Polaris Inc (PII) 2017 Q3 法說會逐字稿

Good morning. My name is Christina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Polaris Third Quarter 2017 Earnings Conference Call. (Operator Instructions) Thank you.

Richard Edwards, Head of Investor Relations, you may begin your conference.

Thank you, Christina. And thank you and good morning, everyone, for joining us for our 2017 Third Quarter Earnings Conference Call. A slide presentation is accessible at our website at www.polaris.com/irhome, which has additional information for this morning's call. Today, you will be hearing prepared comments from Scott Wine, our Chairman and Chief Executive Officer; and Mike Speetzen, our Chief Financial Officer.

During the call, we will be discussing various topics, including updating our 2017 guidance and some preliminary comments on 2018, which should be considered forward-looking for the purposes of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those projections in the forward-looking statements. You can refer to our 2016 10-K for a more detailed discussion of these risks and uncertainties.

Throughout the presentation today, all references to third quarter 2017 actual results and 2017 guidance are reported on an adjusted non-GAAP basis, unless otherwise noted. Adjusted refers to GAAP results, excluding our [TAP] integration expenses and the impact associated with the Victory wind-down and manufacturing realignment costs. We have provided a reconciliation of the adjusted non-GAAP to GAAP results, which is shown here on Slide 3 for the third quarter and in the appendix for the year-to-date numbers.

Now we'll turn it over to our CEO, Scott Wine.

Thanks, Richard. Good morning, and thank you for joining us. I am pleased that we are able to talk about better results this morning. Our third quarter was markedly improved from the depressed earnings we posted a year ago and well ahead of expectations. However, this was not a good quarter, just a better one, as we again had too many issues and challenges to overcome. A good football game is well played with few areas in penalties and of course a win in the end. In the third quarter, we won, but we will not be good again until we eliminate these 2 frequent earnings impediments that return to delivering the sustainable, profitable growth that we expect. We are on that journey and making progress, and we will discuss this, this morning.

The highlight of the quarter was certainly our return to double-digit retail growth and much-needed market share expansion. With overall North American retail up [13%] and RZR and Indian ahead of this mark, consumer demand was encouraging throughout the quarter. As we continue to transition to RFM and reap the benefits of customer and dealer pool, we must deliver improved performance at our plants and supply chain to meet higher retail requirements.

With Huntsville ramping up nicely and Monterrey operating at a high level, we met our shipments objectives and continued to drive improvements in safety and quality. Conversely, we had too many supplier issues and corresponding quality holds at our factories, which created logistics challenges that were exacerbated by hurricanes and floods.

A concern I hear regularly is that our significant emphasis on improved quality will impact our ability to generate industry-leading innovation. It takes products, not words, to refute this argument, and the successful third quarter launches of our all-new RANGER XP 1000, RZR XP Turbo EPS with Dynamix and the Scout Bobber demonstrated that we can deliver quality and innovation simultaneously.

[We made a] little notice to internal change earlier this year to combine our sales team with our Off-Road Vehicle business, primarily to gain efficiency. This move was more than validated in the third quarter, as the integrated team delivered our most productive and impactful Factory Authorized Clearance event ever.

In addition to higher unit volume, we also saw increased growth in PG&A in our after-market portfolio. International sales were strong in every region of the world, and we maintained momentum in Global Adjacent Markets, with solid performances from Aixam, Goupil and Polaris Government & Defense.

While the top line retail numbers were high, some surely will want to attribute the year-over-year improvements solely to an easy comp. That certainly played a role, but the results were actually much better than that. Consider these 2 facts. First, September was the highest retail month in Polaris' history and August was among the top 3. Second, off-road vehicles and Polaris retail sales were up also compared to the third quarter of 2015, which was definitely not an easy comparable.

ORV results were aided by an improving market and boosted by market share gains from both ATVs and side-by-sides. Momentum carried throughout the quarter, with September ORV retail also up low double digits.

To provide a bit of color on how promotions impacted retail, I will share insights that we got from our ORV analytics team. Of the 3 primary players in the sport rec side-by-side market where RZR plays, we were #3 out of 3 in promotions in the quarter but gained significant market share. In the more crowded utility side-by-side market, we were the second highest in promotions to prepare for the RANGER launch. And in ATVs, where we had lagged the industry in the first half, we spent more to lead the industry and were rewarded for it.

Moving to motorcycles. Indian generated all of their 16% retail growth from market share gain as the industry remained sluggish. Equally strong performance from both heavyweight and midsized bikes drove Indian to its highest market share ever in September.

Slingshot continued to be a drag on overall retail as it was down more than 15% in third quarter. Between the launch of the new Icon Slingshots with ride command and new color schemes and aggressive marketing campaign, we expect to return to growth in the fourth quarter with Slingshot.

With higher retail, dealer inventory was down 7% in the third quarter, with ORV down 12%, leaving some areas lower than we would like during the peak riding season. We are making good progress with our transition to RFM. With most dealer profiles set, we expect to be able to improve dealer inventory position throughout the fourth quarter and finish the year with dealer inventory down modestly from year-end 2016 levels.

