Polaris - 10-Q quarterly report FY

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial statements and, therefore, do not include all information and disclosures of results of operations, financial position and changes in cash flow in conformity with accounting principles generally accepted in the United States for complete financial statements. Accordingly, such statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, previously filed with the Securities and Exchange Commission. In the opinion of management, such statements reflect all adjustments (which include only normal recurring adjustments) necessary for a fair presentation of the financial position, results of operations, and cash flows for the periods presented. Due to the seasonality of the snowmobile, all terrain vehicle (“ATV”), motorcycle and the parts, garments and accessories (“PG&A”) business, and to certain changes in production and shipping cycles, results of such periods are not necessarily indicative of the results to be expected for the complete year. Certain amounts in the 2005 periods presented have been reclassified for consistency of presentation. Polaris’ allocable share of the income (loss) of Robin Manufacturing, U.S.A. (“Robin”) has been reclassified to Equity in (income) of manufacturing affiliates, net of tax, in the consolidated statements of income and Polaris’ investment for Robin has been reclassified to Investments in manufacturing affiliates in the consolidated balance sheets for each period presented. These changes had no impact on previously reported net income. Additionally, during the first quarter of 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which requires companies to recognize in the financial statements the fair value of stock options and other equity-based compensation issued to employees. Certain amounts in the financial statements in the 2005 period have been adjusted to give effect to the adoption of SFAS 123(R). See Note 2 for further discussion.

On September 2, 2004, the Company announced its decision to discontinue the manufacture of marine products. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the marine products division’s financial results are reported separately as discontinued operations for all periods presented.

Polaris provides a limited warranty for ATVs for a period of six months and for a period of one year for its snowmobiles and motorcycles. Polaris may provide longer warranties related to certain promotional programs, as well as longer warranties in certain geographical markets as determined by local regulations and market conditions. Polaris’ standard warranties require the Company or its dealers to repair or replace defective product during such warranty period at no cost to the consumer. The warranty reserve is established at the time of sale to the dealer or distributor based on management’s best estimate using historical rates and trends. Adjustments to the warranty reserve are made from time to time as actual claims become known in order to properly estimate the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Factors that could have an impact on the warranty accrual in any given period include the following: improved manufacturing quality, shifts in product mix, changes in warranty coverage periods, snowfall and its impact on snowmobile usage, product recalls and any significant changes in sales volume. The activity in Polaris’ accrued warranty reserve for the periods presented is as follows (in thousands):

During the first quarter 2005, the Company paid the CPSC $950,000 to settle claims alleging that the Company violated the Consumer Product Safety Act dating back to the late 1990’s. Polaris entered into the settlement to avoid continuing legal costs associated with protracted litigation.

In the first quarter ended March 31, 2006 Polaris adopted Financial Accounting Standards Board (“FASB”) SFAS 123(R) which requires companies to recognize in the financial statements the grant-date fair value of stock options and other equity-based compensation issued to employees. Polaris adopted SFAS 123(R) using the modified retrospective method. In accordance with the modified retrospective method, the consolidated financial statements for prior periods have been adjusted to give effect to the adoption of SFAS 123(R). In addition, Polaris recorded on the consolidated statements of income in the first quarter of 2006 an after tax benefit of $407,000 or $0.01 per diluted share from the cumulative effect of the accounting change. Beginning with the first quarter 2006, the Company has reclassified other share-based compensation expenses, previously reported in General and administrative expenses, to Cost of sales and the Operating expenses lines on the consolidated statements of income. The balance sheet and statements of cash flow for the quarter and year to date periods ended September 30, 2005 have also been adjusted to reflect the impact of SFAS 123(R). The impact to the Company’s net earnings of adopting SFAS 123(R) is consistent with the pro forma disclosures provided in the footnotes contained in previous financial statements.

