Pool Corporation (POOL) — Q3 2017 Earnings Call Transcript

Thank you, Phil. Good morning, everyone, and welcome to our third 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 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. As reported, we had a solid third quarter with 6% base business sales growth or 7% after considering one less sales-day in the quarter. Year-to-date, our base business sales also increased 6% on top of last year's 7% base business sales increase that benefited from the favorable weather. This level of growth is a reflection of the resiliency and favorable characteristics inherent to our business together with our team's ability to provide exceptional value and our being rewarded with an ever-increasing share of our customers' business. Our base business gross margins were also solid, especially when you factor in the 30 basis points increase realized in last year's third quarter. Year-to-date, our base business gross margins were up 11 basis points on top of last year's 20 basis points increase. Expenses were largely as planned as we continue our ongoing investments in our business. Altogether, a solid quarter as we further solidify our foundation as a value-added distributor. Our base business sales growth in our four largest markets, California, Florida, Texas, and Arizona; and in the rest of the markets was 6% in both cases. Within the quarter, the storms were the most disruptive with the impact from Harvey essentially recovered in the quarter, and the impact from Irma expected to be recovered this month. Also, our base business sales result includes our green business, which had a 4% base business sales increase in the quarter despite the exit of a product line that adversely impacted its sales. On the product side of sales, building materials and related outdoor living products continued its strong performance with 9% growth in the quarter despite the disruptions of the storms. The lost sales-days in these product categories will likely not be recovered as builders and remodelers were already working at capacity in many cases. Year-to-date building material sales were up 12%. Commercial had 10% sales growth in the quarter and year-to-date, excluding the Lincoln acquisition that we closed in the second quarter. POOL equipment growth was 10% in the quarter and 9% year-to-date. The growth of 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 product side of our business was essentially flat in the third quarter, primarily due to postponed sales in Florida from Irma. Year-to-date retail sales increased 2%, which is consistent with growth in the online channel. Our base business gross margins were up 26 basis points in the quarter, which is very strong considering the increase realized in the third quarter of 2016. Our base business contribution margin was 20% in the quarter and 17% year-to-date, even with our continued investments in our business and consistent with our expectations. Our diluted EPS increased 13% in the quarter and 11% year-to-date excluding the new accounting standard is consistent with our expectations, as is our ROIC increasing by 60 basis points to 24% on a trailing four-quarter basis, all of which reflects the ongoing effectiveness and discipline in our execution and the allocation of capital. At this juncture, we are fully immersed in laying the groundwork for 2018 while closing out another successful year. Of course, our 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. Now I'll turn the call over to Mark for his financial commentary.