It is fitting for Matt Homan to go out on top as he is choosing to transition after leading Polaris to one of the best quarters in ORV history. Matt started with Polaris back when off-road vehicles was really just an ATV business and spent most of his past 1.5 decades guiding us to industry leadership in side-by-side and ATVs. I would like to sincerely thank Matt for his 15 years of service and wish him continued success.

As we reported earlier this month, Chris Musso will take the reins from Matt on November 6 and lead the expanded Off-Road Vehicle business, which now includes our legacy snow portfolio. Chris is a passionate off-road enthusiast as well as an avid motorcyclist and is intimately familiar with both Polaris and our industry. His extensive experience designing and implementing new product development processes and sustainable problem solving for a variety of complex industries will surely benefit Polaris. Chris is incredibly bright and ridiculously competitive, yet somehow manages to remain humble as well. We are excited to have him join the Polaris leadership team and look forward to introducing him to you soon.

Given our improved performance in 2017, we are investing extra time developing our long-range financial targets to ensure we set the proper goals. As our longtime followers may recall, back in 2009, we set our original target to become a $3 billion, 8% net income company. After exceeding these objectives, we reset our goals to become a $5 billion, 10% net income business by 2018. In hindsight, those would have been good goals to keep, but our strong progress through 2014 led us to again raise our target to become an $8 billion in revenue company with 10% net income by 2020.

Since the compound annual growth rates needed to achieve these targets no longer seem realistic, we will introduce revised goals in January when we provide our more detailed guidance for 2018. Expect us to focus more on productivity than sales, reaffirming our commitment to sustainable, profitable growth.

With that, I'll turn it over to our CFO, Mike Speetzen.

Thanks, Scott, and good morning. As Scott stated, we are very pleased with our third quarter results, which were driven by strong retail sales and improved execution in spite of some headwinds during the quarter.

Third quarter sales were up 25% on a GAAP and adjusted basis versus the prior year. Transamerican Auto Parts added $191 million of sales during the quarter, which more than offset the lost revenue from the Victory wind-down of $39 million reported in Q3 for 2016. Organic sales, which adjusts for TAP and Victory, was approximately half of the growth for the quarter, including strong PG&A and international growth as well as an improvement in company average selling prices, driven by positive vehicle mix in most businesses during the quarter.

Our sales growth for the quarter was only minimally impacted by the recent natural disasters, although on a production basis, there were supply and manufacturing delays, which added cost and complexity to the quarter. I will highlight a few of those later in my gross margin remarks.

Third quarter earnings per share on a GAAP basis was $1.28. Adjusted earnings per share was $1.46 when adjusted for Victory wind-down, TAP integration and manufacturing realignment costs taken in the quarter. The increase was driven by a combination of improved gross margins, operating expense leverage and a lower tax rate. The tax rate contribution to EPS enabled us to offset the added costs from a combination of supply chain and natural disaster headwinds.

Given our year-to-date performance and top line momentum, we are raising our overall sales and [guidance] for the year. We now expect total company sales to be up in the range of 18% to 19%. We are again increasing our ORV/snowmobile guidance and now expect sales to increase in the mid-single-digit range year-over-year given the strong year-to-date performance in ORV, international and PG&A. We're increasing our Global Adjacent Markets guidance to up low double digits percent given the strong sales in most of our adjacent market businesses. Our Motorcycle guidance remains unchanged. Indian Motorcycle sales momentum is expected to continue and more than offset the expected lower Slingshot sales for the year. And finally, our aftermarket business remains strong with the addition of TAP for the full year.

The company's organic sales for the full year, which is defined as total revenue excluding TAP, Victory sales and the effects of foreign exchange, is expected to be up in the 6% to 7% range, which has improved from our previous guidance. Lastly, given our progress to date, we now expect dealer inventory to be down low single digits on a year-over-year basis by year-end.

Taking into account the above changes, adjusted earnings per share guidance is now expected to be in the range of $4.75 to $4.85, up 36% to 39% compared to the full year 2016 adjusted EPS of $3.48.

Given our year-to-date results and revised sales and EPS guidance, our fourth quarter implied sales growth is in the range of up 9% to 13% and EPS is in the range of $1.38 to $1.48 per share.

Let me walk through some key points as it relates to our Q4 expectations. We began lapping the TAP acquisition made in the fourth quarter of 2016. Last year's Q4 included $109 million of TAP revenue. We also expect that overall shipments will be more in line with retail sales, and I would also note that we expect sales to be down sequentially in Q4 given lower motorcycle shipments due to seasonality and slightly lower ORV shipments as we more closely align the retail sales -- with retail sales through our RFM implementation.

Promotional spending will be down sequentially and versus Q4 of 2016, which was one of the key drivers behind our anticipated sequential improvement in gross margin. Warranty expense is anticipated to be down year-over-year but will remain at levels similar to what had been experienced through Q3.