Share-Based Plans

Polaris maintains a stock option plan (“Option Plan”) under which incentive and nonqualified stock options for a maximum of 8,200,000 shares of common stock may be issued to certain employees. Options granted to date generally vest three years from the award date and expire after ten years.

Polaris maintains a broad based stock option plan (“Broad Based Plan”) under which incentive stock options for a maximum of 700,000 shares of common stock could be issued to substantially all Polaris employees. These options expire in 2009. Options with respect to 675,400 shares of common stock were granted under this plan during 1999 at an exercise price of $15.78 and of the options initially granted under the Broad Based Plan, an aggregate of 518,400 vested in March 2002.

Polaris maintains a restricted stock plan (“Restricted Plan”) under which a maximum of 2,350,000 shares of common stock may be awarded as an incentive to certain employees with no cash payments required from the recipient. The majority of the outstanding awards contain restrictions which lapse after a two to four year period if Polaris achieves certain performance measures.

Polaris maintains a nonqualified deferred compensation plan (“Director Plan”) under which members of the Board of Directors who are not Polaris officers or employees can elect to receive common stock equivalents in lieu of director’s fees, which will be converted into common stock when board service ends. A maximum of 200,000 shares of common stock has been authorized under this plan of which 75,248 equivalents have been earned and an additional 59,810 shares have been issued to retired directors as of September 30, 2006. As of September 30, 2006 and December 31, 2005, Polaris’ liability under the plan totaled $3,096,000 and $3,500,000, respectively.

Polaris maintains a non-employee director stock option plan (the “Directors Stock Option Plan”), under which nonqualified stock options for a maximum of 200,000 shares of common stock may be issued to non-employee directors. Each non-employee Director as of the date of the annual shareholders meetings has been granted an option to purchase 4,000 shares of common stock at a price per share equal to the fair market value as of the date of grant. Options become exercisable as of the date of the next annual shareholders meeting following the date of grant and must be exercised no later than 10 years from the date of grant.

Polaris maintains a long term incentive plan (“LTIP”) under which awards are issued to provide incentives for certain employees to attain and maintain the highest standards of performance and to attract and retain employees of outstanding competence and ability with no cash payments required from the recipient. The awards are paid in cash and are based on certain performance measures for the Company that are measured over a period of three consecutive calendar years. At the beginning of the plan cycle participants have the option to receive a cash value at the time of awards or a cash value tied to Polaris stock price movement over the three year plan cycle. At September 30, 2006 and December 31, 2005, Polaris’ liability under the plan totaled $0 and $3,997,000, respectively.

Share-Based Compensation Expense

The amount of compensation cost for share-based awards to be recognized during a period is based on the portion of the awards that are ultimately expected to vest. The Company estimates option forfeitures at the time of grant and revises those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company analyzes historical data to estimate pre-vesting forfeitures and records share compensation expense for those awards expected to vest. During the second quarter of 2006 it was determined that the likelihood of the

performance measures associated with 93,000 shares of restricted stock awards outstanding being achieved was no longer probable. Therefore the previously recorded expense of $2,971,000 associated with these restricted stock awards was reversed during the second quarter of 2006. Additionally, during the third quarter of 2006 stock based compensation expenses for the LTIP were adjusted to reflect the anticipated lower Company financial performance for the 2006 year.

Total share-based compensation expenses for the three and nine month periods ended September 30, 2006 and 2005 are as follows (in thousands):

These share-based compensation expenses are reflected in Cost of sales and Operating expenses in the accompanying consolidated statements of income. For purposes of determining the estimated fair value of share-based payment awards on the date of grant under SFAS 123(R), Polaris has used the Black-Scholes option-pricing model. Assumptions utilized in the model are evaluated and revised, as necessary, to reflect market conditions and experience.

At September 30, 2006 there was $9,286,000 of total unrecognized stock-based compensation expense related to unvested share-based awards. Unrecognized share-based compensation expense is expected to be recognized over a weighted-average period of 1.0 year. Included in unrecognized share-based compensation is approximately $9,137,000 related to stock options and $149,000 for restricted stock.

