Pool Corporation (POOL) — Q1 2016 Earnings Call Transcript

Thank you, Amie. Good morning, everyone, and welcome to our Q1 2016 conference call. I would like to remind our listeners that our discussion, comments, and responses to questions today may include forward-looking statements, including management's outlook for 2016 and future periods. Actual results may differ materially from those discussed today. Information regarding the factors and variables that could cause actual results to differ materially from projected results is discussed in our 10-K. With that I will turn the call over to our President and CEO, Manny Perez de la Mesa.

Thank you, Mark, and good morning to all on the call. Favorable weather in many markets, including the acceleration of pool opening and seasonal markets, and increased ability for customers to perform remodeling, replacement, and new construction activity was the significant contributing factor to our 13.5% base business sales growth in the quarter. The other significant factor was our increase in early buy shipments to help position our customers for the upcoming season. Altogether, we believe that almost one half of our first-quarter sales growth was sales that would naturally have been realized later in the year, primarily in the second quarter. We are fortunate in that we can operationally support these increased sales efficiently in the first quarter, which will help us realize strong operating leverage again in 2016. Material sales led the way with 15.4% growth in the quarter, including both industry growth and market share gains. The industry growth encompasses the ongoing gradual recovery of remodeling activity, as well as the benefit from the favorable weather. Commercial product sales were up 19.2%, given the favorable weather and market share gains. We are on track to surpass $100 million in commercial product sales in 2016, an industry first for any distributor. The best illustration of the impact of weather in the quarter was retail product sales increasing by 18.4%. With a pool installed base up roughly 1%, this kind of sales increase for pool maintenance and repair products is primarily a shift from the second quarter, although we did pick up some market share. These gains, though, were dwarfed by the favorable market conditions. Gross margins were modestly up, with full-year gross margins anticipated to be essentially flat with 2015. On the expense front, the leverage benefits became apparent as increases were primarily volume driven freight costs and variable compensation, creating positive momentum for another year of operating margin expansion. The increase in our annual guidance, our earliest in four years, factors in all that we know at this time while considering that we are just now entering the busiest time of the year. It is also the time of the year when our service level and value proposition are most distinctive, enabling our customers to be more efficient and realize greater success. Now I'll turn the call over to Mark for his financial commentary.

Thank you, Manny. I'm going to start my comments today by putting additional emphasis on the weather impact on our business at this time of year. As noted in our press release and as Manny commented on, the warmer than normal winter and early spring benefited our seasonal markets by allowing the construction and renovation of pools that occurred in the fourth quarter of 2015 to continue in many of these markets into 2016. In markets that are capacity-limited due to a combination of demand and market seasonality, we believe that this activity will be a net benefit for us in 2016. In other markets, this activity could be a pull forward in business for later in the season. Another impact of the warm weather and the seasonal markets is the earlier than usual opening of pools, which was further helped by the Easter holiday occurring in late March this year compared to early April in 2015. Easter is the time in many seasonal markets when pool owners traditionally open their pools. As we've mentioned in the past, pool openings drive industry revenue in seasonal markets, as higher loads, maintenance supplies, and equipment repairs are often necessary when opening the pool after the winter season. While there is some benefit to us and the industry from the longer pool season, the primary revenue event by the early pool openings results in the shift of revenue from later in the season to earlier in the season. The third and final point to make on Q1 weather benefit relates to customer early buy activity. I mentioned on our last call that we expected higher Q1 early buy sales as retailers stock up ahead of expected seasonal demand, which turned out to be the case. This increase in customer early buy activity was a pull forward of sales from the second quarter into the first quarter, as we've mentioned. The bottom line in all this discussion is that we do expect to benefit for the year from the early warm weather and seasonal markets, with the primary benefit coming from increased Q1 construction and renovation activity, with an estimated impact of $15 million in sales and roughly $0.05 in earnings per share, which is reflected in our new guidance range. Our second-quarter results will likely be adversely impacted by the acceleration of events mentioned with more modest revenue growth than otherwise expected. Our listeners can estimate for themselves what they believe the revenue and earnings impact from this will be. At this point, I'll turn to a discussion of our operating expenses. In preparation for my remarks this morning, I referred back to my commentary from our year-end call two months ago, where I discussed our expense management targets and our success in achieving those targets in 2015. Given our start to 2016, I think it's appropriate to reiterate a couple of points I made then. First, this year, like every year, we want to leverage our infrastructure to grow our operating income at a faster rate than our rate of gross profit growth. And we do that by targeting expense growth at about half the rate of gross profit growth. We've been relatively successful at doing that over time, and we obviously have a jump on that goal in 2016. Keep in mind, however, that the seasonality of our business plays into this objective, as we have more operating capacity in our seasonally slower first and fourth quarters than we do in our second and third quarters. So the timing of our revenue growth helps determine how much operating leverage we will achieve for the year. The magnitude of operating leverage we reported in the first quarter would not be possible for us in season. In other words, if I were modeling out my expectations for the rest of the year, I'd want to tone down some of the enthusiasm I might have taken from our first-quarter results in projecting operating expense leverage for the balance of the year. Moving over the balance sheet and cash flow, our total net receivable growth of 19% year-over-year is reflective of the mid-teens rate of sales growth in the quarter plus the additional billing day in the month of March. The quality of our receivables remains high, as they have historically. Likewise, our other significant asset inventory grew at a rate that is aligned with our anticipated seasonal demand, so nothing particularly notable here. Despite these year-over-year working capital increases, our cash use from operations was lower than last year, as we were able to defer payment for inventory purchases through vendor early buy programs in addition to benefiting from the increase in net income. As is the case every year, our goal on cash flow from operations is to exceed net income, which in turn supports our objective of growing our return on invested capital. My last point is to make regarding our share repurchase activity in the quarter, which consisted of buying 822,000 shares at an average price of $76.85 per share for total cash usage of $63.2 million during the quarter. I should also point out that the forecast and share count for the year that I provided on our last call remains largely unchanged, as a reduction in shares from our share repurchases is offset by the share dilution we now expect from the increase in our share price so far this year. At this point, I'll turn the call back over to our operator to begin our question-and-answer session.