Now turning to gross margin. On a GAAP basis, gross margins improved 261 basis points to 24.6% in the third quarter, which includes $7.6 million of Victory wind-down costs and $6.2 million of manufacturing realignment and network optimization costs. Our adjusted gross margin increased 351 basis points to 25.5%, reflecting lower warranty expense, cost savings and positive product mix, somewhat offset by anticipated higher promotional costs and added costs from a combination of supply chain and natural disaster headwinds. Additionally, it's important to note that we had several suppliers who declared force majeure during the quarter, citing hurricane impacts which required increased efforts to overcome production delays. As mentioned earlier, while warranty expense is down year-over-year, on a quarter and year-end-to-date basis, as expected, the percentage is still trending higher than our historical average. Sequential gross margins were impacted by these higher warranty expenses as well as the costs associated with the supply chain and natural disaster headwinds mentioned earlier.

For the full year 2017, we continue to expect adjusted gross margin improvement in the 180 basis point range versus last year, which implies an improvement in gross margin for the fourth quarter and a sequential improvement from the third quarter, driven by ongoing cost savings and product -- positive product mix.

Moving down the P&L. Adjusted operating expenses are now expected to increase in the 50 to 60 basis point range as a percentage of sales versus last year given the higher sales growth expectations. The increase to operating expense ratio year-over-year is driven primarily by the acquisition of TAP, higher R&D expenses, increased variable compensation and legal-related cost.

Income from financial services is now expected to be down about 5% for the year, an improvement from previously issued guidance given better retail performance.

The income tax rate is now expected to be approximately 32% for the full year 2017, primarily due to the benefit recognized from certain favorable outcomes of federal tax audits in the third quarter and the adoption of a new employee share-based accounting standard in 2017.

And lastly, share count is expected to be down about 2%, narrowed from previously issued guidance as we were more aggressive in share repurchases earlier in 2017. We have repurchased just over 1 million shares year-to-date at a total cost of $89 million. We have approximately 6.4 million shares remaining under the board's current authorization.

Now let me provide a few brief highlights on our business segments. ORV/snowmobile segment sales were up 12% in Q3, driven by improved ORV shipments of side-by-side worldwide and higher snowmobile sales, along with a 5% increase in PG&A-related sales. Average selling prices increased 6% on improved mix despite higher promotional costs. Full year sales for the segment are expected to be up mid-single-digits percent, an improvement over previously issued guidance given our strong year-to-date performance and anticipated positive momentum into Q4.

Motorcycle reported and adjusted sales decreased 14% in Q3. Excluding the Victory sales of $39 million reported in the third quarter of 2016, motorcycle sales were up 10%. The company's sales of Indian Motorcycles were up in the low 20% range in the third quarter, driven by new products, including the new Chieftain Dark Horse Limited and Elite lines as well as the new Roadmaster Classic. Slingshot sales were down in Q3, although the rate of decline slowed during the quarter. Motorcycle segment sales expectations for the full year remain unchanged at up mid-single-digits as compared to 2016, excluding Victory sales.

Global Adjacent Markets sales increased 17% in the third quarter. The growth was primarily driven by Aixam, Goupil and our Government & Defense businesses. We now anticipate Global Adjacent Markets segment sales to be up low double digits for the full year given the year-to-date performance.

Aftermarket sales, which includes TAP along with our other aftermarket brands, were up significantly, primarily due to the addition of $191 million of TAP sales in Q3. TAP results were in line with expectations and integration plans are on track. Pro forma revenue growth for the aftermarket business was up approximately 6% in Q3.

Our operating cash flow performance was up 16% year-to-date through September compared to the same period of 2016, driven by improved working capital performance. Our outlook for operating cash flow has improved and is now expected to be down low double digits. The drivers for the year-over-year decline remain unchanged: timing of cash outlays associated with the prior year promotional warranty accruals and Victory wind-down and manufacturing realignment costs.

Net debt continues to decline as our improved cash flow performance enabled us to pay down our debt at a faster rate than originally anticipated. Net debt improved to approximately $790 million in the third quarter, down sequentially from our second quarter by approximately $150 million. In Q3, our leverage ratio improved to just over 1.5x EBITDA.

With that, I'll turn it back over to Scott for some final thoughts.

Thanks, Mike. While we are primarily focused on finishing the year strong, our planning for 2018 is well under way. The recent progress on tax reform is encouraging even as the rhetoric around NAFTA is discouraging. This is the uncertain reality of the current political environment, which we believe will continue into 2018. That said, with regulatory relief already aiding our customers and the industry and a reduction in the corporate tax rate likely forthcoming, we do expect Washington to be more helpful than harmful in the year ahead.

We do not expect a major shift in the trajectory of the powersports industry, resulting in a planning scenario that projects modest ORV growth and continued weakness in motorcycles. Transamerican Auto Parts and our overall aftermarket business are expected to generate above-market growth, with profitability improving as we attain many of our synergy targets.

