Polaris Inc. Q2 FY2021 Earnings Call

Thank you, Cole, and good morning, everyone. Thank you for joining us for our second quarter earnings call. A slide presentation is accessible at our website at ir.polaris.com, which has additional information for this morning's call. Mike Speetzen, our Chief Executive Officer; and Bob Mack, our Chief Financial Officer; have remarks summarized in the quarter and our revised expectations for the full year, then we'll take questions. During the call, we will be discussing various topics, 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 2020 10-K for additional details regarding these risks and uncertainties. All references to the second quarter 2021 guidance are reported on an adjusted non-GAAP basis, unless otherwise noted. Please refer to our Reg G reconciliation schedules at the end of this presentation for the GAAP to non-GAAP adjustments. Now I'll turn it over to our CEO, Mike Speetzen. Mike?

Thanks, Richard. Good morning, everyone, and thank you for joining us. I continue to be incredibly impressed with the dedication, commitment, and execution of the Polaris team as we navigated ongoing supply chain pressures, logistical challenges, and increasing input costs to deliver impressive second quarter results. Focused execution is our mantra and it once again paid off as the team expertly navigated the challenges to enable us to exceed expectations. I want to again thank the entire Polaris team for their continued focus and commitment to this great company. The powersports industry has experienced significant demand, and that trend continued into the second quarter. Demand, while down from unprecedented levels in the second quarter of last year, was up over prepandemic levels of Q2 2019 by 14%. Overview market share gains continued in the second quarter with gains in both ATVs and side-by-sides. We did, however, lose a small amount of share in India, particularly in our midsized bikes given the supply chain challenges. That said, demand remains strong for these models, and we anticipate our share gains will resume as our vehicle supply improves. Boats also remained strong, growing retail sales and market share during the quarter, and we have a healthy and significant backlog. Although it's off season for snowmobiles, with over half our snowmobile build this year being represented by our near-record high snow check preorders, the sales cadence of our snowmobile business will be even more heavily weighted toward our fourth quarter this year given the timing variation in our component deliveries. Our PG&A and International businesses also performed quite well. PG&A sales were up 35% during the quarter. I'd also note that we are experiencing an increase in the attachment rate for PG&A as more consumers look to personalize their vehicles. Our International business continues to see strength. We grew sales 64% as the economies outside North America continued to improve in Q2. Our earnings outperformed expectations, demonstrating the team's ability to overcome challenges with focused execution. Not surprisingly, production and delivery were and continue to be impacted by global supply chain and logistics challenges. As a result of this and continued strong consumer demand, our dealer inventories are at the lowest levels in decades. I'll talk more about this in a moment. Given our first half results, continued strong consumer demand, and our team's hard-fought ability to execute, I am pleased to report that we are again raising our full year earnings guidance. Bob will give more details shortly. On a two-year basis, our retail is up 14%, reflecting continued growth in powersports driven by strong underlying consumer demand. As expected, our second quarter North American retail sales were down 28% from the 57% increase reported in the second quarter of 2020. The gating factor for retail sales today compared to a year ago is low dealer inventory driven by supply chain impacts on delivery. Retail sales would have likely been significantly higher without these impacts. Despite the supply impacts to ORV retail sales, market share again grew during the quarter. Our ORV business gained over 1 percentage point of market share in both ATVs and side-by-sides. Motorcycle retail sales also continued to grow, increasing 22% during the quarter. However, Indian lost a modest amount of share during the quarter, driven by low availability of bikes, particularly our very popular Scout and Chief models. Strong boat retail also continued and remained ahead of the industry. Dealer inventory levels ended the quarter down 57% on a year-over-year basis and were also down sequentially. Our presold order process continues to be an effective lever that our dealers