing to us. We hadn't necessarily planned for that as we had done our plans and budget, so that was a detriment to our gross margins. In total, the warranty expense that hit the P&L for the second quarter was about $9.6 million, compared to $9.1 million a year ago. So it was somewhat higher than a year ago, even though sales were down 24%. So you'd expect that number to be significantly less. And it wasn't. And it wasn't primarily because of the snowmobile issue.

Is that one time? We shouldn't see that going forward?

We believe so.

Okay. All right, Thanks for taking my questions, and see you next week.

Our next question comes from Tim Conder with Wells Fargo.

Thank you. Gentlemen, just a few questions. Bennett, on the MVP program, you said 50%, and I think that was in dollar terms a year end goal. Is that still year end, or were you saying with the launch of the new model year products here in the third quarter you'll have 50% in dollar sales for your ORV dealers on that?

We generally, just because of the timing on how we're executing that roll-out of the program, we'll essentially go to 50% of our retail volume, is how we're describing that, Tim. And that will be effective with this upcoming order period that really essential begins in August and September.

Okay. So third quarter. Okay. Great. So a little bit earlier than you originally planned.

Maybe from what we communicated to you. This is what we had hoped we would be able to stay on this plan, was around a model year switchover. So essentially we're right on our plan. It's hard to do it in the middle of traditional order period. You have to break it based on when traditional order periods end or begin.

To convert them, right. And the feedback we get from the dealer based on that is they're just very ecstatic about it.

Yes, and I would tell you I think we're optimistic. Again, we're still learning. We'll probably continue to get smarter and enhance, but we believe the benefits will become even greater for some of those folks you're talking to six, 12 months from the line, because, again, it's an evolution and a progress. We're pretty excited about it.

No, it's very good feedback. Scott, on the gross margin side -- or Bennett or Mike -- whoever wants to take this, what do you see that progress potential carrying on into 2010, or should we maybe think, Scott, I think when you have been out on the road a little bit you've talked about more things in terms of a net margin goal. But directionally, looking into 2010, obviously 130 basis points improvement year over year is not sustainable going into 2010. How should we directionally think about that?

What I've talked about before, is that when we finished last year at net income margins of 6%, and we think we've got long-term potential to drive a couple hundred basis points in the bottom line, actually driving net income margin expansion, part of that is going to come from gross margin expansion. And I'll let Mike talk about -- we're not going to give 2010 guidance right now, but Mike if you want to provide any more color on our ability to drive that.

As I said in the prepared comments, we've been working this for quite awhile. We're seeing significant benefits in cost reduction activities that are going to play in the model year 2010 product, which obviously continues into calendar 2010, so we would expect that that can be helpful. We expect hopefully the currencies will be less harmful next year than they've been this year. We'll see. Who knows about that. It's impossible for me, anyway, to predict what's going to happen there. The commodity cost situation, we're planning on escalating. It's at historical lows right now. We don't think that that can continue forever, so our plans right now are that we're going to have to deal with an escalating commodity cost structure going forward. So everything moves around, and puts and takes, but at this point in time, Scott's right, we're not going to give guidance for gross margins for 2010, but I see no reason why we can't continue our trend of the last couple years of expanding gross margins going forward.

Okay. And then along that line, Mike, have you guys hedged out for the model year here, looking at currencies, and then also the commodities?

Yes, we've actually been pretty active in that. The currencies, as I said, have been unfavorable from a year ago, but they have actually moved a little bit more favorable than they were a quarter or two ago. So we've leaned forward and hedged a fair amount as those moved more positive. So right now we're hedged 80% of our exposure for the balance of the year on the Canadian dollar. It's quite punitive to last year still, but a little bit better than what our earlier expectations were. The yen, we're hedged only about 30% for the balance of the year. We started to hedge the Australian dollar, and we're hedged about half right now of the balance of the year on the Australian dollar.

On the commodity side, we've also seen the favorability and have leaned forward with things like aluminum, for instance, where we've hedged quite a bit actually into 2010, of our aluminum exposure. Diesel fuel is another one that we've seen come down significantly from a year ago, so we've hedged exposures on the diesel fuel, as well, throughout the balance of 2009. So we're trying to use opportunistic timing here to lock in where we can some favorability. Okay.

And then finally, could you just give us a little more color again, or just go over again the change you did in the dealer hold-back during the quarter?

Yes, the idea there was, as you know, our hold-back is paid out to the dealers twice a year, in the first quarter and the third quarter. And what we did was we made an early payment in the second quarter of what normally gets paid in the third quarter to assist the dealers with improving their cash flow. We recognize they're under a lot of pressure with the market environment the way it is, and so we thought it was appropriate to do a one-time assistance to pay out early.