Retail Flow Management, or RFM, will be fully implemented in 2018, and we expect this to drive both inventory savings and growth synergies. We plan to improve plant leverage throughout the year as our network optimization savings begin to fall through. We also anticipate a much-needed decrease in operating expenses as a percent of sales in the year ahead. We will continue investing to enhance safety and quality and expect to reduce the significant onetime costs that have been a tremendous drag on earnings for the past 2 years. We will increase our focus on productivity using a multifaceted approach to put us on a path to record operating margins in the future.

It is too early to tell whether 2018 will be a good year or simply better, but rest assured the entire Polaris team will be focused on improving customer satisfaction, accelerating productivity and driving profitable growth.

With that, I'll turn it over to Christina to open the line for questions.

(Operator Instructions) Your first question comes from David Beckel from Bernstein Research.

Scott, I was hoping you could help frame the ORV industry's recent strength over the last 2 quarters. Is oil and gas demand sort of driving the inflection upward? And sort of related, to what extent do you believe the industry-wide retail sales in Q3 were driven by FAC and other rebates versus sort of what I'd call natural demand?

Yes, Dave, good question. Overall, I think we are seeing an upward trend in the overall consumer demand. I wouldn't put too much weight on oil and gas. It stopped being a significant drag, but it's not leading the turnaround. I would say, and I said in my prepared remarks, the overall -- not just for our industry but the less stringent regulatory issues is really helping many industries where our companies -- where our customers work. And we're seeing improved traffic. That's part of it. Also part of it, I think, consumer sentiment is just high despite all the political rhetoric you are hearing. And there's a lot of good products out there from Polaris, of course, but also from our competitors. And you throw that in with the higher promotional mix, and it's just a good recipe for an improved market. What we're pleased with is in that environment, we were able to gain market share, and we feel good about how the quarter went for us in that regard.

And, David, just to add to the specifics around that. The oil and gas markets that we track were up kind of low single digits, so we actually saw a little bit of growth. And ag was actually pretty strong, although it's recovering from some pretty bad numbers that we've seen over the past couple of quarters.

Got it. And as a quick follow-up, Mike, I have a question on just the gross margin guidance. Obviously, it didn't increase relative to last quarter despite increase in sales and some FX benefits, it looks like. Can you help frame just sort of what the offsets are to that sales leverage and FX benefit and maybe specifically as it relates to natural disaster effects of this quarter?

Yes. I mean, I -- in my prepared remarks, I made a comment that the tax benefit, depending on the math you do, we picked up somewhere between $0.10 and $0.13 from the tax benefit. And that largely offset some of the headwinds that we saw in the third quarter that we talked about relative to the effects of the natural disaster as well as the lingering effects that impact our suppliers as well as some supplier quality issues. A couple of things I'd point out. If you look at what we're doing gross margin-wise sequentially, we're sitting year-to-date just shy of 26%. The guidance would imply the fourth quarter is going to be around 28%. That's reflective of the fact that promo costs are down. We are seeing a little bit of abatement from a foreign exchange standpoint. But most of the benefit we're getting is actually coming through in hedge accounting, which sits down in our other income line, which I think a number of analysts picked up on. We had a couple million dollars of favorability there that will help. And then just the overall mix of the business improves as we head into the fourth quarter. So we've indicated in past calls that our warranty cost continues to be, although down versus last year, higher than we had expected, so that's put some weight on the guidance relative to gross margins. But we've been able to offset that through improved volume mix as well as pushing harder on the productivity actions.

Your next question comes from Tim Conder from Wells Fargo Securities.

Just a clarification, Mike, on your statement there on FX. What do you have implied, I guess, or your expectation here on the top line, both for Q3 and then looking here into the balance of the year? And also, clarification on the tax side. So you called out the $0.10 to $0.13, and that offset some of the other issues, which is all good, but what about the stock comp here? What are you building in, I guess, for the full year and Q4, in particular, related to that?

There was a lot packed in that one question.

Well, I got my follow-ups, so...

Yes. So for foreign exchange, if you look at our guidance summary page, you'll notice that we've got Victory wind-down/foreign exchange at about $150 million headwind. That's down about $25 million from what we showed last quarter. So we're picking up about $25 million on the top line. And I'd say that's about evenly split between Q3 and Q4. We're not picking up a whole lot on the bottom line. We've been effectively hedging off a significant portion of our transactional exposures. So where we're losing or gaining in the business, we're offsetting that with the derivative positions that we've put in place. So we feel pretty good about that. As it relates to the tax position, we had a couple of, I'll call them onetime items. They were obviously very positive from a cash flow standpoint, so we're encouraged with the work that was done there. We've lowered the guidance for the full year from 34% to 32%. That would imply our fourth quarter is going to be about 34%. And I think that will help you in terms of looking at the number. I don't know that we're going to get into a lot of detail in the stock comp detail, but it's certainly -- the incentive comp is a little bit of a headwind just relative to the performance we had last year and the fact that the senior executives didn't get a bonus.

I mean -- no, I understood there and how that has to normally come back. But I mean, on the tax portion, there, Mike, on the stock comp tax benefit.

Yes, I'm not sure I follow your question, Tim.