General Stock Option and Restricted Stock Information

The following summarizes share activity and the weighted average exercise price for the following plans for the nine months ended September 30, 2006:

The weighted average remaining contractual life of outstanding options was 5.4 years as of September 30, 2006.

The following assumptions were used to estimate the weighted average fair value of options of $12.58 and $14.39 granted during the nine months ended September 30, 2006 and 2005, respectively:

The total intrinsic value of options exercised during the nine months ended September 30, 2006 was $6,721,000. The total intrinsic value of options outstanding and exercisable at September 30, 2006 was $43,694,000 and $41,800,000, respectively. The total intrinsic value at September 30, 2006 is based on the Company’s closing stock price on the last trading day of the quarter for in-the-money options.

The following table summarizes restricted stock activity during the nine months ended September 30, 2006:

The total intrinsic value of restricted stock expected to vest as of September 30, 2006 was $2,160,000. The total intrinsic value at September 30, 2006 is based on the Company’s closing stock price on the last trading day of the quarter.

Polaris has an unsecured bank line of credit arrangement with maximum available borrowings of $250,000,000 expiring on June 25, 2009. Interest is charged at rates based on LIBOR or “prime” (effective rate was 6.00 percent at September 30, 2006).

Polaris has entered into an interest rate swap agreement to manage exposures to fluctuations in interest rates. The effect of this agreement is to fix the interest rate at 7.21 percent for $18,000,000 of borrowings under the credit line until June 2007.

As of September 30, 2006, total borrowings under the bank line of credit arrangement were $78,000,000 and have been classified as long-term in the accompanying consolidated balance sheets.

In 1996, a wholly owned subsidiary of Polaris entered into a partnership agreement with a subsidiary of Transamerica Distribution Finance (“TDF”) to form Polaris Acceptance. In January 2004, TDF was merged with a subsidiary of General Electric Company and as a result of that merger, TDF’s name was changed to GE Commercial Distribution Finance (“GECDF”). Polaris Acceptance provides floor plan

financing to Polaris’ dealers in the United States. Polaris’ subsidiary has a 50 percent equity interest in Polaris Acceptance. The receivable portfolio is recorded on Polaris Acceptance’s books, and is funded 85 percent through a loan from an affiliate of GECDF and 15 percent by a cash investment shared equally between the two partners. Polaris has not guaranteed the outstanding indebtedness of Polaris Acceptance. Substantially all of Polaris’ U.S. sales are financed through Polaris Acceptance whereby Polaris receives payment within a few days of shipment of the product. The net amount financed for dealers under this arrangement at September 30, 2006 was approximately $768,000,000. During the first quarter 2006, the term of the partnership agreement with GECDF was extended to February 29, 2012.

Polaris’ investment in Polaris Acceptance is accounted for under the equity method, and is recorded as a component of Investments in finance affiliate in the accompanying consolidated balance sheets. The partnership agreement provides that all income and losses of the portfolio are shared 50 percent by Polaris’ wholly owned subsidiary and 50 percent by GECDF. Polaris’ allocable share of the income of Polaris Acceptance has been included as a component of Income from financial services in the accompanying consolidated statements of income.

A wholly owned subsidiary of Polaris has entered into a multi-year contract with HSBC Bank Nevada, National Association (“HSBC”), formerly known as Household Bank (SB), N.A., under which HSBC will continue managing the Polaris private label revolving credit card program under the StarCard label. The terms of the multi-year agreement, executed on August 10, 2005, became effective as of August 1, 2005. The agreement provides for income to be paid to Polaris based on a percentage of the volume of revolving retail credit business generated. The previous agreement provided for equal sharing of all income and losses with respect to the retail credit portfolio, subject to certain limitations. The current contract removes all credit, interest rate and funding risk to Polaris and also eliminates the need for Polaris to maintain a retail credit cash deposit with HSBC. Polaris’ income generated from the HSBC agreement has been included as a component of Income from financial services in the accompanying consolidated statements of income.