are utilizing to ensure they don't lose a sale. And I'll go into this in more detail in the next slide. Looking at the remainder of the year, dealer inventories are expected to remain lean into Q4, which is when we are anticipating the supply chain issues will begin to slowly improve. Given stronger-than-anticipated demand coupled with continued supply constraints, our expectations for dealer inventory levels to return to RFM profile levels is now sometime in late 2022 or even into 2023. As I discussed earlier, the unprecedented demand, coupled with the supply chain constraints, has created significant disruption in our shipping cadence. With dealer inventory at record lows, the most effective, efficient way for our customers to secure the product they want and for our dealers to maximize retail and profitability is through our presold order process. The advantage to consumers is that orders placed in the presold system receive priority in our production and shipping schedule. In addition, dealers and consumers can receive PG&A priority is placed at the time of the vehicle order. As a result, presold orders have increased significantly since the pandemic began. Pre-pandemic, presold orders accounted for roughly 3% of our retail. Exiting Q2, ORV presold orders were approximately 80% of retail. While there have been some reports that the presold order process can be misused, our audits have found that not to be the case. We regularly audit the system looking for a name change from the presold order at the time of registration. These audits have found less than 1% where the names changed at registration and where there were changes, the majority had valid reasons for the change. I'd also point out that the presold order cancellations remain at low single-digit percent, which is similar to pre-pandemic levels. Lastly, we have analyzed shipping patterns to our dealers by tiers, volumes, and regions and were all within 1% of pre-pandemic levels. The bottom line is that there's high confidence in the presold order process, which is why it continues to be a competitive advantage in this very tight inventory environment. Our manufacturing plants are operating at peak supply chain constrained capacity. Our manufacturing, supply chain, and logistics teams continue to execute at a very high level, managing the ever-changing production schedules driven by component availability with a singular focus to meet the demand of our consumers and dealers with high-quality vehicles and components. Despite our efforts, we couldn't meet all the demand during the quarter. As I indicated earlier, our presold order levels have increased significantly, and it appears those customers are waiting for the high-performing, high-quality vehicles we produce. I'd like to be able to say today that we see the light at the end of the tunnel. But given the ongoing heightened demand for our vehicles and supplier challenges, it appears we, along with the entire powersports industry, will be in a period of tight vehicle supply for the remainder of the year. Our teams are doing impressive work to keep the flow of products moving, including expediting components, adjusting build schedules, substituting materials where appropriate, and buying select materials on the spot market. Focused execution and teamwork will ensure we win the competitive battle. As indicated in our last call, we are also adding capacity later this year and into 2022 that will bring on 30% more production capability between ORV boats and motorcycles. This capacity is needed to meet demand, fill the dealer channel and allow for the addition of some very exciting new products coming next year. One of the drivers behind the unprecedented demand has been new customers coming into powersports. New customer growth in the first half of 2021, while down slightly from the robust rates in the first half of 2020, remains comfortably ahead on a comparable two-year pre-COVID basis with approximately 300,000 new customers coming into the Polaris family over the first half of 2021. The mix of new to existing customers has remained high at over 70% of the total customers for ORV, motorcycles, snowmobiles, and boats. Our existing customers continue to grow at a healthy rate. And lastly, it's exciting to see the diversity of our customers also grow, led by Hispanic and female riders joining the Polaris family. Overall customer demand in total remains very strong. We track repurchase rates for our customers, which are increasing on a year-over-year basis. This provides us with the confidence that our customers intend to remain with the sport. I'll now turn it over to Bob Mack, who will summarize our second quarter results and our updated expectations for 2021.