Hey guys, good morning, nice quarter.

Thank you, sir.

So, I just want to be clear you beat by $0.13, you raised the guide by $0.05, so most of the beat is just a shift from the second quarter to the first quarter. But the raise of $0.05, what was that for? Is that just a better market, better margin performance, what was that for?

Well, as Mark just mentioned, there was some benefit that we had because there was some business that took place that was not a pull forward. For example, there was some remodeling activity that took place that just enables our customers to have a longer work year by virtue of the fact that they were able to get some of them worked done in the February/March timeframe.

Got it, makes sense. I know Mark suggested we should try to estimate our expectations for Q2, but can you provide some guidance on where you believe sales might end up year-over-year in the second quarter? Also, could you share some thoughts on April if you are already noticing a decline in the growth rate due to the pull forward?

Sure. I would think that the second quarter, which is, as you know, by far the biggest quarter of the year; a 5% to 7% type growth number is a reasonable expectation. There are some pluses and minuses there, the minus being obviously some of the volumes that were happening in March that would otherwise have happened in April or May. The other part of the benefit, the other side is that we had extensive rains in Texas and adjacent states through the better part of six weeks last year that hurt our business. So I think a 5% to 7% is a reasonable expectation for the second quarter, and we are pretty much tracking at that rate to date in April. With respect to the rest of the year, it's tough to gauge; September to December was very positive, so the back half of the year I think 5% to 7% is reasonable, and therefore realistically we should finish the year at 6% to 8% when you factor in the first quarter results. Of course, in all of this, we are stocking-based business given that new locations and acquisitions don't generally provide a lot to the bottom line and end up being roughly 1% of sales.

Right. Okay, very helpful. I don't recall if you talked about the green business and its growth rate, specifically what you're observing in California. Is that situation improving at all?

I did not mention the green business and the situation in California is, they've gotten a little better in the sense that particularly northern California has a lot more rain, but this year’s first quarter was milder than last year's first quarter in California. So that is one area where the weather did not help us but again, net-net to the overall country, and including Canada and other countries, our weather was definitely a big positive. Though the green business did not do as well; it did not grow as strongly as the blue business. And part of that is the fact that their west coast is weighted, and the other part is that there are still some headwinds there from the drought repercussions affecting them in terms of timing on some of their business.

Okay, very good. I'll get back in line, thanks.

Thank you.

Hi, good morning guys.

Good morning.

Hi, Dave.

You continue to do really well in some of the relatively newer offerings like building materials and commercial products as you outlined, but could you tell us what percentage of your sales are from new products that you just started distributing within the past year or maybe the past three years, just to give us an idea of the rolling impact of new products on your growth.