A wholly owned subsidiary of Polaris entered into a multi-year contract with GE Money Bank (“GE Bank”) under which GE Bank will make available closed-end consumer and commercial credit to customers of Polaris dealers. The terms of the new multi-year agreement, executed on February 28, 2006, became effective April 1, 2006. The new agreement provides for income to be paid to Polaris based on a percentage of the volume of sales generated pursuant to the program. Polaris’ income generated from the GE Bank agreement has been included as a component of Income from financial services in the accompanying consolidated statements of income.

Polaris facilitates the availability of extended service contracts to consumers and certain insurance contracts to dealers and consumers through arrangements with various third party suppliers. Polaris does not have any incremental warranty, insurance or financial risk from any of these third party arrangements. Polaris’ service fee income generated from these arrangements has been included as a component of Income from financial services in the accompanying consolidated statements of income.

The caption Investments in manufacturing affiliates in the consolidated balance sheets represents Polaris’ equity investment in Robin, which builds engines in the United States for recreational and industrial products, and the investment in the Austrian motorcycle company, KTM Power Sports AG (“KTM”), which manufactures off-road and on-road motorcycles. Polaris has a 40 percent ownership interest in Robin and during the third quarter of 2005 purchased a 25 percent ownership interest in KTM. Polaris’ investments, including associated transaction costs, totaling $97,348,000 at September 30, 2006 and $87,772,000 at December 31, 2005, are accounted for under the equity method. Polaris’ allocable share of the operating results of these investments was income of $2,653,000 and $945,000 for the three month periods ended September 30, 2006 and 2005, respectively, which are recorded in Equity in (income) of manufacturing affiliates in the accompanying consolidated statements of income. Polaris’ allocable share of the operating results of these investments for the nine month periods ended September 30, 2006 and 2005 totaled $3,614,000 and $945,000, respectively.

Additionally, Polaris and KTM’s largest shareholder, Cross Industries AG (“Cross”), have entered into an option agreement which provides that, under certain conditions in 2007, either Cross may purchase Polaris’ interest in KTM or, alternatively, Polaris may purchase Cross’ interest in and become the majority shareholder of KTM. The exercise price under both option agreements are based on a predetermined pricing formula to be derived from the operating results of both companies and the market price of Polaris’ common stock in 2007. Although the options provided for in the option agreement are not exercisable until 2007, the Company views it as likely that Cross would have the initial option to purchase Polaris’ equity interest in KTM. On July 28, 2006, the Company announced that it has been informed by Cross of Cross’ intention to retain its majority interest in KTM. In the event that Cross exercises its option to purchase Polaris’ equity

interest in KTM, the sale by Polaris to Cross could result in a gain or a loss to Polaris, depending on the calculation of the exercise price at the time of exercise, which in either case will not be based on the market price of KTM shares at that time.

During the first nine months of 2006, Polaris paid $109,353,000 to repurchase and retire approximately 2,576,000 shares of its common stock. As of September 30, 2006 the Company has authorization from its Board of Directors to repurchase up to an additional 2,082,000 shares of Polaris stock. The repurchase of any or all such shares authorized for repurchase will be governed by applicable SEC rules and dependent on management’s assessment of market conditions.

Polaris paid a regular cash dividend of $0.31 per share on August 15, 2006 to holders of record on August 1, 2006.

On October 19, 2006, the Polaris Board of Directors declared a regular cash dividend of $0.31 per share payable on or about November 15, 2006 to holders of record of such shares at the close of business on November 1, 2006.

Basic net income per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during each period, including shares earned under the Director Plan and the Employee Stock Ownership Plan (“ESOP”). Diluted net income per share is computed under the treasury stock method and is calculated to reflect the dilutive effect of outstanding stock options and certain shares issued under the Restricted Plan.

