North American sales of ATVs and related PG&A of $473.2 million in 1997 were six percent higher than $445.9 million in 1996. The increased sales reflects the continued growth of the industry and Polaris’ ability to provide the consumer with a quality product at a competitive price. North American sales of ATVs and related PG&A comprised 45 percent of total Company sales in 1997 compared to 37 percent in 1996.

North American sales of PWC and related PG&A were $73.4 million in 1997 as compared to $190.4 million in 1996. The decrease is attributable to significantly lower production levels of PWC in 1997 to compensate for the increased dealer inventory remaining from the prior season reflecting the reduction of industry growth. North American sales of PWC and related PG&A comprised seven percent of total Company sales in 1997 compared to 16 percent in 1996.

International sales of snowmobiles, ATVs, PWC, and related PG&A of $58.7 million in 1997 were 20 percent higher than $49.1 million in 1996. The increase in international sales was across all product lines. Polaris continues to focus on international markets as an opportunity for future growth. International sales comprised six percent of total Company sales in 1997 compared to four percent in 1996.

Gross profit of $262.5 million decreased slightly in 1997 from $263.8 million in 1996. However, the gross profit margin percentage was 25.0 percent in 1997 as compared to 22.1 percent in 1996. The increase in gross profit margin percentage is primarily a result of (a) continued cost reduction efforts, including expanded domestic engine production, (b) reduced warranty costs, (c) decreases in costs of certain purchased components due to the strengthening of the U.S. dollar in relation to the Japanese yen when compared to 1996, and (d) a change in sales mix with less sales of the lower margin PWC product compared to 1996.

Polaris has continued to invest in new product development, innovation and product diversification. During 1997, Polaris reclassified its research and development costs as a component of operating expenses in the consolidated statements of operations for each period presented. Previously, research and development costs were reported as a component of cost of sales. Research and development expenses were $26.7 million (2.5 percent of sales) in 1997 and $28.3 million (2.4 percent of sales) in 1996. In addition, Polaris incurred tooling expenditures for new products of $19.3 million in 1997 and $18.0 million in 1996. In 1997, more than 76 percent of sales came from products introduced in the past three years.

Operating expenses in 1997 increased two percent to $169.4 million from $166.4 million in 1996. Expressed as a percentage of sales, operating expenses increased to 16.2 percent in 1997 from 14.0 percent in 1996. These increases are primarily attributable to the higher level of promotional and advertising costs related to assisting dealers in selling their remaining snowmobile and PWC inventory.

The improvement in nonoperating expense (income) in 1997 from 1996 primarily reflects (a) the positive impact of the Canadian dollar exchange rate hedging activity, (b) the positive financial impact of the Company’s equity in the income of Polaris Acceptance, and (c) lower interest expense resulting from lower average outstanding borrowings in 1997 as compared to 1996.

The provision for income taxes has been recorded at a rate of 36.0 percent of pretax income for each of 1997 and 1996.

Net income increased five percent to $65.4 million in 1997 from $62.3 million in 1996. Net income as a percent of sales increased to 6.2 percent in 1997 from 5.2 percent in 1996. Net income per basic and diluted share increased nine percent to $2.45 in 1997 from $2.24 in 1996.

1996 vs. 1995

Sales increased to $1.192 billion in 1996, representing a seven percent increase over $1.114 billion of sales in 1995. The increase in sales was primarily attributable to the continuing popularity and broadening of the Company’s ATV product line.

North American sales of snowmobiles and related PG&A of $506.5 million in 1996 were two percent lower than $514.8 million in 1995 as the market absorbed an extraordinary growth rate over the prior two years. New model introductions during 1996 were highlighted by the award-winning 700 RMK. Sales of snowmobiles and related PG&A comprised 43 percent of total Company sales in 1996 compared to 46 percent in 1995.