Thanks, Mike, and good morning, everyone. The Polaris team is battling each day for the components needed to meet the strong demand of our consumers. And as our results this quarter indicate, we are winning many of those battles. Second quarter sales were up 40% on a GAAP and adjusted basis versus the prior year. Shipments and sales improved considerably across all segments: ORV, motorcycles, adjacent markets, aftermarket, and boats. Second quarter earnings per share on a GAAP basis was $2.52. Adjusted earnings per share was $2.70, which was up 108% for the quarter, exceeding our expectations. This strong performance was driven by a combination of revenue growth, lower promotional costs, increased pricing, and operating expense leverage during the quarter, partially offset by higher input costs. Adjusted gross margins were up approximately 310 basis points year-over-year, primarily due to lower promotional and floor plan financing costs driven by low dealer inventory and strong demand, which requires minimal promotional dollars to drive retail. This was muted somewhat by higher input costs associated with supply chain constraints, including logistics, commodity, and labor cost pressures. Operating expenses were down considerably due to the goodwill and intangible asset impairments recognized in Q2 2020. Adjusted operating expenses were up 33% in the quarter relative to Q2 2020, which was heavily impacted by short-term cost actions taken to offset COVID-19 shutdowns. Q2 2021 operating expenses grew sequentially versus the prior quarter due to the timing of legal, sales, and marketing and engineering expenses along with staffing additions. Operating expenses are expected to be down slightly versus the Q2 run rate in the second half of 2021. Foreign exchange also had a positive impact on our quarterly results, primarily driven by the Canadian dollar. From a segment reporting perspective, all segments reported increased sales for the quarter driven by strong demand. ORV/Snowmobile segment sales were up 38%. Motorcycles were up 50%, Adjacent markets increased 98%, Aftermarket was up 15%, and Boats increased 49% during the second quarter relative to Q2 2020, which was adversely impacted by COVID-19 closures. Average selling prices for all segments were up; ORV increased about 13%, Motorcycles were up approximately 8%, Adjacent markets increased 10%, and Boats were up 14% for the quarter. All segments benefited from continued lower promotional costs given high demand and the lack of product in the channel. Pricing actions taken in the quarter and model mix also had a favorable impact. Our International sales increased 64% during the quarter, with all regions and segments growing sales as the heavily pandemic impacted countries began to open their economies again. Currency added 15 percentage points to the International growth for the quarter. And lastly, our parts, garments, and accessories sales increased 35% during the quarter, driven by increased demand across all segments and categories of that business. Moving on to our guidance for 2021. Given the stronger-than-anticipated performance in the second quarter, we are increasing our full-year adjusted earnings per share guidance for 2021 and now expect earnings to be in the range of $9.35 to $9.60 per diluted share. The increase is driven by the expectation that the even lower promotional environment we experienced in the second quarter will continue through the second half as demand is expected to remain high and dealer inventory levels low for the remainder of the year. Additionally, we expect price increases and surcharges for the upcoming model year to provide incremental benefit in the fourth quarter. These benefits are partially offset by the escalating input costs, particularly component cost increases driven by both the global supply chain shortage and higher commodity prices, along with the increased cost from manufacturing inefficiencies, increased expedites, and higher logistics costs. Overall, for the full year, we are pleased that our product pricing and promotional cost reductions are offsetting the expected annualized incremental cost headwinds on a dollar basis. We are narrowing our total company sales growth guidance by holding the upper end of our sales guidance range at 21% and raising the lower end of the range to 19% given our sales growth performance to date. Our dealers have ample presold orders in hand that, combined with additional product, would typically allow us to increase the top end of our sales guidance range. However, given the uncertainty around component supply, we are leaving the upper end of our sales guidance unchanged at this time. Moving down to P&L. Adjusted gross profit margins are now expected to be down in the range of 40 to 70 basis points. This is an improvement from our previously issued guidance and primarily due to the higher-than-expected margins in the second quarter which was driven largely by lower current quarter promotional costs and the timing of promotions accrual adjustments as dealer inventory continued to decline. Adjusted operating expenses are now expected to improve 90 to 120 basis points as a percentage of sales versus last year given the higher sales growth expectations. Income from financial services is now expected to be down in the mid-20s percent range driven by the historically low dealer inventory levels as well as lower retail financing income due to lower penetration rates of our retail providers as more customers are buying with cash and/or have more time to shop their financing needs with other financing sources given the delays in delivery. Guidance for the remainder of the P&L items remains materially unchanged from our previously issued guidance. While our full-year earnings guidance improved as a result of our year-to-date performance, and the pricing actions being implemented at the upcoming model year changeover, our second half performance is expected to be down compared to the second half of 2020 and sequentially from our reported first half results. Let me give some clarity on the second half cadence for earnings. Our first half 2021 EPS finished at $4.99, a 228% increase over the first half of 2020. Given our full-year revised guidance, the second half EPS equates to a range of $4.36 to $4.61 per diluted share, a decrease of 26% to 30% on a year-over-year basis and an 8% to 13% decline on a sequential basis from the first half of 2021. This reduction in EPS on a sequential basis is driven by a number of positive and negative factors, including increases in input costs in the second half of the year, principally commodities, labor, expedite and rework costs related to supply chain shortages as well as unprecedented ocean and truck transportation rates and the timing of operating expense spend. These costs are expected to be partially offset by increased product pricing through both low promotions, higher base prices and surcharges. On a two-year basis, our second half EPS results at the high end of the range are expected to be up over 30% compared to the second half of 2019. I would also add that the quarterly cadence for EPS in the second half of 2021 is more heavily weighted towards the fourth quarter with approximately 60% of our second half EPS occurring in Q4. This is driven by a couple of key factors: First, the majority of our high margins, no Check snowmobiles won't ship until Q4 as compared to a stronger Q3 shipping quarter in 2020. Second, while we are increasing selling prices and adding surcharges to offset a portion of the cost increases, these increases do not take effect until late Q3, thus having a larger impact in Q4. Let me quickly cover our sales expectations by segment. ORV snowmobile sales guidance remain unchanged at up high teens percent. The only modification is the timing of shipments, as indicated earlier, with more snowmobiles being shipped in the fourth quarter of 2021 versus prior year, given the supply chain disruptions and the timing of our pricing actions hitting Q4 more heavily than Q3. Motorcycle sales are anticipated to be up low 30%, down slightly from prior guidance. While we continue to expect our motorcycle business to grow and take share for the year, supply chain challenges are impacting production enough to possibly shift some shipments into 2022. In the remaining segments, Global Adjacent Markets, Aftermarket and Boats, we are increasing our sales expectations given the sales growth realized through the first half of 2021. Year-to-date second quarter operating cash flow finished at $196 million, down 37% compared to the same period last year, driven by an increase in factory inventory due to the supply chain inefficiencies. Our expected full year cash flow performance remains unchanged at down mid-30% compared to last year. During the second quarter, we spent $111 million on share repurchases. We will continue to prioritize organic investments in our business, along with share buybacks throughout the remainder of the year, subject to market conditions. With that, I will now turn it back over to Mike for some final thoughts.

