Polaris 2005 Annual Report Download - page 6

POLARIS INDUSTRIES INC.2
In addition to these operational successes, we made three strategic
moves that will provide substantial benefits over the next several years.
KTM partnership. During the summer of 2005 we announced the
purchase of 25 percent of Austrian motorcycle manufacturer KTM.
KTM has a 50-year history comparable to Polaris’ and is currently the
second-largest motorcycle manufacturer in Europe. KTM and Polaris
form a natural partnership; we compete against largely the same
competitors, but are not direct competitors ourselves. We have the
potential to help each other, while strengthening each of our
own businesses.
For Polaris specifically, the KTM partnership offers us the
following benefits:
• A stronger European presence. As the North American market for
ATVs slows, it is critical that we expand our presence in Europe.
While we have been quite successful on our own, Europe is
KTM’s home market, so they can help accelerate our progress.
The KTM brand is among the strongest in Europe, the KTM
dealer network is large and powerful, and KTM’s engineering
and manufacturing facilities in Austria are world class.
• A technology partner. KTM has some of the best engine technology
in the world, and its more than 100 world championships in
racing demonstrate its performance and reliability in a way that
enthusiasts instantly recognize.
• Additional scale to reduce component costs for both companies.
In cases where we purchase components from the same suppliers,
we’ll purchase jointly to gain economies of scale.
• A complementary presence in motorcycles. Victory competes
in the heavyweight cruiser market. KTM offers a line of off-road
and performance on-road motorcycles that complement the line
of Polaris ATVs and Victory motorcycles.
• An experienced management team with a track record of success.
For the last 14 years, KTM has produced growth through
the same recipe that has made Polaris successful — innovation.
Similarly, we believe that Polaris can provide specific benefits to
KTM in terms of a strong North American presence, chassis technology,
a strong market presence in ATVs, and a similar demonstrated track
record of performance.
We have structured the first two years of our strategic partnership
to answer two questions. First, we want to know if these apparent
financial benefits can actually be realized. Second, we want to know
if we can build a good working relationship between the two
organizations. To do this, we are collaborating on seven, well-chosen
strategic projects that will help demonstrate whether the marriage
will work — in such vital areas as product development, sourcing,
engine technology, manufacturing, dealer financing and distribution.
We are optimistic about having a good cultural fit and mutual
financial benefits, but, sometimes, mergers that look beautiful in the
boardroom may get ugly in the cubicles. By following this approach,
we’ll have specific, tangible financial results to measure before we
make the final decision on a next step. If the first phase is successful
and both companies agree to proceed, Polaris will have an opportunity
in late 2007 to purchase a majority share of KTM at a price based
on predetermined pricing formulas to be derived from operating results
of both companies in 2007.
Although we’re focused on making this deal work, we haven’t
closed the door on other internal and external opportunities to
accelerate growth and profitability. With our strong balance sheet and
healthy cash flow, we can continue to fund other good ideas, pay
dividends and buy back stock for the foreseeable future. We believe
that purchasing Polaris stock at current market prices continues
to be an excellent use of the Company’s capital.
Completion of R&D center. Experienced Polaris investors know that
innovation has been the lifeblood of the company throughout its
history, fueling the organic growth of the company over the long run.
Over the last 25 years, for example, Polaris has grown by a factor
of 150 — all based on the innovative ideas of our team.
One of the most important developments of 2005 was the
opening of the new Product Development Center in Wyoming,
Minnesota. With this high-tech facility we are making a $35 million
investment in the future — the largest single capital investment in
company history — attracting the best people to work with state-of-
the-art tools to design the finest vehicles. And it is paying off already.
If you are product development nuts, as we are, this may be one of
the most fun, magical places to work on the planet. We believe that
over the next 20 years, the Wyoming R&D center will prove to be
one of our best investments ever.
Restructuring the retail financial services eliminated the credit risk
and preserves the upside. A restructured retail financing agreement
removed all credit, direct interest rate and funding risk we had under
our prior contract. In August 2005, we received $50 million in a
return of our cash investment and, in the future, Polaris will receive
income based on the volume of retail credit business generated.
We anticipate that the future income levels from the new agreement
to be comparable to our old structure, but without the credit risk.
In addition to the successes, there were also some disappointments
in 2005:
Execution in snowmobiles was below our expectations. We had a
number of challenges: warranty and product costs were up, and
market share and margins were down. We did not perform to our
expectations in our heritage business, and it showed in our financial
results. In addition, due to unfavorable weather conditions, the
market contracted further. While we can’t predict the weather, we
expect to execute significantly better in 2006.
Commodity prices hurt. Higher prices for oil and raw materials didn’t
just affect our component, manufacturing and transportation costs.
Consumers faced with rising gasoline prices and interest rates
thought twice about making big purchases. Inventory backed up at
dealers and the factory. We will work through it, but the impact on
our gross margins was significant. As we reduce inventory and
intensify our productivity efforts, we expect to generate gross margin
expansion in 2006.