Just from the new standard that's been implemented this year.

Oh, I'm sorry, yes. So it's issued 2016-9. I had to memorize that one. So we've had -- we had small benefits in Q1 and Q2. We saw a larger benefit in the third quarter. Essentially, they changed it such that when employees execute the sale stock options, you end up recording that through your stated rate as opposed to going through equity. And so for us, we picked up it was probably around $4 million in the quarter. The bulk of our favorability was really driven by the favorable outcome from a IRS audit on our R&D tax credits from prior years.

Okay, okay. Great. That's helpful. And then a follow-up on the military side. Scott, you'd called out how you had a contract there should benefit you, I think, about $50 million this year and next year and then maybe another contract that you've recently had. Just give a little more color on what's happened in the military here for the back half of the year and then looking into '18.

Yes. Tim, no, don't get ahead of yourself. The military business is just over $50 million in total at this point. But we do feel exceptionally good about what John Olson has brought since he stepped into this leadership role and what that entire defense team is doing with some really advanced technology platforms. We are still leading the ultralight utility vehicle space and feel really good about where we're positioned with our MRZR platform and DAGOR as well. So lots of good things happen, not only with the U.S. military, but internationally as well. So we're bullish on the military, but just let's not get too far ahead about the size of that business and what it can do for us at the overall company level.

Your next question comes from Robin Farley from UBS.

A lot of my questions have been asked. Maybe 2 things to clarify. One is, you mentioned Q4 you expect to ship in line with retail. So is it fair to say that you expect off-road retail to be up like at least high single digit? Is that kind of what your shipment guidance suggests? And then also, you allude in the slides and in the announcement to share gain in off-road and then specifically in ATV. I'm just wondering what side-by-side -- was it just -- looks like maybe the bigger share gain within ATV was the side-by-side growth kind of in line with some market. Or just how to think about that?

As I said in my prepared remarks, Robin, that our RZR, even though we were third of the major 3 players in the sport rec market, we were third in promotional spending but had significant share gains, probably the most share gains across the board for us. ATVs were also up, and that was probably on a year-to-date versus where we are now. We had been lagging the market somewhat considerably in ATVs in both spending and market share, and we were able to garner some of that back with more targeted spending in the quarter. But we gained share across the board, all 3 major segments, but I would say RZR led the way.

Robin, on the fourth quarter, in my prepared remarks, I talked about the year-over-year sales guidance being somewhere between up 9% to 13%. If you factor in the [$109 million] of sales we had last year for TAP, which was only partial quarter, as well as Victory coming out, you'll get to an organic sales number that is probably 6% to 7%. And then I would refer you back to the comments that we're looking to ship at pretty much the cadence of retail to kind of give you a sense of what we're thinking.

Okay, great. And then just to clarify, Scott, when you mentioned that all 3 segments are up or something in terms of market share, are you -- does that mean ATV, utility, side-by-side and sport rec side-by-side? Or I'm just trying to understand what...

Yes, yes.

Your next question comes from Joseph Spak from RBC Capital Markets.

First question. I just want to go through maybe the gross margin bridge year-over-year. I guess I'm still a little bit confused by 2 things. One is, last year in the third quarter, you said about 490 basis points of warranty, which I think came to about $57 million. So if we adjust that back out, then you still had gross margins down 200 basis points year-over-year. And so just want to get a better sense of what the offsets are there. And then somewhat related, I guess, I know you called out better product mix as a positive. But I'm a little confused, given sort of the ATV commentary, why mix was so positive on a year-over-year basis.

Well, I'd say a couple of things. One, even with ATV growth from a retail standpoint, when we look within the company's shipment register, we had a heavier level of shipment of side-by-sides. So that's where the mix favorability comes in. As it relates to warranty, yes, you're right, $57 million is what we disclosed last year. What I would tell you is that the comments we made around, we continue to see elevated warranty levels, so not all of that $57 million went away. It's safe to assume that probably 20-plus percent of that remain. So we had to do a lot of work inside the company to really drive at offsetting that from a VIP. And then all of the impacts that we essentially offset from an EPS standpoint with a tax benefit, all of those supplier-related, hurricane-related impacts came through in gross profit.

Okay. And that 20%, is that something that you think can improve over time? Or is that sort of the new sort of (inaudible)...

No, it should. I mean, if you look at last year, our warranty rate bounced somewhere between 4% and 5% of sales. This year, we're registering around 3-plus, 3% to 3.5%. Our view is that we should be able to get down to where we've been historically, but it's going to take us a couple of years to work through that.

Okay. And then just on free cash flow. So the margin, I think, this quarter -- this is typically the strong free cash flow quarter. I think the margin was 13%. And like, I know we can't use last year because there's a lot going on, but I think historically, it's been in sort of the high-teens. And I guess I'm just wondering, was there anything specific? Is -- did the nature of TAP sort of change the free cash flow profile at all? Or...