That's a very good question, David. The actual number is negligible over the last year. The reason for this is that our process is gradual. We don't typically launch new products nationwide or across North America and Europe all at once. Instead, we test them in select markets to assess our success and understand the reasons behind it. We learn from this experience and gradually expand the rollout of those product categories and target customers. In some instances, it may take us four or five years to achieve national distribution of a particular new product category. Another factor is our awareness of the capacity for both ourselves and our customers to tackle opportunities. To execute effectively, we often limit the number of opportunities we pursue in each market. The focus is on effective execution rather than the number of attempts, and this approach causes us to introduce those opportunities over time. Consequently, there are markets today in 2016 that are introducing products or targeting specific categories that other markets may have already addressed five or six years ago. Therefore, the incremental year-on-year impact is currently relatively negligible. However, if you consider the broader perspective, for example, building materials as a whole, we've grown that product category by nearly 20% per year for the past eight years. The significance isn't necessarily in the first year, but in the impact we see four, five, six, seven, or eight years later.

Okay, that's very helpful. And as a brief follow-on here, as you look at the blue branches, I know in the past we've seen fire pits and putting greens and some pretty non-traditional things that are going through there. As you look out then over the next five or ten years and the prospects for continuing to add additional content into those blue branches over the next several years, it would seem that if you're still making headway in things like building materials that you introduced years ago, there is still plenty of opportunity to add additional products as you look forward. Is that correct?

That is correct. When considering outdoor living spaces, pools are certainly significant, along with irrigation for proper landscaping and various other elements. The potential is vast, and I want to highlight that we have numerous opportunities ahead of us. There is so much that can be explored, and it’s all about ensuring we focus on our current priorities to effectively address new possibilities. By pursuing these in a structured and goal-driven manner, we can seize all that is available. Although it might be challenging to fully envision from the Midwest, when examining the Sunbelt, we see substantial growth in homes and a heightened appreciation for outdoor living, which positively impacts family life. Therefore, in my view, we are still in the early stages of tapping into the products that enhance this experience.

Very good, thanks Manny.

Good morning.

Good morning.

So you guys outlined about half the growth or about $30 million, which is about 4% growth year-over-year, it seems on the higher 2Q sales from last year. But when you think about Texas, which had so much rain last year and I believe you guys had flat comps, and in California, in the second quarter I believe you guys said you had flat comps in the second quarter which led to your earnings revision last year. Briefly, how do you think in those two markets, in particular, red states, which are obviously very large, how do you think this pre-buy plays out in those markets where your quote comps are easier considering you had flat sales?

Great question, Ken. First, we should see stronger comparisons in those markets, which were not as impacted in the first quarter. While there was some benefit, the overall impact was significant in these areas. The markets that were more affected were the seasonal ones where pools close for winter and then reopen, and reopening a month or two earlier generates a spike in activity. This was not as pronounced in Texas and California during the first quarter. In those individual markets, we expect to achieve strong high single-digit sales, reflecting a recovery of some of the opportunities we lost last year. Conversely, the seasonal markets experienced the greatest impact, and sales in those areas are expected to be more modest in the second quarter.

Okay. We have noticed a slowdown in existing home sales turnover, which affects you differently compared to many other building products companies. However, throughout this cycle, we are still experiencing significant price increases. Could you share insights regarding how your customers' clients are financing potential discretionary projects that could range from $15,000 to $50,000?

Sure. Starting in 2015, we noticed that banks began to relax their lending policies for home improvement projects. This change involves a few key aspects: lenders are more willing to provide loans, they are offering realistic home value appraisals, and they are approving loans for borrowers with good credit scores, even if those scores are lower than what was previously required. As a result, we are seeing an influx of new in-ground pool owners, who are similar to those interested in kitchen and bathroom remodels. These homeowners are starting to invest in their properties. While we currently have steady data from the four largest states, permit activity in the first quarter is largely flat compared to last year. However, we expect that as the year continues, there will be some positive momentum in new pool construction and growth in 2016, laying a stronger foundation for growth in 2017, 2018, 2019, and 2020 as the construction industry stabilizes and financing returns to more typical levels reminiscent of the 1980s and 1990s.

Right. You mentioned credit scores associated with implied loan-to-value ratios. Do you have any specific numbers in mind that you could share regarding your perspective on the market? I understand that you do not operate a lending unit.

Typically, the LTVs are before the project, which is apparently conservative because the projects add value whether it's remodeling a kitchen or adding a building.

Thank you.

Thank you, sir.

Thank you and congratulations. First question is just on product mix. You talked a bit about some of the pull forward effects from the favorable weather and the early start to the season. I was just curious if there were any changes that you observed in the first quarter and perhaps your expectations for the full year with the mix of businesses as it pertains to discretionary versus non-discretionary spend?