Thanks, Bob. This quarter's results demonstrated the drive and determination of the Polaris team in the face of ongoing challenges. We will continue to effectively manage a challenging environment to meet consumer demand. The underlying earnings power of the company remains strong as does our financial health. Demand for our products remains robust, and we do not see that changing in the medium to long term. Our supply chain remains the top challenge for the company with component supply not expected to improve until sometime late 2021 or even early 2022. And as a result, dealer inventories are not expected to return to normalized levels until sometime in late 2022 or even early 2023. While much of the focus has been on the supply chain, innovation continues to be the lifeblood of Polaris, and we have a number of new products coming, including the all-new electric RANGER, along with exciting model year 2022 launches. Let me close by reiterating that we're winning in a challenging environment, and we remain focused on navigating through the current supply chain challenges and rising input costs to deliver products our customers are demanding while at the same time, delivering improved results and value to our shareholders. With that, I'll turn it over to Cole to open the line for questions.

And our first question today will come from Robin Farley with UBS.

I'm trying to figure out if there's a way to measure how much retail revenue was lost due to product availability. When you mention that preorders are at a record high, can we estimate what percentage of retail sales could have been fulfilled if those preorders had been completed this quarter, and how much higher that would have been? Additionally, this might still underestimate the actual sales you could have achieved if products had been available in stores, but it could provide some insight into the demand that went unfulfilled in retail.

It's difficult to provide a specific number, Robin, but I can say we've had several thousand side-by-side shipments delayed this quarter due to production constraints. The team is doing exceptional work. We're conducting rework operations at each of our factories to keep production lines running, while also retrofitting vehicles with necessary components like shocks or windshields to maintain momentum. Regarding presold units, as mentioned in my chart, we've exceeded 80% of our retail, and it's likely even higher. By the time a product is on the truck or arrives at the dealer, it’s usually already sold or spoken for. Therefore, it’s reasonable to assume our retail sales would have been much higher if the products had been delivered as promised or if there was adequate dealer inventory available on the showroom floor.

Okay. And then just as a quick follow-up. Regarding your full year retail expectations, you previously mentioned that full year retail might be down low single digits due to product availability. Is that still your outlook, meaning there hasn't been any significant change in your ability to address the logistical challenges? Is it accurate to say that it remains in that low single digits range for the year?

Yes. And as we've talked about, motorcycles is expected to be up pretty helpfully, and ORV will be down mid-single digits. So the year down low single digits is what we're expecting right now, but I'll just remind you that when you compare that against 2019, so that it kind of patterns out the substantial lift that we got in 2020. We're still probably going to be up high teens on a year-over-year as compared to 2019. So still pretty healthy growth relative to pre-COVID levels.

And our next question will come from Jaime Katz with Morningstar.

I'm hoping you can comment on the composition of owned inventories. Obviously, there's a significant bump up given some of the supply chain constraints that you mentioned, is there any particular segment that maybe has a disproportionate amount of finished goods inventory on the books? And is there a way to quantify the impact of rework for the year?

Certainly. The main reason for the increase in finished goods is linked to ORV and motorcycles, as we have made a strategic choice to produce items even when they are missing one or two parts. We then place them in rework and ship them out once we receive the necessary parts. This approach is significantly contributing to the rise in finished goods. We are also working to ship out any finished goods we have as quickly as possible. The rework process is the key factor here. Additionally, we have seen a rise in raw materials as we stock up to ensure safety and meet the increased demand we are experiencing. In terms of rework, we are focusing on it, and it is registered in the high double digits for both the quarter and the year.

Okay. And then if we look at the capacity slide that you guys had in the deck, which was, I think, Slide 8, it would imply that over the rest of the year, like you would aim to basically have sort of flattish inventory at dealers assuming all else equal, I think. Is that the right way to think about it?

Yes, what we were trying to convey is that in an unconstrained environment, we have a good capacity position. The constraints we are experiencing are primarily due to supply chain issues. The developments expected in the third and fourth quarters, particularly the rework that Bob mentioned, will help us compensate for the shortfall indicated by the dark blue line in the fourth quarter. We anticipate finishing the third quarter with a significant amount of rework, similar to what occurred in the second quarter. These vehicles will be completed and delivered to meet the anticipated retail increase in the fourth quarter.

Our next question will come from Craig Kennison with Baird.

It's on the dealer network. The pandemic has certainly the potential to disrupt your dealer relationships. I would think more than ever, you're in a position to pick your dealer partners. I'm curious what you're doing to ensure that Polaris is getting a larger share of the best dealers going forward.

You're right, Craig. We have been working over the past few years to reduce some of the smaller dealers that faced challenges and ensure that our dealer network remains robust. The current environment has significantly improved dealer margins. About a month and a half ago, Steve Menneto, Bob, and I visited several ORV dealers, and the consistent feedback was that Polaris has high margin performance. We are actively partnering with dealers to efficiently utilize our promotional funds and manage marketing programs to ensure proper fulfillment. While there will never be unanimous support for a presold order process, most dealers view it positively, allowing them to retain sales. We've communicated with them, and I mentioned that we can accept PG&A orders simultaneously to align with vehicle orders, which enhances their margins. We gather dealer sentiment quarterly, and they are very candid with us. We're proud to remain number one in our network, which largely overlaps with competitors, giving us a clear understanding of our performance. Our main objective now is to continue outperforming competitors in getting products to dealers.

And our next question will come from James Hardiman with Wedbush.

I wanted to revisit Slide 8. There is a lot of information presented here, but regarding the retail numbers you are showing, it seems that overall retail demand decreased in the third quarter despite increased manufacturing output, but then significantly increased in the fourth quarter. Is that an accurate interpretation? If so, what could explain that trend?

