Pool Corporation (POOL) — Q1 2017 Earnings Call Transcript

All right, thank you. Good morning everyone, and welcome to our First Quarter 2017 Earnings Call. I'd like to remind our listeners that our discussion, comments, and responses to questions today may include forward-looking statements, including management's outlook for 2017 and future periods. Actual results may differ materially from those discussed today. Information regarding the factors and variables that could cause the actual results to differ materially from projected results is discussed in our 10-K. In addition, we may make references to non-GAAP financial measures in our comments. A description and reconciliation of our non-GAAP financial measures is posted to our corporate website in our Investor Relations section. Now, I'll turn the call over to our President and CEO, Manny Perez de la Mesa.

Thank you, Mark, and good morning to everyone on the call. Our challenge this first quarter was to surpass the extraordinary first quarter that we had last year, and we accomplished that. In fact, we realized 5% base business sales growth on top of last year's 13% growth, without the same weather benefit. In addition, we continue to make investments in our business as we continue to build for the future, and yet, we were still able to realize growth in our base business operating profit; all together, a strong first quarter as we solidified our foundation as a value-added distributor. Our base business sales growth in our largest four markets, California, Florida, Texas, Arizona, was 6%, while the growth in the rest of the markets was 3%, as these markets were the primary beneficiaries of the mild winter last year. These base business sales results include our green business, which had a modest base business sales decrease in the quarter, although their sales were up when including the acquisition that we closed in April of 2016. On the product side of sales, Building Materials and Related Outdoor Living Products continued its strong performance with 14% growth, while Commercial had 12% growth. Pool Equipment growth was 8% despite the challenging comparable from last year. The growth in these product categories reflects both the ongoing recovery in the remodel and replacement sectors of our business, as well as our consistent market share gains. The retail products side of our business increased by 4% in the quarter, as the installed base of pools grew by 1% with virtually no inflation, and our performance reflecting market share gains. Our gross margins were modestly up due to minor product and customer mix differences. These differences in mix should largely work themselves out as we proceed throughout the year. While our base business operating margins reflect modest declines, that's largely due to both the extraordinary first quarter of 2016 and certain expense timing differences. For the year, we expect operating margins as well as our ROIC to increase. We increased our annual guidance by $0.12, to $4.12 to $4.32 per share, reflecting both an increase in our estimated benefit from the new ASU from $0.20 to $0.30 per share, and an increase of $0.02 in our diluted EPS using 2016 GAAP based on our first quarter results. We are cognizant that we are just now entering the seasonally busiest time of the year, which is when our service level and value proposition are most distinctive as we work to help our customers succeed. Of course, these results are only possible because of the commitment of our people throughout the company to our customers, our suppliers, and each other. We are extremely fortunate to be involved in a business where every day we help people realize their dreams of a better home life while simultaneously assisting over 100,000 customers realize success. We look forward to making 2017 another successful year as we continue to create exceptional value. Now, I'll turn the call over to Mark for his financial commentary.