North American sales of ATVs and related PG&A of $445.9 million in 1996 were 22 percent higher than $366.6 million in 1995 primarily because of the continued growth in the utility and sports-enthusiast markets. Retail ATV sales rose to the highest level in Polaris’ history and management believes that the Company is second in U.S. ATV market share. The average per unit sales price increased by six percent in 1996, principally through the sale of new, higher-performance models that have a higher selling price than economy models. The Company introduced several new models in 1996, including the Xplorer 500 and Scrambler 500. Sales of ATVs and related PG&A comprised 37 percent of total Company sales in 1996 compared to 33 percent in 1995.

North American sales of PWC and related PG&A of $190.4 million in 1996 were five percent higher than $181.1 million in 1995. Weaker consumer demand led to a leveling of the PWC market after several years of unusually high demand. Sales of PWC and related PG&A comprised 16 percent of total Company sales in each of 1996 and 1995.

International sales of snowmobiles, ATVs, PWC and related PG&A of $49.1 million in 1996 were four percent lower than $51.4 million in 1995. International sales comprised four percent of total Company sales in 1996 compared to five percent in 1995.

Gross profit increased to $263.8 million in 1996, representing a six percent increase over 1995 gross profit of $248.0 million. The gross profit margin percentage decreased to 22.1 percent in 1996 from 22.3 percent in 1995. This decrease in gross profit margin percentage is primarily a result of (a) an increase in warranty expense, principally for snowmobiles, as a result of rapid technological innovation and introduction of new high performance models; partially offset by (b) decreases in raw material purchase prices for engines and certain other component parts because of the strengthening of the U.S. dollar in relation to the Japanese yen when compared to the 1995 period.

Operating expenses increased $20.0 million (14 percent) in 1996 over 1995 and operating expenses as a percent of sales increased to 14.0 percent in 1996 from 13.1 percent in 1995. These increases are due primarily to an increased level of promotional and advertising costs targeted to assist dealers in retailing PWC units late in the 1996 selling season.

Nonoperating expense decreased $2.8 million in 1996 compared to 1995 as a result of (a) income recorded in 1996 from the Company’s investment in Polaris Acceptance, offset by (b) interest expense incurred in 1996 from borrowings under the bank line of credit arrangement used to fund the payment of special cash distributions totaling $104.9 million during 1995.

The provision for income taxes in 1996 has been recorded at a rate of 36.0 percent of pretax income compared to 38.5 percent for 1995. This change reflects the settlement reached with the Canadian income tax authorities regarding a claim for additional income taxes payable by the Company’s Canadian subsidiary for tax years 1987 through 1991.

Net income increased two percent to $62.3 million in 1996 from $60.8 million in 1995. Net income as a percent of sales was 5.2 percent in 1996 compared to 5.5 percent in 1995. Net income per share increased two percent to $2.24 in 1996 from $2.19 in 1995.

Liquidity and Capital Resources

Polaris’ primary sources of funds have been cash provided by operating activities, a $150 million bank line of credit and a dealer floor plan financing program. Polaris’ primary uses of funds have been for cash dividends and distributions to shareholders and partners, repurchase and retirement of common stock, capital investments and new product development.

During 1997, Polaris generated net cash from operating activities of $102.3 million, which was utilized to fund capital expenditures of $36.8 million, net investments in affiliates of $2.6 million, cash dividends of $17.0 million and the repurchase of common stock of $39.9 million. During 1996, Polaris generated net cash from operating activities of $89.6 million which was utilized to fund capital expenditures of $45.3 million, net investments in affiliates of $6.8 million, cash dividends of $16.4 million, and the repurchase of common stock of $13.6 million. During 1995, Polaris generated net cash from operating activities of $77.7 million, which was utilized to fund regular cash dividends and special cash distributions to shareholders of $116.6 million, a final cash distribution to partners of $12.7 million and capital expenditures of $47.2 million.

The seasonality of production and shipments causes working capital requirements to fluctuate during the year. Polaris is a party to an unsecured bank line of credit arrangement maturing on March 31, 2000 under which it may borrow up to $150 million until March 31, 1998 and up to $125 million thereafter until maturity. The arrangement provides borrowing for working capital needs and the repurchase and retirement of common stock. Borrowings under the line of credit bear interest, 6.76 percent at December 31, 1997, based on LIBOR or "prime" rates. At December 31, 1997, Polaris had total borrowings under the line of credit of $24.4 million compared to $35.0 million at December 31, 1996. In addition, at December 31, 1997, Polaris had letters of credit outstanding of $7.1 million related to purchase obligations for raw materials.