Thank you, Manny. I'll start with our view of where we're at on operating expenses, which is that we've continued to make progress in bringing down the rate of expense growth as the year has progressed, although this may not be readily apparent. First, as you can see when you look at the base business addendum to our press release, approximately 3% of the 7% increase in our operating expenses in the quarter came from acquisitions. Looking at just our base business operating expenses, you can see that we had a 20 basis point improvement in base business operating expenses as a percent of sales over last year, compared to the 10 basis point improvement we reported for the first half of the year. What is an even better gauge of our progress here is the rate of our base business expense growth by quarter excluding performance-based incentive compensation. For our business, incentive compensation is a significant cost at over 1% of sales, and although paid on an annual basis, the expense recorded each quarter varies based on our progress toward our annual performance targets rather than on business activity in the quarter. This can create some bumpiness in our reported expenses, so stripping this out gives a better view of the rate of our underlying expense growth. For example, our incentive compensation expenses are $1.5 million higher this year than last in the quarter, but $1 million lower than last year on a year-to-date basis. So excluding our quarterly incentive compensation expense, our year-over-year base business expense growth by quarter in 2017 was 7.5% in Q1, 7% in Q2, and just 3.5% in Q3 which demonstrates the progress we've made heading into the home stretch this year. This should keep us on track towards our targeted 20 to 40 basis point improvement in base business operating margins for the year which is in line with our long-term guidance. Moving down the P&L, interest and other non-operating expenses are up $1 million in the quarter, and $1.7 million year-to-date. This was due to higher debt levels which on average were up $109 million, or 25% in the quarter, and to rising interest rates which are up 80 basis points from last year. Our total debt was up $174 million over last year, primarily because of share repurchases of $199 million over the last 12 months, as well as business-driven working capital growth. Despite the increase in debt, we remain conservatively capitalized with leverage at the end of the quarter of 1.6x as calculated on a trailing 12-month basis, which is up slightly from 1.5x last September. Our income tax rate in the quarter of 37.4% was consistent with our 37.7% rate last year. In the third quarter, we drew down our tax reserves which typically result in a Q3 rate that is a bit lower than our annual effective rate. Of note, we had no benefit in the quarter from our adoption of ASU 2016-09, as I mentioned would be the case at our Investor Day meeting in September. Assuming similar rates of employee option exercises in the fourth quarter as in the third, the benefit we had previously anticipated in the second half of the year would instead be recognized in the first quarter of 2018, which is reflected in our narrowed guidance range for the year. On our second quarter earnings call, I gave an estimate of the 2018 effective tax rate of 34.1% for the year. I will update this on our year-end call in February, but we'll continue to use this rate for now for modeling purposes, expecting most of this benefit in the first quarter of 2018. Moving on with the balance sheet and capital statement, you can see that our net receivables grew 13% year-over-year, which was ahead of our 8% sales growth in the quarter. Included on this line are other non-trade receivables related primarily to vendor receivables, which grew $7 million year-over-year. Backing this out, the growth in our receivables was more in line with our sales growth in the quarter. Our days sales outstanding or DSO, which reflects the effectiveness of our collection efforts, was 29.4 days, which was an improvement from 30 days last year. Our inventories grew at 6% year-over-year, which is consistent with our growth in accounts payable and overall growth in business activity. As we mentioned in our press release, our third quarter 2016 estimated tax payment of $37 million was deferred to the fourth quarter of 2016. Adjusting for this, our operating cash flow was ahead of last year's pace and is on track to meet or exceed net income for the year, which is our target. I'll update you now on our share repurchases. During the quarter, we repurchased 1,239,000 shares in the open market at an average price of $107 per share for use of cash of $132.9 million, which accounts for the bulk of our year-to-date share repurchases of $139 million. For those of you who may have missed it, we announced that we completed an amendment and extension to our revolving credit facility before the end of the quarter. This facility provides us with the majority of our cash in use and is used primarily to fund working capital and share repurchases. It has been in place for 3 years and was running at capacity, so we upsized it from $465 million to $750 million, pricing it slightly and extended the term out for five years to 2022. All in all, this was a very good result for the company. One modeling item which I need to make you aware of is our expectation for gross margins in the fourth quarter and for the year. As we have said all year, we expect our gross margins to be relatively flat for the year, which includes an expectation for lower gross margin in the fourth quarter. This is due to a combination of lower-margin post-storm replacement products we are selling in the Florida and Texas markets, as well as year-end accrual adjustments made in the fourth quarter of 2016 that positively impacted margins which were up 20 basis points from Q4 of 2015. At this point I'll turn the call back over to the operator to begin our question-and-answer session.

So my first question is on incremental margins. You mentioned that this quarter was 20%, but what if we adjust for the one less day and for the hurricane impact, would incremental margins be more like 23% or 24%?

Let me just think about that a second. It would be a little bit higher, Ryan, but I haven't done that modeling and calculation to see how much higher that would be, but certainly, it would be a little bit higher, yes.

Okay, that's what I thought. And then at the end, Mark, you mentioned gross margins being down sequentially and actually in line with what I was thinking, but could you put some parameters on that just so we've got to calibrate correctly, how much were you thinking was going to be down sequentially?