Thank you, Manny. I'll start off by commenting on our base business operating expenses in the quarter, which were 7% higher than Q1 2016, and didn't provide the kind of operating leverage that you might be used to seeing. There's a couple of reasons for that. First, while we had a tough comp overall for the quarter, this was particularly true for our operating expenses given that base business expenses were up just 3% on 13% sales growth in the first quarter of 2016. Looking at the two-year growth rate on sales and expenses provides a better view of how expenses have been managed, as well as the leverage we have. Without going into details here, there were also some timing issues on expense recognition, which contributed to the high growth rate this year. One factor of note is our employee-related costs, which accounted for 58% of our total operating expenses in the quarter and are primarily driven by headcount. Our total base business headcount was up less than 2% at March 31, 2017, compared to the prior year period, so no issues here. The bottom line on expenses is that our Q1 expense growth rate does not cause us concern in meeting our projections for the year. Next up for discussion is our tax expenses, which excluding the ASU adoption, were in line with our previously stated guidance of 38.5% for the year. The higher-than-expected positive impact from adoption of the new accounting standard was due to the higher-than-forecasted stock price in the quarter on invested equity and restricted stock, as well as the acceleration or pull-forward of option exercises in the quarter from what we had forecasted. This pull-forward of exercises largely came from exercises that we would've expected to take place over the remainder of the year. As we look out at the rest of the year, knowing that the higher stock price has a positive impact on our ASU-adjusted tax expense, while the pull-forward will reduce the benefit, and largely offset the impact of the higher stock price. We are leaving intact our forecasted ASU tax benefit of $0.18 per diluted share per quarters two through four that I communicated on the February call. As previously stated, we will continue to be very transparent about the impact from this accounting change as we report our quarterly results, and we'll be excluding this when evaluating management performance for compensation purposes. Turning to our balance sheet, and the two major components of our working capital, receivables and inventory, you can see that net receivables increased 2% year-over-year, which was in line with our sales growth. Our net inventories grew $52 million or 9% year-over-year, $51 million of which was for our domestic blue business. 90% of that increase was for new products, and our highest velocity items or what we internally categorize as classes 0 through 4 items, which is out of 14 classes of inventory we carry. So we have no concerns about carrying too much inventory into our peak selling season. Looking at our statement of cash flow, let me first point out how the tax accounting changes impact the statement, which essentially moves the benefit of excess tax deductions we've historically reported as a financing activity up into the Operating Activities section of the cash flow statement. As the benefit is recorded in our reported tax expense and net income, and is therefore now included in operating activities, this increased our operating cash flow by $5.5 million over what would've been reported under the old accounting guidance. One more item to point out in our statement of cash flow is our $19 million purchase of property, plant, and equipment in the quarter, which is up nearly $6 million from Q1 last year. The increase is primarily related to the timing of delivery vehicle purchases which were put in service before the season this year, and also resulted in additional depreciation expense in the quarter. Overall for the year, we expect our capital expenditures to be plus or minus $40 million or about 1.5% of revenue. Finally, you will note we did not repurchase any shares on the open market in the quarter, although we do expect to repurchase $100 million to $150 million of shares for the year. We ended the quarter with a very comfortable leverage level of 1.59, which is calculated on a basis of debt-to-trailing-12-months-EBITDA. At this point, I'll turn the call back over to our operator to begin our question-and-answer session.

Hey, good morning guys, great quarter.

Thank you, Matt.

Manny, you mentioned something about it sounds like there was a little bit of difference in growth rates in the base business, maybe green was down a little bit, can you guys maybe quantify what the base business growth was in the U.S. blue, International blue and green business for us?

Well, we don't have it cut quite that way, but the blue business, basically the surrounding area from a number of standpoints. So the blue business was just over 5%. Overall base business and the green business was modestly down. And given the weighting to the green business, it's about 9% of the total. It still hovers around the same. And the green business was affected primarily by the much higher levels of rainfall that took place in the Western part of the country, which is where our green business is concentrated.

What about the blue business? Did you observe any differences in growth rates between year-round markets and some of the seasonal ones? It seems like last year the weather was more favorable than this year, which has been better than average but still presents a year-over-year challenge. I'm curious if you noticed much variation in growth between seasonal and year-round markets.

Yes, the year-round markets were slightly stronger than the overall performance, increasing by 6%, while the seasonal markets only rose by 3%. The smaller increase in the seasonal markets makes sense given that we faced tougher comparisons in those areas.

Okay, makes sense. As we've gotten into the second quarter, have you guys had the usual pre-buy at this point? Has that begun to happen? I know it helped last year. And as we think about the impact that that may have on margins, I guess it helped you from a mix perspective in the second quarter. Is it therefore maybe hurt a little bit from a mix perspective in the second quarter?

Yes. To provide some context, last year we experienced an unusually mild winter, which allowed us to complete almost all of our early orders and ship them by the end of the quarter. This year, particularly in the northern states, there has been a cold snap in the later part of the month, causing some shipment delays that have already been addressed in April. This scenario affected us by about 2%, equating to roughly $10 million that was shifted from last year or moved from March to April this year.