It's actually more a factor of what we're able to deliver. So when you look at that third and that fourth quarter bar, you see that the blue is above retail. But really, what that's reflecting is we're likely to be producing a ton of vehicles into rework, which won't put us in a position to meet the retail demand. We don't anticipate consumer demand for the product to have a substantial step down. It's really more our ability to meet the demand. And so we know because of the checks we do, we're not alone in this. Many of our competitors are signaling to the dealer network around order taking and pushout of delivery dates. So we anticipate that, that third quarter is going to be a little bit of a challenge. The good news is, is that we've got an incredible process to get those vehicles reworked and out to dealers, and that's really going to allow us to pick momentum up in the fourth quarter.

Understood. In both situations, you are indicating that it is essential to send as many units to dealers as possible. However, in the fourth quarter, the amount will be significantly higher compared to the third quarter.

Yes. Our dealer inventory is expected to improve slightly as we transition out of Q2, but it won't change significantly from there. This indicates that we are focused on keeping up with retail demand alongside our current factory production. The demand has remained strong, and we expect it to continue. It's frustrating because I wish we could reach a point where we could fully meet that demand and start increasing dealer inventory, as I believe that would further boost retail sales based on feedback from our dealers. However, we are facing significant challenges, similar to many others in the industry, including issues with plastics, shocks, and semiconductors. I commend our team for effectively managing these obstacles. Even though we are shifting some shipments between quarters, they are doing an excellent job of maintaining progress.

And our next question will come from Joe Altobello with Raymond James.

I had a couple of questions on your full year gross margin outlook, which seems to get better, but the second half looks a little bit worse. So I guess first, how much of a benefit is the lack of promotion to gross margin this year? And second, you mentioned a number of headwinds. How much of that might be structural versus temporary? And how should we think about gross margins, I guess, directionally next year, given all the cross currents between pricing surcharges and obviously, the higher input costs?

Joe, it's Bob. I would consider gross margins in a few different ways. On a full year basis, there’s about a half-point negative impact from tariffs since we had exemptions in 2020 that we didn’t have in 2021, which put us slightly behind at the start of the year. Regarding price promotions, price has had a greater effect than promotions overall this year, although promotions had a larger impact in the first half due to the decline in dealer inventory. We don’t anticipate higher promotion levels in the second half, but we also don’t expect them to decrease. As dealer inventory decreases, so do the reserves, which impacted the quarter by about 50 basis points. Structurally, there are multiple factors at play. Labor costs will persist as we have raised labor rates, but that won’t have a significant effect. The main issues are driven by commodities and logistics, which have been roughly equal throughout the year. For instance, steel prices have surged by 130% to 150% compared to our three- and five-year averages, marking a substantial increase. Aluminum, copper, and resins have increased by 30% to 40% compared to those averages as well. The impact from these has been considerable and has accelerated throughout the year. Initially, we thought the impact from commodities would be lower, but it’s now four times that level. We expect these levels to normalize, as there’s no indication that they won’t. The key question is how quickly that normalization will happen, and we anticipate that it will take about a quarter to see benefits or drawbacks. In Q2, we are committed to some of our commodity purchases, which ties us to price. Hence, if prices increase, we won’t feel the effects for a quarter, and if prices decline, we similarly won’t see that for a quarter. The logistics side has some expedite costs that should diminish, as we are currently expediting shipments that are delayed or stuck. We expect that to ease. For example, the average cost for ocean containers is currently $8,500, while spot rates are around $15,000; comparing that to $1,700 in 2019. The future trajectory is difficult to determine, but it’s a smaller part of the overall picture. We believe that most of these issues will resolve themselves as supply chain challenges improve and commodities return to normal, with labor being the exception. We will then see how it affects ocean and truck rates.

Yes. I believe the situation for 2022 looks promising, but the timing is crucial. As I mentioned in my prepared remarks, we expect dealer inventory to remain tight, which should help keep the promotional environment better than it has been in the past. If costs start to decrease, we are monitoring that closely. Of course, surcharges may return, but we have made and will continue to make pricing adjustments that put us in a strong position. Overall, the outlook seems positive; however, the main concern is about timing. We will learn a lot in the latter half of the year and will have a clearer understanding when discussing guidance for 2022.

And our next question will come from Scott Stember with CL King.

It clearly sounds that in an unconstrained environment that retail sales in total could possibly be up this year. Can you maybe talk about that? And if that is indeed to talk about it by segment?

Yes. Well, I mean, first of all, retail will be up for motorcycles and that is constrained. So I anticipate it would be even better than where we're at. As I indicated in the upfront comments, the demand for the Bobber as well as for Scout in general as well as our new Chief model have been off the charts. And so I think in an unconstrained environment, we would see a substantial increase relative to even where we are today in motorcycles, and the same goes for Slingshot. From an ORV standpoint, yes, retail would be much better, whether it would get back to flat or be up for the year. I'm not going to make a comment on that because I think there's too much of the year left at this point, but it's safe to say that it would be substantially better than where it is. And thankfully, our team is executing much better than many of our competitors, and that plus the presold order process has put us in a really good spot to continue to gain share.

Got it. And just last question on tariffs. Can you just remind us what the incremental headwind will be for 2021?

Yes. Sure. Incremental for '21 is about $40 million versus '20.