No. I mean -- I think, Joe, the tough thing is, at least through the end of this year and maybe even a little bit of next year, we've got so many dynamics going on around the amount of accruals that we put in place that obviously impact the net income but don't impact cash flow for a period of time. And that's -- and part of what we've been dealing with this year is that while we move through a number of the warranty items pretty quickly, there's others that are taking a little bit longer, so the cash flow impacts are occurring later than we had originally anticipated, which is why when we talk about operating cash flow being up through the third quarter but yet down for the year double digits, you can get a sense that we're anticipating some of those cash outlays happening here in the fourth quarter.

Your next question comes from Michael Swartz from SunTrust.

Mike, first question. Just wanted to clarify if -- I guess, excluding some of the costs you called out in terms of the hurricane-related impacts, supply chain-related impacts, would gross margin have actually improved sequentially versus the second quarter on an adjusted basis?

We would have been a lot closer to the second quarter.

Okay, okay. Fair enough. And then just with the ASPs that you -- I think you said ASPs were up 6% in the quarter. Is that something we should think about as being kind of the run rate going forward? Or was it just heavier mix towards RZR during the quarter?

Some of it was mix. I mean, year-to-date, we're up 3% in ORV, so you can tell that a lot of that really came through here in the third quarter. I don't think we see much changing as we move forward in terms of the mix dynamics within ORV. Obviously, our promotional spend will be coming down in the fourth quarter, as I indicated in my prepared remarks, so that will alleviate a little bit of pressure. So I think Q3 is probably a pretty decent marker for now.

Okay. That's helpful. And then finally, just, Scott, I think you made comments, some general comments on 2018 and your early thoughts in that you said just in terms of the operating expense improvement that you're driving or looking for next year. I guess, how much of that is just revenue growth versus explicit cost-reduction programs?

It's obviously a mix of both, and we talked about reducing it as a percent of sales. So obviously, if sales go up, it gives us a little bit of headroom. But we are also taking steps to reduce the operating expenses across the business. Our indirect spend, we have literally spent liberally to improve our safety and quality. And we'll continue to spend what we need to spend to make sure we get to the levels that we expect performance there. But we do see an opportunity for efficiency throughout the business. We're taking steps this year. We'll take more next year. And we believe that productivity is going to be a major play for us going forward, and obviously, that includes operating expense.

Your next question comes from Greg Badishkanian from Citi.

So 2 questions. First, when you talk about the reasons for the retail pickup being a little bit less stringent regulations, higher consumer demand, why do you think that the heavyweight motorcycle market has been weak?

Greg, I don't really want to talk too much about our competitors, but I believe that there's a very, very large player that weighs on the heavyweight motorcycle industry, and their weakness is pulling the industry down.

Okay, all right. Well, just look at it different way. If -- let's say the market were flat, how do you think your retail sales would have done? Would you have actually -- would you have seen an improvement? Or is it kind of independent of that because of that one big player that's weighting the industry?

Greg, since we launched the Indian brand, we have gained market share. So if the market improves, we will improve on a corresponding basis. I -- you know what, the work that Steve Menneto and his team, the dealer networks that we've built out, the quality of the bikes that we're launching, the strength of the brand, we're really encouraged. As we talk about bringing more riders in and expanding the industry, it's good for all of us. And we would've done better had the industry done better.

Okay. And then just finally, dealer inventories, you talked about those being low and lean. Do you think you lost any sales because of that? It's a good problem to have versus having too much inventory, but do you think it negatively affected retail at all?

Greg, I'm certain that we lost a sale somewhere across the country, but with the results we had, I'm not going to at all suggest that they could have been significantly better if we'd had more availability.

Your next question comes from David MacGregor from Longbow Research.

I guess, first question on just promotional activity. It was so strong in third quarter. What was the thought process behind extending the Factory Authorized Clearance through October? And I guess, do you end up pulling through business from the balance from November and December? Can you just talk about that, first of all?

Yes. David, I think we do that every year. So I mean, maybe once out of 5, we don't do it. So I think it would be more the outlier if we hadn't extended it versus whether we had. And we look at our aged inventory in the field and we make a calculation on what it's going to take to get rid of it and whether it's better to do towards Factory Authorized Clearance sale or the holiday sales event, and I think we're just being more consistent rather than an outlier.

Okay. Second question was just with regard to dealer concentration. I guess, is dealer concentration increasing? Or is it decreasing? And is that a contributing factor to the weaker gross margins? As I guess more volume moves through fewer dealers, they're better able to qualify for volume rebates?

I don't think so. I mean, we track the dealer movements, and I would tell you that the ads and the leads have pretty much offset all year. The -- as I mentioned earlier, from a gross margin standpoint, I mean, more of what we dealt with here in the third quarter had to do with the one-off items that I mentioned as well as just the elevated promotional level that we had fully anticipated and built into the results.

Your next question comes from James Hardiman from Wedbush Securities.

I guess, first thing, can you -- maybe it's difficult to do, but can you quantify the hurricanes and the other -- if you can quantify the hurricanes in any way, that would be helpful. And maybe just a clarification, you talk about supply chain and natural disaster headwinds. Were there supply chain issues that were not attached to the natural disasters in the quarter? And if so, what was going on there?