A reconciliation of these amounts is as follows (in thousands):

Comprehensive income represents net income adjusted for foreign currency translation adjustments and the deferred gains or losses on derivative instruments utilized to hedge Polaris’ interest and foreign exchange exposures. Comprehensive income is as follows (in thousands):

Polaris is subject to product liability claims in the normal course of business. Polaris is currently self-insured for all product liability claims. The estimated costs resulting from any losses are charged to operating expenses when it is probable a loss has been incurred and the amount of the loss is reasonably determinable. The Company utilizes historical trends and actuarial analysis tools to assist in determining the appropriate loss reserve levels.

Polaris is a defendant in lawsuits and subject to claims arising in the normal course of business. In the opinion of management, it is not probable that any legal proceedings pending against or involving Polaris will have a material adverse effect on Polaris’ financial position or results of operations.

Accounting and reporting standards require that every derivative instrument, including certain derivative instruments embedded in other contracts be recorded in the balance sheet as either an asset or liability measured at its fair value. Changes in the derivative’s fair value should be recognized currently in earnings unless specific hedge criteria are met and companies must formally document, designate and assess the effectiveness of transactions that receive hedge accounting.

Polaris has an interest rate swap agreement expiring in 2007 related to $18,000,000 of debt that has been designated as and meets the criteria of a cash flow hedge. At September 30, 2006, the fair value of the interest rate swap agreement was an unrealized loss of $261,000, which is recorded net of tax as a component of Accumulated other comprehensive income (loss) in shareholders’ equity.

Polaris enters into foreign exchange contracts to manage currency exposures of certain of its purchase commitments denominated in foreign currencies and transfers of funds from its foreign subsidiaries. Polaris does not use any financial contracts for trading purposes. These contracts have been designated as and meet the criteria for cash flow hedges or fair value hedges.

At September 30, 2006, Polaris had open Japanese yen foreign exchange contracts with notional amounts totaling U.S. $34,143,000, and an unrealized loss of $1,013,000 and open Canadian dollar contracts with notional amounts totaling U.S. $17,610,000 and an unrealized gain of $44,000. These contracts met the criteria for cash flow hedges and the net unrealized losses, after tax, are recorded as a component of Accumulated other comprehensive income (loss) in shareholders’ equity.

On September 2, 2004, the Company announced its decision to discontinue the manufacture of marine products. In the third quarter 2004, the Company recorded a loss on disposal of discontinued operations of $35,600,000 before tax or $23,852,000 after tax. This loss included a total of $28,705,000 in expected future cash payments for costs to assist the dealers in selling their remaining inventory, incentives and discounts to encourage consumers to purchase remaining products, costs to cancel supplier arrangements, legal and regulatory issues, and personnel termination costs. In addition, there were $8,287,000 of liabilities related to the marine products division at the time of the exit announcement.

In addition, the loss on disposal of discontinued operations included $6,895,000 in non-cash costs related primarily to the disposition of tooling, other physical assets, and the Company’s remaining inventory. Total non-cash charges of $6,895,000 have been made to the accrual since the marine products division exit announcement.

During the second quarter of 2006, the Company recorded an additional loss on disposal of discontinued operations of $3,073,000 before tax, or $2,021,000 after tax. This loss includes the expected future cash payments required to support additional product liability litigation claims and warranty expenses related to marine products.

Total cash outlays of $609,000 were made in the third quarter 2006 related to the litigation and warranty liabilities. Total cash outlays of $38,051,000 have been made since the marine products division exit announcement.

Exhibit 10.dd — Fourth Amendment to Joint Venture Agreement between the Company and GE Commercial Distribution Finance dated March 27, 2006

Exhibit 31.a — Certification of Chief Executive Officer — Section 302

Exhibit 31.b — Certification of Chief Financial Officer — Section 302

Exhibit 32.a — Certification of Chief Executive Officer — Section 906

Exhibit 32.b — Certification of Chief Financial Officer — Section 906