And our next question will come from Gerrick Johnson with BMO Capital Markets.

I have two questions, if I may. First, the price increases. Can you talk about maybe the quantification of your average price increase and then also the mechanics of the surcharge and how that affects dealers and consumers. And then second is I get why financial services expectations are where they are. But what I don't understand is how the outlook for Financial Services changed so quickly. What caught you off guard there?

I'll address both of your questions. Starting with the second one, regarding Financial Services, it's largely due to the current environment. People are taking longer to secure cash, and it's taking more time for them to receive their vehicles, which has led them to explore options like credit unions. Consequently, our third-party partners are experiencing lower penetration rates across the board. We believe this trend will stabilize over time, returning to normal conditions where customers are visiting dealerships to make purchases. This is where our in-house financing programs show their true value. Once things normalize, we expect to see performance return to pre-pandemic levels. We're not facing issues with customers obtaining credit. Additionally, regarding floor plan interest, it has decreased significantly due to the limited dealer inventory. Can you please repeat your first question? Price...

The first question is on pricing and also...

Sure. So on the pricing, yes, we announced last quarter that we were implementing about an average of a 2.5% price increase and that went into effect May 1. On the surcharges and price increases on new vehicles at model year, that's all coming in late Q3. And so we're still working through that as to what that will be. We are seeing a lot of people out there in comparable industries and in our industry go out with surcharges related to both commodities and transportation. And so we're going to look at that. And then, we'll also look at what we think pricing needs to be on a go-forward basis for a model year. So we're trying to be balanced relative to what do we price in that we think is going to be permanent versus what do we think is going to be short term with some of the commodities and trade challenges. But we haven't set those numbers yet for later this year.

And Gerrick, the thing to remember is with financial services coming down, that also means we're not promoting for those financial rate buy-downs. So we pick up favorability that essentially offsets a good portion of that.

And our next question will come from Joseph Spak with RBC Capital.

Could you provide insight into the gross margin outlook? I appreciate your comments on commodities and logistics being challenges. It seems like the timing of when these commodities impacted us is crucial as they have been increasing since last summer. Looking at the implied guidance, the second half gross margin appears to be about 250 basis points lower than the first half. I understand that higher commodities and logistics costs are factors, and there may be some impact from the mix, but there is also the pricing offset to consider. Could you help clarify these points and explain the 50 basis point gap?

Sure. So part of what you're seeing in the Q2, H1 dynamic versus H2 is that the commodities lag a little bit because we are locked out. In most cases, we buy out 30 days in advance to secure volume really more than price. And we don't hedge, obviously, you know that. So what we saw in the quarter was that we were buying out forward on the commodities. We didn't see as much of the commodity impact has actually hit the market in Q2, and we saw the benefit of the pricing which started in May in the quarter. So from that perspective, it lined up really well, allowed us to have really good gross margins in the quarter. You get to Q3 and the pricing is really in the run rate. Promo was benefiting Q2, both from lower promo and some reserve adjustments. Like I said, that account to reserve adjustments were about 50 basis points. You get into Q3 promo stays relatively consistent pricing is relatively consistent, and the commodities start to ramp up pretty seriously in Q3, Q4. So that's the far and away the biggest driver. Expedites are relatively consistent. Ocean freight is certainly higher in the back half of the year, at least as we see it right now.

Yes. Joe, if we look at the numbers, the impact from commodities is four times greater than it was in the second half and also four times what it was in the first half. As Bob mentioned, we are clearing a lot of inventory, and while we don’t engage in hedging, we do use forward locks and similar strategies to mitigate that effect in the first half. However, with commodities rising even more in costs, that has clearly added additional pressure in the second half.

And our next question will come from the electric RANGER, supposedly to be unveiled end of the year on sale early in the industry challenges on both semis and batteries. Is on track? Or has that been impacted by some of these challenges? And maybe also if you could just add any type of investments the dealers need to make in order to support electric product.

Yes, we have been closely monitoring the situation. As you pointed out, the electronics and battery sectors are crucial. Fortunately, we expect to begin production in 2022. Given that we have time, there have been some minor impacts, but the team remains on track. Similar to our approach with other parts of the business when these issues arose earlier this year, we ensured that the team took steps to safeguard this program to avoid shortages or stockouts that could negatively affect it. Additionally, we are collaborating with Zero on the E RANGER. This means we are not starting from scratch with a new supply base; Zero has established relationships with many of the suppliers we are engaging with. We view this as a benefit, as it allows us better access to these suppliers in preparation for our production volume.

And our next question will come from Brett Andress with KeyBanc.

So going back to Slide 8. I don't want to overcomplicate it, but if you use 2019 as a baseline, do the retail bars imply that you're expecting 3Q to flow versus that low double digits that you did in 2Q. I just want to make sure we're using the right baseline for that.

Yes, we still expect to see an increase compared to 2019 in the third quarter, although the growth may not be as significant as we previously anticipated. This is not due to any concerns regarding consumer demand; rather, it is a reflection of the increasing supply chain challenges being faced across the industry. We have our teams focused on achieving better results, and as you know, we have a strong plan in place to execute our business effectively. We are committed to pushing our teams to continue outperforming the competition and growing our market share.