Okay, that's helpful. One of the things you have consistently done well over the years is continue to expand your product offerings. As a result, I believe you are gaining a larger share of wallet in refurbishment activity. I'm curious if you can quantify how much that contributes to your growth rate and discuss what you estimate your share of wallet is in pool refurbishment today compared to five or ten years ago.

Okay. There are two parts to this. I can't really answer the latter part since we don’t have that quantified the way you’re asking. However, regarding our categories, our Building Materials and Related Outdoor Living Products grew by 14% overall for the quarter. This strong growth rate reflects market share gains on products we sold a year ago, as well as our ongoing expansion into adjacent complementary product categories. This is expected to have a long-term impact. In terms of sales magnitude, these typical categories may not significantly contribute to our overall company revenue in the first two or three years, but they will gradually gain more traction over time. Currently, the Building Materials and Outdoor Living Products category accounts for over 12% of our overall business. To give you a perspective, if we look back to around 2011, this share was less than half of what it is today.

Okay, very helpful…

It's adding certainly collectively at least 1% a year to our growth rate, sales growth rate.

And then to be clear, you said that's got a long tail left to it, so that benefit you are seeing is not going to end anytime soon?

As long as people have houses and want to spend money on outdoor living space, and that's obviously a big deal in the Sunbelt, that is a long tail for the next 20 to 30 years.

Okay, great. Thank you, guys.

Thank you. Good morning, everyone.

Good morning, Ryan.

Good morning, Ryan.

So, first question from me, Manny, you had a nice start to the season and I just want to try to calibrate Q2 organic sales growth. So it's 6%, 7% of their range even though you've had such a good start or should we be dialing that back?

Last year, we had 6%. That was a very solid number. For the year, our expectations are five to seven. So, put it this way, if seven possible certainly, but I would say six is much more realistic.

Okay, fair enough. I could be optimistic at times, so I thought I would ask. And then secondly, I was hoping for a little more specific guidance on incremental margins for the remainder of the year, specifically 2Q and 3Q, so I know you gave guidance for the year and we can sort of back into it, but any extra color on what incremental margins can look like in 2Q and 3Q?

When you look at the year for us to have on a base business level contribution margins of 15%, that's a reasonable expectation for the year, obviously that didn't materialize in the first quarter, but some timing things think that we will get back for the course of the year. So I think 15% contribution margins for the year are reasonable and obviously that means that given the weighting of our business in the second and third quarter, it's going to be 15%, 17% in the second and third quarters.

Got it, okay. And then, just lastly in a green business, I recall the fourth quarter was down a little and now the first quarter is down a little as well, and I know you had the rain, but what's going on and I think you were making some changes. Maybe just give us an update there because your main public peer is doing a bit better?

Well, not necessarily. If you look at the recent S-1, you'll see that they also experienced a decline in base business sales in the first quarter. They don't provide a specific number, but I suspect it's similar to ours. Ultimately, it wasn't a favorable first quarter for that business. In our case, the sensitivity to weather is concentrated on the West Coast, where we have a strong presence. Everything is proceeding well, and we anticipate that as the year progresses, comparisons will improve, leading to consistent growth in both revenue and profits.

Okay. Fair enough. Thank you.

Thank you, sir.

Thank you. Good morning.

Good morning, David.

Good morning. In your model log, you mentioned that OpEx grew a bit faster than you anticipated, which outpaced gross profit dollar growth in the quarter due to some cost timing issues. Do you expect that in total, OpEx for the first half will still grow at about half the rate of gross profit, and is this a reasonable expectation for the year overall? I assume this is just a matter of timing?

Yes, well. Actually it's a little more challenging for the first half given that we are halfway through the first half, but for the year that is certainly still the target whether we are on that or outside of that a little bit, I think that our expectation is we will be close to that a little bit I think that our expectations as will be close to that here.

Okay. With the $0.12 benefit from ASU 2016-09 and the $0.18 remaining for the rest of the year, do you think the impact will be distributed evenly across the three quarters, or will it be more concentrated in one of them?

