Margaret Giles: Welcome to Investing Insights. I’m your host, Margaret Giles. School is back in session and summer is drawing to a close. Now you might be thinking about where to store your summer toys, or maybe you’re regretting buying that boat you never managed to get out on the water. But even though the boat in your garage is giving you buyer’s remorse, you might consider buying the company that made it. Jaime Katz is a Senior Equity Analyst for Morningstar Research Services. We talk about two companies that stand out in an industry that has taken a beating. Here’s our conversation.
Thanks for being here today, Jaime.
Jaime Katz: Thanks for having me.
Giles: So, I’m interested to hear if this rings true for you, but it seems like the COVID-19 pandemic led more people outside finding new hobbies like gardening, golf, and even riding ATVs and boating. I know in Chicago we’re used to seeing boats on Lake Michigan every summer. So, in terms of the recreational industry, I want to hear vehicle-wise is demand the same then as it is now? How has it changed?
Katz: Yeah, I think it’s really interesting. With more time working from home, people have been able to carve out an exceptional opportunity to participate in outdoor sports, which maybe they hadn’t done before. So, we bifurcate the industry between boating and recreational vehicles. And when you look at PCE data from the BEA, the recreational vehicle categories has performed really, really well. In fact, it’s up pretty significantly from 2019. So, the demand there has really maintained. On the boating side, we look at conventional outdoor retail. That has languished a little bit. It bounced really quickly in 2020, and it’s pruned back since then. So, I think when we look at the level of spending in the category, it’s come off at about a high single-digit rate since 2019. A little bit of a difference between the two subsectors.
Giles: Got you. So, what kind of environment are these companies dealing with today? I know there’s consumer demand issues, and then also potentially on the dealer side of things, there’s a couple of different factors that are impacting them.
Katz: For sure. I think the higher prices have really hurt consumers and their willingness to spend on lots of different discretionary items, but in particular, big-ticket discretionary items. Some of the luxury or higher-end models are doing okay. They’re still hanging in, but that’s a much smaller part of the market than the mass market. So, when you look at things like ATVs or motorcycles or jet skis, those have been a little bit more difficult in recent quarters. And I think part of it is that while inflation growth has calmed, price levels haven’t really come down. So, consumers are still cautiously watching their wallets. On the dealer side as well, floor plan financing has been a lot more expensive. So, the willingness to take units and keep them in the dealership and hold on to them is something that has really waned in the last year or so.
Giles: Okay. So, when we think about potential interest rate cuts, will those have an impact on consumer demand and then maybe some other of these players in this industry?
Katz: I think the impact will probably be slightly delayed. So, if we’re looking at something like a 25-basis-point interest rate cut, I’m not sure it’s going to move interest rates enough for both dealers and consumers to be very bullish on $30,000 to $60,000 purchase. I think really once we have maybe two to three interest rate cuts, 75 basis points to 100 basis points, we could see more movement in interest here and that may resurrect some of the sales again. And so, I think we’re really looking at a six to nine-month window before we have evidence of this bottoming and turning around.
Giles: Got it. So, this is just something that I’ve heard, and I don’t know if this is actually true or not, but someone has told me that demand for recreational vehicles is actually correlated with oil prices. Is that true or is that just anecdotal?
Katz: So, I think there was an interesting period of time in the middle of the last decade where the oil producing regions were shrinking very quickly. And when you think about both Western Canada and Texas, they’re super important distribution regions for ATVs. And so, I think it was more a function of the fact that the consumer in those oil producing regions were really getting sort of hit in the wallet through layoffs and things rather than that oil prices were moving directionally one way or the other. And I think that I look for it to be more tied to sort of the general economic environment rather than one commodity.
Giles: Got it. And so, you mentioned earlier the higher end market is doing all right on the boat side. Is that because overall the stock market has been doing all right, and so, you have that kind of wealthier consumer that’s not as concerned with maybe the financing side of things?