Okay. Great way under the "how to win friends and influence people" category. Thank you, gentlemen.

Our next question comes from Craig Kennison with Robert Baird.

Good morning, everybody. Most of my questions have been addressed so maybe I'll ask more of a policy question. How are you thinking about the policy changes you're seeing out of Washington relative to healthcare or cap in trade or potentially surcharge taxes on some of your customers? Is that something that may strategically affect you in any way?

Craig, we actually thought we were having a decent call until now. Are you trying to end it on a really bad note? On a serious note, it's very, very unhelpful. We're going through our strategic planning process now, and part of the dampening down of our longer term outlook for demand that we don't create, we're confident in our ability to create demand, but for tailwinds coming back from an economic pickup we are very concerned. We work very closely with NAM on what's happening with the Employee Free Trade Act, Free Choice Act, which is a terrible name. The tax implications of the healthcare policy is horrible. So it's very, very concerning.

That's all I had. Thank you.

We have time for one more question. Lori?

We'll take today's final question from Joe Hovorka with Raymond James.

Thanks, guy, couple questions. One is on your cost control so far in operating expenses through the year, and specifically in the quarter, your deepest cuts were in R&D, which, given that you're such a product-driven company, two questions. One, why so deep? And does this mean anything for products one year, two years, three years down the road?

Joe this is Bennett. We thought to make actually formal remarks as we talked about that. I think based on what you've seen with model year 2008 and model year 2009, and what you are going to see in 2010, is we are not off the gas one bit. One of the benefits of this operational excellence initiative and all the speed that we're getting and the stabilization of our platforms, we're just way more efficient in what we're doing in engineering, so we're getting new products to market much much quicker. So in essence we're getting more for less or the same for less.

So as I look at our, so to speak, product portfolio, what's in the pipeline, it feels good. There's not reductions. As much as we're trying to cut every penny, we're a product driven company, and that's the last place we'll cut investment. So I would tell you, that's really a benefit of efficiencies around operational excellence and our speed more so than we've cut our appetite in R&D.

And that, Bennett, also applied not only to the R&D spend on the P&L but that also applies to the new product tooling investments that we're making in capex. Those investments also are coming down significantly year-over-year, but as Bennett said, we're not cutting to the bone there from a new product innovation perspective. We're just getting much more efficient with the operational excellence initiatives.

So if I look at the declines there versus, say, selling and marketing and G&A, is it fair to say there's more fat there? You've got almost a 20% decline versus an 8% decline in G&A or 12% decline in selling and marketing. Was there just more room for improvement?

There's some timing, frankly. I wouldn't necessarily say there's more room, but it's timing related. Things tend to be a little lumpy quarter to quarter.

This is the six-month number. It was down 25 in the quarter. Is down 20 the number we should look at for the full year or no?

In that range, yes.

Okay. And then Bennett you made a comment about side-by-side inventory being up on a year-over-year basis but down versus the first quarter. Seasonally we should see a decline from 1Q to 2Q, right, or am I thinking of core ATVs?

I think in general, Joe, what we've seen historically is that you don't generally see a seasonal decline from Q1 to Q2. It's generally fairly flat. So we're encouraged by that trend. And again, based on what you've seen what we've done with our shipments, that's in large part what's driving both of those sequential declines.

Great. I think you commented that the side-by-side industry looks like the rate of sales decline at retail was a bit larger in the second quarter than the first quarter for the industry. Is that also true for your product?

No, actually, we saw sequential improvement in side-by-side sales from the second quarter versus the first quarter.

On a percentage basis.

On a percentage basis.

For Polaris products?

For Polaris products. As I said on the industry data, we all have to be pretty careful on that. We're trying to share information with you, but in all honesty it's not MIC level of data or from a month-to-month basis. We're giving you directional feedback, and that's why we tend to be a little bit broader in that range. To me, the first quarter to second quarter, we didn't see dramatic differences in behavior that I would call from an industry standpoint.

That the declines were similar?

Yes.

Okay. Actually, I guess that's it. I think all my other questions were answered. Thank you, guys.

Thanks, Joe. And I want to thank everybody. That's all the time we have this morning. We look forward to seeing many of you next week at our dealer meeting, and the rest of you, we'll also again talk to you in our third quarter call. So thanks again for participating. Good-bye.

Thank you very much, ladies and gentlemen, for joining today's Polaris conference call. This concludes your call. You may now disconnect.