Sure. Non-discretionary spending on items like chemicals, parts, and accessories tends to be consistent, especially in year-round markets. In seasonal markets, however, we see an increase when pools are opened, and this year we noticed that pools opened earlier than they did last year and even in the past three years. For discretionary spending, there are two categories. The first is somewhat discretionary, which includes things like heating and lighting for existing pools or remodeling a deck around an existing pool. Because of the earlier pool openings and warmer weather, we've seen an increase in this kind of activity, which is a positive sign. Overall, since 2011, there has been a gradual recovery in remodeling and replacement activities following a significant change in behavior during 2008 and 2009. While we're not fully back to normal yet, we are getting closer. We anticipate that the industry will achieve normalized behavior regarding somewhat discretionary items within the next two to three years. The most discretionary item is new pool construction, which has been limited by financing. Historically, about half of new pool construction and major home improvements were financed through home equity, whether through new first or second mortgages or home equity loans. While financing has improved slightly since the low point in 2009, it remains a critical factor to returning to normalized levels in the future.

Okay, thanks.

Thank you.

Sure. Just from a fundamental standpoint, if you look at our SG&A, about 60% of the expense there is payroll related, and then the other two significant factors are facility costs and freight. So just to understand there is a fundamental baseline. When we look at our peak times of the pool season, which basically is April through August, we are virtually at capacity. That means to the extent that there are blips in sales above expectations, we'll drive more overtime, more contract labor, and more third-party freight carriers. The leverage opportunity that exists beyond a pre-set expectation is not as strong, as in the first and fourth quarters where we are essentially in volume of business below our capacity. So we can handle increases in activity like we realized this first quarter with virtually no increase in overtime or contract employees or third-party freight. So that's the consideration. The leverage goes back to the premise that Mark outlined in the outset, and that is that we target based on process improvements, technology, the greater use of technology, and deployment of best practices throughout the organization. We factor in a rate of sales growth that is greater than the rate of operating expense growth. That's built inherently into our plans as part of our DNA and while at the end of day, that results in our operating expenses growing at approximately half the rate of our sales and gross profit dollar growth. One more thing I might add there, a relatively significant part of our labor cost at least is incentive-based pay. Incentive-based pay, we record that throughout the year based on our expectations for the full year as well as how we're progressing throughout the year on those expectations. Looking at year-over-year changes this year versus last year, incentive pay will stick out in the second quarter, likely based on expectations as a fairly significant increase.

Good morning guys, congrats on a great quarter.

Thank you, sir.

A lot of the long-term issues have been addressed, so I want to focus on a few shorter-term matters. Specifically about the weather in the second quarter, I remember last year April and May were very rainy in Texas. We just experienced a significant flood in Houston earlier this week, but I'm assuming that overall the weather hasn't been nearly as severe, so is that what you're referring to regarding the more favorable weather comparison in Texas this year?

Yes, the heavy rains in Texas and neighboring states began in mid-April and continued through mid-June. We did experience flooding earlier this week in Houston, which had a negative impact on us during the first two days of the week. However, our expectations are based on normal weather conditions. For instance, we are not anticipating 70 inches of rain in the Dallas-Fort Worth area, where the normal is around 35 inches. We recognize that there will be loss days each year, and we are accounting for normalized weather in our projections.

So were you seeing so far in Texas then the growth rate kind of more in that high single-digit range so far this quarter or is that sort of where you're tracking there?

Well, we were until Monday and obviously, Monday and Tuesday was a little bit of an aberration.

But we'll make that back up presumably if we don't have a repeat of that major flood as last year.

Exactly, throughout May and June, yes.

Okay, got it. And then Mark, just on the breakdown of sales growth and the various pieces of the business, could you maybe run through what growth was in the U.S. blue, international blue, and green business?

Sure, I have that in front of me. Our international, which is all blue business, was 10.5% in dollars. The overall blue business was a little bit over 14%, and the green business was low single-digits.

Yes, it does, it does. And so on the international piece, was currency I guess not much of an impact?

Exactly; currency was relatively speaking a non-issue in the quarter.

Manny, regarding SG&A leverage, this situation illustrates what can occur during slower periods of the year when there's a significant revenue increase. I'm also interested in understanding how much capacity your business has from a fixed-cost standpoint for continued growth. My question arises from the potential for high single to low double-digit growth during seasonal peaks in your business in Q2 and Q3. Do you have the ability to achieve better leverage than the target of operating profit growth exceeding gross profit growth by a substantial margin?

Let me give you an example. We experienced 13.5% base business growth in the first quarter, and our base business expense growth was 3%. In the second and third quarters, assuming a base business sales growth of around 10%, our expense growth would likely be in the range of 5% to 6%.

Okay, that's very helpful. And is that just a headcount or sort of seasonal headcount additions that you would plan to help handle those high points in the business?