Katz: Yeah, I mean, I certainly think the wealth effect is a real factor in it. But also, the people that high net worth consumers are going to be less impacted by this cycle just generally. So, it’s not going to make much of a difference and maybe they’re more willing to pay in cash. And so, the decision is not based on whether you’re paying 9% on financing your boat, but rather whether you want it now or when the next cycle of innovation comes out.
Giles: So, I want to start focusing on a couple of these companies that you cover. So, both Polaris and Malibu Boats have these durable competitive advantages, these economic modes that they’ve carved out in this kind of competitive industry. Can you talk about how they’ve been able to fend off their competition? And maybe you can start with Polaris.
Katz: Sure. I think the most important thing that we see out of these businesses is that they’re willing to spend on R&D and innovation. Most consumers are willing to buy products that have sort of the best, most interesting, most new technology. If there’s a different paint coating or if there’s a different hull or something that makes the product differentiated, you will see consumers sort of float to that new product. And I think that largely most of the companies we cover are very willing to spend on that innovation and that keeps them sort of front of mind for their consumers.
The other pieces, a lot of these – particularly, if you think about ATVs, snowmobiles, motorcycles, they’re pretty concentrated industries with pretty significant market leaders. Snowmobiles are basically made by three players, same with personal watercraft. So, there’s not a lot of incentive for other competitors to enter the market. And then lastly, these OEMs have really spent time cultivating a dealer network that is in tune with the products and can really help convey the messaging of what their brand offers.
So, I think Polaris has a very broad umbrella of products that they’re offering now. They have ATVs, snowmobiles, boats, some work vehicles. And when you look at Malibu, that’s a little bit more narrow. So, they’re basically selling water products. Malibu, the brand and Axis are a key product for them that they sell. And the boat industry is much more fragmented. So, there are a lot more operators in it. So that sort of differentiates them and puts them in that narrow bucket because we really don’t have the same sort of confidence on durability of the competitive edge with so many players in the space.
Giles: Got it. That makes sense. So, Malibu has that kind of narrow focus among that huge kind of – or larger competition pool. So, turning back to Polaris, what is Morningstar’s outlook for the company?
Katz: So, we actually have a pretty conservative outlook for the company longer term. We do have them returning to growth, 2% to 4% growth on the top line. We have really modest operating margin expansion in the model. And a lot of this is focused on their return to their core competencies. They have divested some distracting businesses maybe in the last few years. And so, as they get back to their core competencies, they can squeeze some more efficiencies out of the business. And that is really what underlies our $120 fair value estimate. I mean, these shares have been really undervalued and probably will remain so at least for a few quarters given where we are in the cycle and the necessity for interest rate cuts to evolve.
Giles: Got it. So maybe a spring jump forward as demand increases. And then lastly, what do you think about Malibu looking forward?
Katz: Yeah, Malibu is a really fascinating company. And I think the thing that underlies our $58 fair value estimate is that we expect them to continue to be acquisitive. It’s something that has been sort of in the DNA of the business. And so that allows us to embed 6% to 8% sales growth in the model and be able to grow the business over a long period of time. They’ve articulated they want to go into pontoons, reach new adjacent categories. And I think building a brand that resonates well with consumers under a leadership that has actually changed and now has – they have an old Polaris leader running the business as CEO now. So, there’s a lot of institutional knowledge there to grow this business in a really smart way. And I think that’s why we view it favorably.
Giles: Interesting. All right. It’s been really interesting to hear both about the industry at large and then a couple of these kind of key players. Thanks for being on the podcast today.
Katz: Thanks for having me.
Giles: That wraps up this week’s episode. Thanks for listening. If you enjoy hearing market trends and analyst insights on our podcast, feel free to leave a five-star review on Apple Podcasts. It will help others find us. Thanks to senior video producer, Jake VanKersen, and associate multimedia editor, Jessica Bebel. I’m Margaret Giles, content development editor at Morningstar.
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