Yes. So I think, James, just to quantify it, think of the tax EPS offsetting the EPS impact from the supply chain. I would tell you that there was a supplier quality issue that we had to work through and resolve, and that backed up production. So at the same point, we were trying to catch up on production. We were running up against the effects of the hurricane, which put constraints around shipping, both in terms of being able to get at trucks, given the high demand for the vehicles, as well as some of the challenges associated with being able to actually travel through some of the impacted states.

Okay. So the supply chain issue predated the hurricanes, the hurricanes made it worse, but that essentially is offset -- both of those things are offset by the tax benefit. Is that the right way to think about it?

Correct, correct.

And then maybe another unfair question, if you haven't looked at this in detail. But I think the comparisons to maybe the third quarter of '15 seem maybe really relevant just given how messy last year's third quarter was. Maybe talk about where market share has gotten back to after a really good quarter of share versus where we were at the high watermark. And then as we think about some of these costs, I mean, obviously gross margin is down, selling and marketing up, how do I think about that relative to 2 years ago? I think we get the warranty stuff, but maybe exclusive of the warranty stuff. I guess I'm just trying to figure out how much more promotional are things today versus 2 years ago.

Yes, James. I will tell you that interestingly, the third quarter of '15 is very relevant. The fourth quarter of '15 is not very relevant because that was when things started to go south for us. But if you look, what we talked about since the third quarter of '15 is a significant increase in competitive environment. We've obviously had a -- more than our fair share of recall issues. And I'd say, in side-by-sides, we're down 2 points of market share in that time. So I'll -- I mean, I never want to be down in market share and we're glad we reversed that trend in the third quarter. But if you look at that scenario, if somebody were to play it all out for you, I would have predicted a different outcome in -- than down 2 points. So we have a lot of work to do. I mean, there is no doubt in my mind that we are nowhere near as good as we can or should be. But the third quarter was helpful and it's stemming the market share losses, but we're still down on a couple year basis points.

Yes, and James, I went back and looked at our average selling prices back to 2015, and we're down in ORVs probably 2% to 2.5%. So we've recovered a fair amount relative to where we were at in 2016. But we're not still back to parity, but I think that's reflective of a little bit more challenged market and higher level of competition.

And just so I understand that last point, Mike, that was a really helpful data point, does the ASP encapsulate all the promotional spending? I mean, selling and marketing is up a bunch. How should I factor in all?

Yes. So it factors in all of our promotional costs. So when you hear FAC or the holiday event, it's got all that built in because that's a contra sale. The thing to remember and keep in mind is our sales and marketing is up a ton because we bought TAP. I would tell you, about 90%, 95% of that increase is because we just layered in that business year-over-year.

Your next question comes from Joe Altobello from Raymond James.

So first, a couple of quick housekeeping items. I guess motorcycle ASPs were down 4% in the quarter. I assume all of that was due to the mix given the weakness in Slingshot. But what was that number for Indian alone?

Well, Indian was probably more of a driver than anything because the Bobber launch was so successful. And as we talked about, we had our highest midsized bike market share in history. So the continued strength of Scout, which we're pleased wasn't cannibalized by Bobber, really drove that lower.

Okay. So it wasn't all Slingshot. And then the tax rate for next year, does it go back to 34%? Does it stay at 32%? And obviously, this excludes any corporate tax reform.

Yes. I mean, look, our starting point is typically when you look at all the puts and takes around 34%. This year, we've had more impact from this work done around the R&D tax credit. So at this stage, it's tough for us to have perspective as well as understand what the implications of the potential tax reform initiative will be.

Okay. Understood. And just a bigger-picture question. This has obviously been a -- very much a recovery year in terms of margins with a lot of moving parts. You've got lower recall-related costs, but you've had higher R&D expense, higher promo, higher variable comp, et cetera. With that in mind, and obviously, volumes will drive a lot of this, but can you help us frame how to think about the operating margin improvement for next year, at least directionally? Could we see a similar improvement next year as we're seeing this year with a little less from gross margin coupled with lower operating expenses?

Joe, we're not going to provide any more detail than I provided in my prepared remarks on 2018 at this point.

Your next question comes from Drew Lipke from Stephens.

I'm curious, so we've cleared a lot of the model year '17 inventory with the Factory Authorized Clearance. And I'm curious, you mentioned the higher traffic rates that we're seeing. Can you talk about maybe the order trends or the up-sale opportunities for the model year '18 products? And then coupled with that, if you look at your new RZR pricing strategy for model year '18, how are you seeing the up-sale opportunities so far through this new RZR pricing strategy?

Yes. The -- we've spent a lot of time talking with our off-road vehicle group [through] to make sure that things are working as anticipated. I would tell you that the new pricing structure in the Turbos is working exactly as we had intended. Reiterating what we disclosed back when we were in Huntsville, the new RANGER order level is being up 150%, Dynamix being up 200%, so the dealers are very enthusiastic. We have not retailed out a significant number of units yet. We want to clear through the 2017 inventory. So we've now got both the new RANGER as well as the Dynamix products in the hands of dealers. For those that we have retailed, we've been very happy with what we've seen so far. So we're highly encouraged with where we stand.