Got it. Okay. You mentioned a 30% capacity increase across the business in 2022. How much is being added to ORV? Are the investments being made more in labor or adding shifts, and are there any new greenfield builds in that capacity expansion?

I wouldn't describe it as 'greenfield.' It's located on our existing Monterrey campus. We are adapting a building that was previously designated for light tasks and warehousing. Therefore, we are modifying that existing structure. The capacity additions will primarily concentrate on ORV, as noted in our chart, although we are also expanding capacity across the business, including boats and PG&A, due to the increase in demand we've experienced this year, which we expect to continue into 2022 and beyond.

And our next question will come from David MacGregor with Longbow Research.

My question is about new incoming retail orders and any changes at the margin. I'm curious about the patterns you've observed regarding new retail orders throughout the quarter and how these evolved from the beginning to the end of the quarter. I'm also interested in how the 80% presold figure, which I assume is an average for the quarter, changed over that period.

It continued to increase throughout the quarter. Based on the number of emails I receive, consumers are increasingly seeking our product. Therefore, we believe the underlying demand environment remains quite strong. However, we share the concern about how long consumers will maintain their interest. We are ensuring we communicate with them about the lead times for preorders, keeping them updated as much as possible through our communications with our dealers, and making sure we are getting products to consumers as quickly as we can. As our margins reflect, we are not holding back on expenses. When we need to expedite, we do. If we must direct ship from our factory to dealers to get the product to consumers, we are doing that. We understand that we can recoup those costs later, and we want to ensure we are providing as much product as possible to consumers, especially those who have made advance payments.

Great. Great. And second question is just with respect to your motorcycle gross margins, which I guess there's a lot of things moving around in motorcycles this quarter, but the margins were up very nicely. And I'm just wondering, is that just because those smaller bikes were weaker in the mix? Is it because Slingshot considered to be more. Can you just talk about as well how sustainable the improvement might be?

Yes. So there's no question the mix, as you stated, helped motorcycle margins in the quarter with both Slingshot and heavyweight being a higher percentage than they have been in prior quarters. But the focus for motorcycles, as we've talked about, we've been building out the product portfolio. The chief was the last big sort of bike we needed to add to have a pretty full and robust motorcycle portfolio. So now we'll be focused more on derivatives and focused on profitability. So that team has a pretty tough objectives to go after, and we're focused on their path to profitability to continue to improve that business.

And our next question will come from Mark Smith with Lake Street Capital.

Another question just on motorcycles. As we look at competition, maybe primarily in midsized bikes, any impact in the quarter from competition versus just purely supply?

Well, I do think, obviously, one of our key competitors, I think, has found their footing, which certainly is helping them. I think their supply challenges are probably dampened relative to us given a fair amount of insourced components that they do. But what we're hearing from our perspective is the demand for our product given the brand recognition is incredibly high. And at this point, the biggest impact we had was just simply our lack of ability to produce those bikes. So we feel really good. We know that there's some competitive news that came out. Our team has done the assessment, and we still think that we've got the best product in the market.

Okay. And then second one for me is just circling back to capacity. And as you've added some capacity here, primarily in Monterrey, can you just talk about your other facilities and what opportunities there are in adding additional capacity? And longer term, if supply chain issues get worked out and demand continues to be robust, do we reach a point where we start to look at a new facility that's needed?

Yes. We are actively making progress. While Monterrey tends to draw more attention as our largest manufacturing site, we have also increased capacity in Indiana for boats. We revitalized a facility that was closed when we discontinued Rinker and Larson to accommodate the hurricane brand. Additionally, we are expanding distribution space in Ohio to better serve our East Coast and southern dealers. I believe we will need to reassess the possibility of larger capacity additions soon. Our team is currently working on this and it will be discussed with the Board. For now, our main priority is managing the current environment effectively while also preparing for when we might hit our next capacity threshold. We encouraged our teams to thoroughly evaluate labor markets, recognizing that while labor hasn't been a significant constraint for us due to supply chain issues, we want to ensure we are in a strong position once those challenges ease. The team has done a commendable job assessing each facility and making specific adjustments to attract and retain labor, preventing labor from becoming a new obstacle when supply chain issues are resolved. I am confident that our team is performing well. I believe that both our immediate capacity enhancements and potential long-term strategies will position the business favorably.

And our next question will come from Billy Kovanis with Morgan Stanley.

In your opening remarks, you mentioned inventory levels could get back to normalized levels by late '22, early '23. Just wanted to confirm, is that the new timeline you think it will take to replenish inventory even despite some of the enhanced capacity you have coming on in Q4 and a pretty strong retail sales environment calling for flat growth versus the plus 25% growth in 2020? And then do you worry about losing customers and share given this delayed timeline?