Yes, well, and I wasn't talking sequentially, I was talking year-over-year. So what I said was that margins for the year would be relatively flat. We're up year-to-date, so the difference essentially consists of relatively flat margins plus or minus. And again the difference there is first of all the fourth quarter, most of the business is coming from the year-round markets, Texas and Florida being significant components of that, and some of the storm recovery business is equipment sales which is generally lower margins. And then we also had a tough comp last year, which we had a 20 basis point improvement in margins in the quarter.

Okay, got it. And then just lastly, retail up 2% year-to-date, you mentioned storms caused a little bit of delays here in the quarter, but do you think you should be doing a little bit better than that? And my recollection is you've been growing about 4% in retail the last couple of years?

That's correct. Two things; first, we have been running up through August right around 2% to 3% year-on-year and obviously this year we didn't have the same weather benefit that we did last year in the seasonal markets where it was a longer season with an earlier start. So therefore we had a tough comp on that retail side, again because of seasonal markets having a longer season last year. But then the storm hit and between August and September we essentially gave the year-on-year increase back. So that's the essence of that. The chemical side of retail is pretty much on track with our expectations, but the other sides of retail are down a little bit again with lost sales days in both Florida and Texas primarily.

First question, just wondering if you'd any color you can provide on the New Star Holdings acquisition from July?

I'm sorry, what acquisition?

The New Star Holdings acquisition?

Yes. That is an acquisition in Australia that we did earlier this year. It is at this juncture early, as you can well imagine, the seasons run a different program than here, so the first three months' worth of activity was right on plan and it's all moving in the right direction and we're realizing also some synergies with our existing business there before. So it's progressing nicely, but it's still just three months in.

That's helpful. Then second question, Manny, just wondering what your outlook for new pool construction is heading into 2018? Just wondering if there's any clues in growth could be nearing an inflection point here? And as far as factors to watch, would you say that borrowing availability is the most important factor that we should be watching at the margin or is there something else that you guys are watching closely?

I think that's a great question. The natural demand is really poised for an inflection point, if not in 2018, then certainly within the next two or three years. However, I want to caution that new pool construction is the most labor-intensive part of our customer activity. Specifically, the cost of materials for a new pool typically represents 15% to 20% of the total cost, with remodel jobs having higher labor percentages because their labor content is somewhat lower. The main barrier to realizing this demand is labor availability, and you may have noticed this in the new home construction sector, where strong demand exists but labor constraints are generally limiting potential growth. I anticipate solid growth next year, but if demand were to indicate a 30% growth potential, labor constraints might result in only a 10% growth in new pool construction, which seems reasonable for next year.

And then if I could just get another one in quick, Mark, you had mentioned a 34.1% effective tax rate. I didn't catch the year that you were referring to when you gave that, just if you could clear that up for me?

Yes, that was just reiterating tax rates guidance I gave on the second quarter call for 2018, which was at 34.1% and given the push of ASU benefits of the first quarter that would be heavily weighted to the first quarter. I also gave a rate of 2019 on the second quarter call of 34.6%. So we will take a look at that and have some kind of update on that on our year-end call in February.

So Mark, I'll piggyback on that last one just real quick. If it was 34.1% before you saw the shift to the first quarter of '18 from the back half of this year for options exercised, how do you think we should adjust that rate for '18? It seems as though it's got to be a decent amount lower now, but what are we now thinking?

Well, I guess my guidance would be to keep it at 34.1%, as you could assume that will be a little bit conservative. I'm a little gun-shy, Matt. These option exercises are extremely hard to predict and they're relatively meaningful, and so we predicted too high when we entered this year and had to bring it down when we got into the back half of the year. So the 34.1% is certainly very doable and it includes almost $10 million of benefits we expect in the first quarter on the tax expense line with little marginal benefit in the rest of the year, and so I would start with that, and we'll update it when we have a better view.