During 1996, the Polaris Board of Directors authorized the repurchase of up to one million shares of Polaris common stock. On January 23, 1997, the Board of Directors expanded the share repurchase program, authorizing the cumulative repurchase of up to three million shares. During 1997, Polaris paid $39.9 million to repurchase and retire 1,455,900 shares. During 1996, Polaris paid $13.6 million to repurchase and retire 521,000 shares. Polaris has 1,023,100 shares available to repurchase under this authorization as of December 31, 1997.

In February 1996, a wholly-owned subsidiary of Polaris entered into a partnership agreement with Transamerica Distribution Finance (TDF) to form Polaris Acceptance. Polaris Acceptance provides floor plan financing to Polaris dealers and distributors and may in the future provide other financial services to dealers, distributors and retail customers of Polaris. Under the partnership agreement, Polaris’ subsidiary had a 25 percent equity interest in Polaris Acceptance throughout 1996. In January 1997, Polaris exercised its option to increase its equity interest in Polaris Acceptance to 50 percent for an additional investment of approximately $10.4 million. Polaris guarantees 50 percent of the outstanding indebtedness of Polaris Acceptance under a credit agreement between Polaris Acceptance and TDF. At December 31, 1997, Polaris’ contingent liability with respect to the guarantee was approximately $92.0 million.

Polaris has arrangements with certain finance companies, including Polaris Acceptance, to provide floor plan financing for its distributors and dealers. These arrangements provide liquidity by financing distributor and dealer purchases of snowmobiles, ATVs and PWC without the use of Polaris’ working capital. Substantially all of the sales of snowmobiles, ATVs and PWC (but not PG&A) are financed under these arrangements whereby Polaris receives payment within a few days of shipment of the product. The amount financed by distributors and dealers under these arrangements at December 31, 1997 and 1996, was approximately $289.0 million and $327.0 million, respectively. Polaris participates in the cost of dealer and distributor financing up to certain limits. Polaris has agreed to repurchase products repossessed by the finance companies to an annual maximum of 15 percent of the average amount outstanding during the prior calendar year. Polaris’ financial exposure under these agreements is limited to the difference between the amount paid to the finance companies for repurchases and the amount received on the resale of the repossessed product. No material losses have been incurred under these agreements. However, an adverse change in retail sales could cause this situation to change and require Polaris to repurchase financed units.

Polaris has made significant capital investments to increase production capacity, quality, and efficiency, and for new product development and diversification. Improvements in manufacturing capacity, distribution capacity and vertical integration include (a) an investment of $9.1 million since late 1996 for the construction of a 250,000 square foot parts, garments and accessories distribution center in Vermillion, South Dakota which was operational in mid-1997, (b) the purchase of a 90,000 square foot building adjacent to Polaris’ Osceola, Wisconsin facility in 1995 to house the manufacturing of Polaris designed and built domestic engines, and (c) the construction of a new 58,000 square foot injection molding facility in Roseau, MN that began in 1997 and is expected to be operational in mid-1998. Polaris anticipates that capital expenditures, including tooling, for 1998 will range from $60 million to $70 million.

Management believes that existing cash balances, cash flows to be generated from operating activities and available borrowing capacity under the line of credit arrangement will be sufficient to fund operations, regular dividends, share repurchases, and capital expenditure requirements for 1998. At this time, management is not aware of any factors that would have a materially adverse impact on cash flow beyond 1998.