No, no, I had gone through that the year-end call in terms of how I thought that broke out by quarter. I just the first quarter that the difference was significant, but my comment on the $0.18 relates not only to the total, but also to how it breaks out by quarter. And I have to go back and look, but it's generally smaller benefit in the second quarter and third quarter and the bigger benefit in the fourth quarter.

Got it, okay and then finally, Manny, just wondering as you look at the new pool construction market this cycle, does it feel like it's evolving as you were expecting and same I guess for replacing refurbished, did those continue to evolve as you thought they would this cycle?

Yes, David. The replacement and remodeling activity has been robust and has been recovering since 2011. When you examine our growth rates for building materials and equipment over the past six years, they've been quite strong. New construction is indeed on the rise, with increasing consumer demand observed, particularly over the last two or three years. However, I want to emphasize that the potential for growth is somewhat restricted due to labor capacity issues. While growth is possible, we may not see an increase from 65,000 in-ground pools to 100,000, even if demand is present. I'm not suggesting that demand will reach 100,000 this year, but it is definitely stronger and will continue to grow; yet, the extent of that growth will be partially constrained by the availability of labor.

Okay, thank you.

Thank you, sir.

Yes, good morning, and let me add my congratulations on the solid start to the year.

Thank you, sir.

My question relates first question relates to Q2 and sort of the outlook that you just talked about, remember correctly last year weather was not as favorable in later April into May and if we look back a couple years you kind of had a flattish base business growth so you seemed to have a fairly easy comparison I'm just curious why you might not be a little more optimistic going back to the earlier question for the potential in Q2 and also if you just comment a little bit on trends in the quarter to date. Thank you.

Sure. I am confident in what we're going to be doing in the second quarter and as I mentioned just a ago one of the issues we are having and this is not unique to our space but at certain times of the year and given that our business is seasonal and the second quarters, the biggest quarter of the year. There is essentially a capacity limits on the part of our customers. As you all know on the call know what we sell to our customers is for them largely to utilize as they do what they do so, that while they're selling their, their time and their talent. They're using the materials and supplies that we provide to them to provide that at their customer experience. So therefore our growth from an industry standpoint is limited by the customer's ability to grow and in fact the labor is a constraint in some of the more labor-intensive services that they provide. So therefore my reference to 6% earlier in response to Ryan's question is more along the lines of how much share can we grow and how much is the industry overall capacity well. If it were, if it were more like the retail side of our business that is not as labor constricted then perhaps it would be higher than six, right since the line of our business is in fact labor constricted, I think six is a very reasonable number.

And the trends to date pretty much in line with that?

Yes.

Yes, and in fact we forecasted as much based on the activity.

Okay and then Mark somewhat housekeeping question on the ASU impact or for the rest of the year you basically assuming the current price or range around the current price.

That is correct.

Okay. And then one last question sort of bigger picture Manny, Peter have been I guess in Covington now for a few months, can you just give your sense on where he's focusing, what the opportunities might look like and you just sort of the early puts and takes of what might be happening there? Thank you.

Sure. He'd been involved on board now three and half months and during that time he has I think visited around 50 of our sales centers throughout the company primarily in well entirely in the U.S. He is actively participating in every decision of any consequence in the company he is and he's actively involved meeting not only our people and looking at operations and providing input into how we can get better but also meeting with our more strategic vendors as well as a number of customers so, he is I don't know about and contributing to our business to help us get better faster.

Thank you. Good luck, and see you soon.

Thanks, sir.

Yes, good morning and thank you for taking the questions. So, first I just want to follow up on the SG&A for the quarter so I guess Mark if you were to exclude the timing issues would you have been able to leverage your SG&A expenses for the quarter or not?

Well, Anthony, I would say yes we would certainly have leverage but maybe not to the historic degree because timing has to do both how expenses recorded last year as well this year and then we had some acceleration of expenses leading into the second quarter so as we're preparing for the peak season we got a head start in some areas to make sure that all the infrastructure is in place and ready to go so, I think that contributed to a little bit higher expense load just from a first quarter standpoint so. That's helps there.