As long as we continue to perform as we have been, customers have nowhere else to turn. We have the best delivery performance, and when combined with the best product in the market, it puts us in a strong position. The team is aware of this, and our focus is there. The comments regarding dealer inventory levels highlight that they are at historically low levels. Considering a return to a low to mid-single digits retail growth rate in '22, even with the increased capacity, we understand it will take time to elevate inventory levels. We mentioned late '22 or even into '23 because it's uncertain when these supply challenges will ease. Initially, we believed these issues would be resolved by mid-year, allowing us to rebuild dealer inventory in the latter half, but that hasn't occurred. We're not alone in this situation; finding products in stock is a challenge across many markets. Most of these issues relate to shortages of steel, aluminum, resins, and specialty components. Therefore, the team must remain focused. I believe the presold order process allows us to engage customers and get them excited about the vehicles, ensuring they are ready for the next riding or boating season, which is crucial, and we will do everything possible to improve on that.

Got it. And just on the cost pressures, if these don't abate towards the end of '21, would you consider a substantial price increase for new models in '22? And would that be able to fully mitigate some of the cost inflation there?

Yes. I mean, obviously, we're evaluating weekly what's going on with commodities and logistics costs. We have a review once a week. And we'll continue to look at that as the year develops. And as we head into next year, we're going to look at, as we said, surcharges. We're relooking at model year pricing. We already took 1 price increase that was an unscheduled midyear price increase on the ORV motorcycle side. Boats actually has done a couple of price increases. So we're trying to be balanced between price increases to offset the costs versus how long we think those costs are going to stay in the system. And that's a bit of a moving target, but we will continue to be as aggressive as we can be.

And our next question will come from James Hardiman with Wedbush.

I just wanted to clarify, Mike, earlier in the call, you mentioned that you expect retail to be up in the high teens compared to 2019. The comparable estimate from a quarter ago was 20% to 25%. Can you confirm that those two numbers are directly comparable? If so, does this essentially reflect the amount of retail business you believe has been lost due to supply chain issues compared to three months ago?

Yes. I probably was mixing a couple of things. The high teens was more of an ORV expectation. For the total company, it's still in that low to mid-20% range.

And our next question will come from Shawn Collins with Citigroup.

My question is on the electric RANGER coming out in the fourth quarter and next year. The electric vehicle revolution is really picking up steam in autos. So I wanted to ask what reaction you've seen so far on the soon-to-be released RANGER. And any thoughts on your best guess on how electric plays out in the ORV and powersports world in general?

Yes. The reception around the electric RANGER, at least the feedback we've gotten is people have looked at the teaser videos and the value proposition around it being the highest performing ranger that we'll have has been positive. And we've had historically people who bought our electric RANGER in the past, and this obviously will perform immensely better. And so we think that's a positive. We do think that there's other areas in off-road vehicle that could be attractive. Obviously, there's portions of our youth portfolio where electric makes a heck of a lot of sense. And then there's going to be other areas that we're going to continue to explore. Now at the same time, there's a lot of challenges. When you start talking about products like Razor and the areas that they're used, charging infrastructure as well as the use case and how those vehicles are used means that the run times are short and the opportunity to charge them is tough. So we're not just going to use that as an excuse not to go do anything. We've got some ideas around partnerships and how we look at the charging infrastructure that others will likely be investing in. And we're likely to be a fast follower around things like that. But we've got our plate full with what we've got going on with the RANGER. It's an excellent product. And the team is in full force to make sure we get that launched at the end of the year and in the hands of consumers in 2022.

And our next question will come from Xian Siew with Exane BNP Paribas.

Thanks for the question. So one of the challenges that you highlighted on Slide 8 was COVID pressures in places like India and Southeast Asia. And now, for example, in Southern Vietnam, there were some lockdowns recently. So maybe if you could just give us an update on the situation there for you guys? And if you can maybe remind us of how exposed are you to these regions.

Yes. I mean we have component supply that comes out of all those regions. And much like we've had with other elements of the business, we try and manage those as best we can. And where we've got the opportunity to either source from an alternative location, we will do advanced buys or frankly, produce the vehicle with the components missing and then go back and do the rework once we're able to get the continuity of supply. So we are literally managing a lot of different variables. It's whether there's shutdowns in a specific geography, the availability of shipping containers, availability of trucks or rail, it is literally one thing after another. And the team, as we've demonstrated, has done a great job of managing that. So I think the backdrop hasn't necessarily improved. And you could argue with the Delta variant becoming a bigger, bigger discussion. That's obviously going to continue to be a challenge, not just for us, but I think for the entire manufacturing industry.

Okay. For the presales, if I were to order an ORV now, how long would the consumer have to wait for delivery? Just trying to get a sense of how long people are willing to wait.

Yes. I mean it really depends on the vehicle that you're ordering, but you could say it's going to be anywhere from 6 to 10 weeks, and there could be variation on either end, just depending on the type of vehicle and where we're at, at that moment relative to supply. And the good thing is, is that we're doing a good job of communicating with dealers so they can keep consumers up to date. And as we pointed out, the fallout rate for preorders has been incredibly low. So consumers are definitely wanting to wait to get their vehicles.

Okay. I want to thank everyone for participating this morning and your interest in Polaris, and we look forward to talking to you next quarter. Again, have a good day. Goodbye.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines at this time.