Injection Research Specialists commenced an action in 1990 against Polaris in Colorado Federal Court alleging various claims relating to electronic fuel injection systems for snowmobiles. In April 1997, a judgment was entered in favor of Injection Research Specialists, before interest, for $24.0 million in compensatory damages and $10.0 million in punitive damages against Polaris, and $15.0 million in compensatory damages and $8 million in punitive damages against Fuji Heavy Industries, Ltd. ("Fuji"), one of Polaris’ engine suppliers. The judgment against Fuji was subsequently reduced on post trial motions to $11.6 million in compensatory damages and no punitive damages. Polaris has appealed the judgment against Polaris and has been advised that Fuji has also appealed the judgment against it. Depending upon the conclusion of the appeal, Polaris may require additional reserves associated with this litigation.

In 1997, Polaris evaluated its computer system year 2000 compliance issues and began a conversion process to address necessary changes. In order for a computer system to be year 2000 compliant, its time sensitive software must recognize a date using "00" as the year 2000 rather than the year 1900. Polaris has implemented a plan to make its computer systems critical to managing its business year 2000 compliant by the end of 1998 and to make its remaining computer systems year 2000 compliant by the end of 1999. Expenses incurred by Polaris in 1997 to address year 2000 compliance issues were immaterial and Polaris does not expect the level of expenses to be incurred under its conversion program during the next two years to have a material effect on its financial results of operations.

Inflation and Exchange Rates

Polaris does not believe that inflation has had a material impact on the results of its operations. However, the changing relationships of the U.S. dollar to the Canadian dollar and Japanese yen have had a material impact from time-to-time.

During 1997, purchases totaling 17 percent of Polaris’ cost of sales were from Japanese yen denominated suppliers. The strengthening of the U.S. dollar in relation to the Japanese yen since late 1995 has resulted in lower raw material purchase prices. Polaris’ cost of sales in 1997 and 1996 were positively impacted by the Japanese yen exchange rate fluctuation when compared to the prior year. In view of the foreign exchange hedging contracts currently in place, Polaris anticipates that the Japanese yen–U.S. dollar exchange rate will continue to have a positive impact on cost of sales during 1998 when compared to the same periods in 1997.

Polaris operates in Canada through a wholly-owned subsidiary. Sales of the Canadian subsidiary comprised 15 percent of total Company sales in 1997. Polaris utilizes foreign exchange hedging contracts to manage its exposure to the Canadian dollar. Although the U.S. dollar in relation to the Canadian dollar strengthened in 1997 on average, Polaris experienced a positive financial impact on nonoperating expenses as a result of favorable hedging activity. In view of the foreign exchange hedging contracts currently in place, Polaris anticipates that the Canadian dollar currency fluctuation will have a negative impact on net income during 1998 when compared to the same periods in 1997.

In the past, Polaris has been a party to, and in the future may enter into, foreign exchange hedging contracts for both the Japanese yen and the Canadian dollar to minimize the impact of exchange rate fluctuations within each year. At December 31, 1997, Polaris had open Japanese yen foreign exchange hedging contracts with notional amounts totaling $81.5 million U.S. dollars, and open Canadian dollar foreign exchange contracts with notional amounts totaling $108.4 million U.S. dollars which mature throughout 1998.

Since October 1995, Polaris has been manufacturing its own engines for selected models of personal watercraft and snowmobiles at its Osceola, Wisconsin facility. In addition, earlier in 1995, Polaris entered into an agreement with Fuji to form Robin Manufacturing U.S.A., Inc. ("Robin"). Under the terms of the agreement, Polaris has a 40 percent ownership interest in Robin, which builds engines in the United States for recreational and industrial products. Potential advantages to Polaris of these additional sources of engines include reduced foreign exchange risk, lower shipping costs and less dependence in the future on a single supplier for engines.

Forward-looking statements herein are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. There are certain important factors that could cause results to differ materially from those anticipated by some of the statements made herein. Investors are cautioned that all forward-looking statements involve risks and uncertainty. In addition to the factors discussed above, among the other factors that could cause actual results to differ materially are the following: product offerings and pricing strategies by competitors; warranty expenses; foreign currency exchange rate fluctuations; environmental and product safety regulatory activity; effects of weather; uninsured product liability claims; and overall economic conditions, including inflation and consumer confidence and spending.