Thanks for that. Manny, are there any potential new product categories you can share with us? You've done a great job over the years expanding your offering to customers. Is there anything noteworthy you can share about what else you might offer to them?

Certainly, we do not have a single solution for this, and our approach involves continuously assessing various product categories that enhance the overall outdoor living experience. We typically introduce these products in one or two regions to evaluate customer and consumer feedback. Based on our observations, we then gradually expand into adjacent markets over time. While there isn't one standout product category that we view as a game changer, many product categories have gained traction and will contribute to our overall business growth. Additionally, we recognize that our main focus is on our current customer base, and the best opportunity for us lies in selling more to these existing customers. As we make progress in this area, our product availability may allow us to reach out to other similar customers, but that process is more challenging and does not offer the same level of leverage. Therefore, while it presents an opportunity, it also comes with limitations as our primary focus remains on increasing sales through the same channel.

Got it, yes. Thanks for the clarification. And then, lastly you did touch on a commercial sector I believe it was up 12% overall looking at that piece of the business, what are the opportunities there and can you just also share with us, so we have a better perspective, what percentage of your sales is now tied to commercial?

There are around 335,000 commercial in-ground pools in the United States, primarily within the hotel, apartment, and condominium sectors. Additionally, there are competition pools and water parks. Last year, our net sales in this market reached nearly $100 million, which represents about 4% of our total business. This figure reflects products specifically sold to the commercial sector, while our actual sales in this area are higher since many of our chemicals are also sold to the residential market, where the majority of the volume occurs. Consequently, our share of the commercial business should grow at a double-digit rate for several years as we enhance our inventory and expand regionally, adding sales talent to better serve our customers and as we develop our product portfolio for the commercial sector.

Okay. Thank you everyone.

Thank you.

Good morning gentlemen.

Good morning.

Good morning, Al.

Mark, I wanted to clarify and get more details on the expense question. Are you referring to the increase in support costs for the peak selling season?

I already mentioned tax. Our capital expenditures were high for the first quarter, covering about half of what we plan to spend for the year. This leads to depreciation expense as we prepare to have the right equipment and locations ready for the upcoming season. This points to a timing issue along with our preparations for the season ahead.

All right. So regarding the DNA component that I might not have fully captured, I have another question. This might be broader in nature and could reflect a trend that isn't necessarily a cause for concern, but it appears that trade expenses may be influenced by increased labor costs. I'm curious if the mix of business is leading to greater demand from customers for product shipments, which in turn could be causing higher freight costs. Is there anything else to consider beyond those comments?

Two parts; Certainly on the freight side, we had been playing catch-up the last few years as we entered the season getting our fleet straight away and this year or last year we made the decision to order those delivery vehicles earlier, which is what Mark referenced a minute ago. Part two is, fuel costs are marginally higher than last year. But when you get to essence of your question, which is mix, there isn't anything significant from a mix standpoint in terms of delivery versus pickup that we've seen so far this year, and don't anticipate anything significant from a delivery versus pickup mix to take place for the year.

Okay. And then a follow-up to a question earlier and on the green business, in my observations it appears you're proceeding, well, strategically but also cautiously. Is that fair, or is it a function of just not seeing the right business opportunities out there to further expand that business, whether that be geographically to the East Coast or less reliance on the West Coast?

Sure. First of all, in light of our overall operations, we maintain a strong filter when it comes to returns. Our return on invested capital after tax exceeds 20%, which is much higher than most companies. While we aren't opposed to making short-term investments that may temporarily dilute our return on invested capital, we need to ensure that these investments will ultimately yield an appropriate return and be justified in terms of overall company value and price. Regarding our irrigation business, we concentrate on specific product categories, customer segments, and geographical areas that we believe can achieve similar returns and organic growth rates as our swimming pool business. Consequently, we aren't pursuing every market opportunity across the country, nor are we heavily engaged in certain product categories like perishables, which have unique distribution challenges. Those areas may be viable, but they don't align with our investment criteria. Additionally, we are mindful of our approach. While our focus is predominantly in the Sun Belt region for irrigation, we still engage in discussions for potential deals. However, we avoid making deals just for the sake of it; we prioritize long-term organic growth and return on invested capital over short-term earnings per share boosts, as the latter is a low benchmark. We did acquire a sizable regional distributor in the irrigation sector last April, and they successfully met their profit targets for the remainder of 2016, contributing positively in the first quarter of 2017. Therefore, this segment is performing well, and we are actively seeking similar opportunities throughout the Sunbelt.