Okay. And then of the Victory dealers, how much of that floor space was actually converted over to ORV space? Was that a noticeable benefit at all?

No.

Okay. And then just last one for me. With the delay in shipping model year '18s and you mentioned the natural impacts and moving on to side-by-side with RFM and still factory-level inventory looks to maybe a little high relative to historical levels, how should we think about -- as Huntsville comes online and RFM gets fully up to speed through '18, how should we think about maybe a normalization to historical inventory levels from a factory perspective?

Yes, Drew, I -- the thing I'd encourage you to take a look at is our year-over-year increase in inventory is driven by TAP. When we pulled that out to look at the underlying business, our underlying business through the third quarter was actually down 6%. So we've continued to make improvements through the lean initiative, getting ready to support RFM. Inventory turns are up. So we feel pretty good about where we're at from an inventory perspective right now. Not that we can't continue to make improvements, but we've certainly changed the direction and trajectory from what we've seen historically.

Your next question comes from Jaime Katz from Morningstar.

Can you talk a little bit more about Slingshot? I know last quarter, you talked about high promotional costs and working on dealer engagement. It sounds like you guys feel good directionally where you're going with that. So if there's any elaboration, I'd appreciate it.

Yes, Jaime, obviously, we're pleased with the level of innovation we brought with Slingshot, getting us into a new market. We're not happy with the execution in terms of quality and reliability that we had. And I will tell you, the team has been working extremely diligently to drive improvements in refinement and performance and quality of the vehicle. And as I said, I -- the new Icon series brings to bear a lot of the technology and capability that we know we can. The new production line in Huntsville is driving quality enhancement. So we feel good about the opportunity for profitable growth in the future. But we do have some work to do to get rid of the model year '17 products still in the field. We'll work through that in the fourth quarter and early next year. But with the Icon series coming out, we believe that with the right focus, we can get that business back to a sustainable profitable growth platform.

Okay. And then for G&A, I think it's come down quite a bit this year. Is there a way that you guys think about squeezing more efficiencies out of there, out of that line item, just from sort of scale, leverage as the business improves? Or is it naturally higher than maybe it has been historically because of the businesses that you have folded in over the last few years?

Well, there's a little bit of that. I mean, TAP comes with a little bit higher SG&A overall, just given the model that they have. I would tell you that, as Scott mentioned earlier, we're driving for efficiency. And we want to make sure that people don't interpret that as we're going to go on a cost-cutting spur because at the same time, we need to make sure that we're supporting the revenue growth in the company. So efficiency is the key word. So we'll be looking to really try and leverage as much of that cost base as we can going forward. And we think we've got ample opportunity to continue to do that, as Scott suggested for the 2018 outlook.

Yes. And when we talk about our 2018 outlook in January, we'll talk about -- in a little bit more detail some of the productivity initiatives that we'll be focused on to provide a little bit more color in that category.

Your last question comes from Seth Woolf from Northcoast Research.

Real quick. A couple of questions. First one, I think, Scott, you mentioned that the FAC event was really helped out by some improved execution. I was wondering if you could talk about some of the things that have changed compared to FAC promotions in years past, besides the actual financial incentives. And then now that we've kind of worked through some of the carryover inventory, is there any line of sight you can provide on kind of what October retail has been looking -- has looked like thus far?

Yes. Obviously, Seth, I'm not going to provide too much detail on what we think is a competitive advantage in how we executed FAC. I will tell you that with some of our digital resources and the way the team -- the integrated team was focused, we were able to be more targeted in our approach, and that yielded better results. And I think you know the answer about our willingness to talk about October retail.

I had to take a shot. I guess the last question and I guess kind of along the same vein, I know you don't want to get ahead of yourself with 2018, but just bigger picture, what's the best way to think about the ATV market? Because it's really been like a yo-yo this year, very volatile. So any thoughts on that would be super helpful.

Well, Seth, I mean, if you just look at the -- you talked about big picture. Look at the long term. I mean, ATVs are less than half of where they were a decade ago. And we have said before, and I'll say it again, we believe that industry is relatively flat going forward, not so different from the snow business. So it becomes a share gain and a little bit of innovation happens. Not nearly as much innovation is happening in ATVs as it is side-by-side. And I think when some of that happens -- so therefore, you've got most of your promotional-driven environment with ATVs, and I think that's what's driving the volatility. As you know, we had a major player, what do they call it? A no-brainer sale. Just, I mean, thousands of dollars off. And that drove some volatility in the industry. But I believe, over the long term, it's a flat to slightly up market.

Okay. So the modest ORV growth you discussed is -- I mean, is all side-by-side driven. I think that's a safe assumption.

Has been and will be.

Okay. Thanks. I want to thank everyone for participating and your interest this morning. And we look forward to talking to you again next quarter. Thanks again, and goodbye.

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