It would be contract employees, overtime, and then third-party freight carriers.

Got it, perfect. Okay, that's all I have. Thank you, Manny.

Thank you, sir.

Good morning, let me add my congratulations. Question about your market share gains, Manny. How much faster do you think you grew relative to the industry or in other words, what do you think the growth was in the industry relative to your base business?

What I'll call legacy products and legacy product categories, we probably grew at about twice the industry growth rate. That would be right around double digits, and that's pretty much par for the course for the past 20 years; we grow at about twice the industry growth rate.

As the industry is coming into Q2, and you're sort of benefiting a little more from that it seems like from the weather, do you see the industry or your competitors positioned, coming into the key part of the season, or is there an opportunity for you to continue to grab share at this pace or potentially even faster if they haven't replenished as fast as you?

Well, we all replenish on a regular basis so I don't know that that will be an adverse impact. I think the T-factor there is, if we have 5% to 7% sales growth, what that implies inherently is that the industry will grow at the balance of the year at about a 3% rate, and that I think is a reasonable expectation.

Good morning. So just a follow-up on the demand side, also it looks like 10-K has one less. Actually one more in the selling day.

I would believe Mark here over my memory.

I would 100% confirm that.

We did have a leap year, so coming back to February, we picked up that day; there may have been an extra day in the year. I'd have to go back and confirm, to be honest.

Okay, not a problem. I just wanted to follow up on a couple of other questions. As far as building materials, what percentage of your sales is that currently, and how do you expect that to be in the next two or three years?

Well, that is a little bit over 10% of our total sales presently, and we believe that it will cross over to be 11% of our sales, if not in '17, certainly by '18.

Okay, thank you for that. And also, Manny, you talked about the fact that you want to carry more new products; there are still a lot of opportunities for additional products. So can you give us some examples of some product categories perhaps that you would like to carry in your sales centers? And also do you have the physical space to carry these extra products?

I'll address the second part of your question first. We regularly assess our capacity and seek ways to improve it by designing and organizing our facilities more effectively. Each year, we typically move around 50 of our facilities to larger spaces or expand into nearby areas if relocation isn't necessary. This ongoing process of expanding capacity involves both internal design efficiencies and increasing our available workspace. For instance, we have four central distribution sites that support our local locations, and we recently upgraded two of those sites to larger facilities this past winter. This process is continuous, so there's no need to worry about our capacity, as we consistently add to it each year. While the number of locations may not change significantly, we do increase our overall space. Regarding product categories, I can share some exciting options, such as our water-resistant speakers designed for poolside use that connect via Wi-Fi to stream services like Pandora. We sell these through our retail partners. Additionally, we have items related to paddleboarding, which is also quite popular.

Stand up paddle boards?

We sell stand-up paddle boards to retail locations, and we have various fun and exciting product categories. Our range includes cool toys for our retail store customers. Additionally, we offer products for outdoor spaces, such as decking materials, natural stone, man-made stone, and other variations. We also provide outdoor kitchens and complementary items like coolers. Our theme centers around creating a vacation atmosphere in your own backyard, enhancing the entire experience by adding fun and function.

Anthony?

Yes.

Believe it or not, Manny talked long enough for me to run and get my billing day numbers. Let me just run through that for you for the rest of the year here. Just so we're clear, so we're minus one in April, plus one in May, no change in June, no change for the second quarter; minus two in July, plus two in August, no change in September, so no change for the third quarter; minus one in October, plus one in November, minus one in December, so we lose one in the fourth quarter.

Okay, got it. So basically, your 10-K should have reflected one more day in the first quarter and one less in the fourth quarter.

I believe so.

No problem. And lastly, what's your longer-term outlook for acquisitions, Manny?

We are constantly exploring opportunities, mainly in markets where we currently have a presence or where our market share is low. In North America, especially in our blue business, there are a few areas with potential, but they are limited. Most of our future acquisitions will focus on the green sector and international markets. Ultimately, acquisitions serve as a strategic way for us to enter or strengthen our position in markets where our share is low. Additionally, we will continue to open our own locations, a strategy we have successfully implemented for over 20 years. From a capital perspective, whether through new openings or acquisitions, we generally allocate around 1% of our sales each year. This can vary, with some years being 2% and others closer to zero. While this isn't significant in the short term, it does establish a foundation for growth, similar to how an increase in installed pools offers future growth opportunities as we expand our presence and penetrate more markets.

Okay, thanks very much.

Thank you, Amy, and thank you all for joining us today. Our next call is scheduled for July 21, where we will discuss our second-quarter results. Have a great day.