Correct. And just to clarify, Manny, that was very helpful. Given the broader governmental policy and potential lower tax rates, does that open up more opportunities for sellers due to their ability to possibly achieve a higher reinvestment rate, or are the candidates that come through the filter influenced by broader events like death, divorce, and so on?

Yes, there are several factors that motivate a business owner to exit. The most common one over time is age, but other factors also come into play. For instance, tax changes can certainly motivate people to act. Taxes, age, and other significant events in a business owner's life are all influencing factors. Our practice is to only buy businesses when the owners are willing to sell, which is an important distinction in the process.

Great. Thanks a lot, and good luck guys.

Thank you.

Good morning.

Hi, Ken.

A lot of ground has been covered today. Much of what has been discussed aligns with conversations from previous quarters regarding what has been noticeable this year. When considering your guidance for a 6% to 10% growth rate, the core aspect appears to be the 1-2 range; everything seems to revolve around singles and doubles for your company. This isn’t bad if it continues in that direction. I’d like to approach this from a different angle. Our housing research indicates that older homeowners now represent about 52% of owners, up from the low 40s a decade ago, which seems to fall within your target demographic. If your volume constraints relate to customer constraints, do you consider local demand drivers? You often mention seasonal factors, but are there other variables that come into play, such as significant price depreciation or job growth? Or is it primarily about having a steady operating pool, regardless of other macroeconomic conditions?

Okay. There are two parts to consider. First, for basic maintenance and repair, the pools are present and will require attention. Regarding discretionary spending, that includes replacement, remodeling, and new construction, with new construction being the most discretionary. I listed them in that order because, from a labor perspective, that reflects the nature of our products. For instance, replacing a heater or pump requires a specific amount of time, and that time correlates with the products we sell, which may account for 30% to 60% of the total costs involved. Remodeling is more labor-intensive and the materials we provide represent a smaller percentage of the consumer's total expenses. New construction, being the most complex and labor-intensive, involves building the pool's foundational structure, which means the materials we sell play an even lesser role in the overall costs. Overall, I recognize the positive dynamics you mentioned for the industry. However, we have not yet observed the financing conditions that were prevalent in the 1980s and 1990s, where homeowners could borrow against 80% of their home’s value. The demand is certainly there along with the desire, but labor capacity is limited. Therefore, I don't anticipate any restrictions in basic maintenance and repair, see minimal restrictions on equipment replacement, some restrictions on remodeling, and the most significant constraints are in new pool construction, which is the most labor-intensive. This constraint isn't negative; rather, it simply limits the rate of growth.

Right. Okay, thank you, Manny.

Thank you, sir.

It didn't really affect the blue business for the quarter. It had an impact in January and February, but March saw a significant recovery. As you pointed out, California is a very large market with a substantial number of pools installed. While construction faced constraints due to rain, which mostly affected it, basic maintenance, repairs, and a significant portion of remodeling and replacements were still carried out as usual. Therefore, our customers didn't experience as many lost days in that area compared to construction, where the green business is primarily affected.

Okay, got it. That's helpful. And then, just lastly, just to put a ball around, the guidance and your view of some of the capacity constraints, you raised the guidance excluding the tax benefits, just to reflect the strength in the first quarter, is it just fair to assume that the relative conservatism in taking up the guidance for the rest of the way isn't much a concern about underlying demand, but that's just more of an issue around capacity as you…

That is correct. That is correct.

Thank you, Anita, and thank you all for listening to our call. Our next conference call is scheduled for July 20; mark it on your calendars, when we will discuss our second quarter 2017 results. Thank you very much and have a great day.