Okay. That helps. In terms of revenue growth, you obviously had a very strong growth rate this quarter. If my calculations are correct, excluding hurricanes and one less selling day, daily sales seemed to increase by about 9%, which is a nice acceleration from the second quarter and falls at the higher end of your targeted growth range of 6% to 9%. Manny, is there anything specific that you would highlight that's contributing to this higher growth right now? Are you noticing any strength in seasonal markets compared to year-round markets, or are there particular product categories making an impact?

I believe there are two main factors at play. Firstly, the external environment is looking positive. Current pool owners are still investing in their homes, which is increasing demand from potential new pool owners. However, the key factor is that existing pool owners are committed to enhancing their outdoor living spaces. Secondly, our ongoing efforts to introduce new products and collaborate with our customers are enabling us to grow at a rate that surpasses the market. These two factors are encouraging signs, although we did face challenges due to a recent storm that disrupted many of our customers and employees. However, from a long-term business perspective, we typically recover from such disturbances quickly. The main concern going forward is not necessarily the limitations we might face this year, but rather the capacity for our customers to expand their businesses over the next three to five years, which heavily depends on the availability of labor. I remain confident in our long-term projections of 6% to 9% growth, alongside our 15% to 20% EPS growth, driven by national demand and our increasing market share. Ultimately, whether our top-line growth is closer to 6% or 9% will largely depend on labor availability more than anything else.

Are you noticing an increase in homeowners undertaking more extensive backyard remodels when they are refurbishing their pools? Is there a change in the types of products they are purchasing? Are they enhancing their pools in some way? Is there perhaps a positive trend related to this happening right now?

Definitely. Definitely, and I don't see that changing anytime soon.

So just to go back to the previous caller's question, Manny, you had mentioned that you are looking to roll out some new products. Can you give us some examples perhaps for what you're looking to do in 2018 and beyond?

Sure. I need to take you back a bit, Anthony. At one time, distributors in our industry, including us, were selling products specifically designed for pools. Over time, we noticed what our customers were purchasing from other sources and began offering products available through different distribution channels that our customers wanted. As we assessed the pool market, we started to explore adjacent areas, such as hardscapes. While we do sell hardscapes, our strength lies in offering hardscapes that complement pools. More pool owners are enhancing their outdoor living spaces with premium decking and outdoor kitchens, effectively creating another room in their homes. This trend is beneficial for us. We collaborate with manufacturers globally, continuously introducing new products and generating demand for them, all aimed at enhancing the outdoor living experience for homeowners.

Thanks for that color, Manny. And also certainly you guys stepped up your share buyback activity pretty heavily in Q3. How should we think about 4Q and heading into 2018?

I believe it's important to take a broader view. Our target for the trailing twelve months is a debt to EBITDA ratio of 1.5x to 2x. We were nearing the lower end of that range over the past year, and when opportunities arose, like they did earlier this year, we seized them. As the market presents opportunities, we aim to capitalize on them while staying within the 1.5x to 2x range. Mark noted that we ended slightly above last year’s debt to EBITDA ratio, yet we still have significant capacity and our EBITDA is on the rise. Therefore, we will continue to be opportunistic in our buying, with about $140 million spent year-to-date, which aligns with our expectations. I anticipate next year we will strive for a similar amount, consistently moving forward. This has been an integral part of our strategy for many years, tied to our disciplined approach to capital deployment. We are selective in the businesses we enter, ensuring they meet our criteria for returns and organic growth. With our strong cash flow, we have ample cash available, and we prefer not to reduce our already low debt levels as it represents a low cost of capital. Instead, we intend to use that capital for the benefit of our shareholders, including share repurchases.

And I guess we should assume as far as the other usage of cash would be your cash dividend that we should assume a continued increase in there?

Yes, the policy that the board has established is 35% of net income as the payout ratio and that's reviewed when we have the capital structure discussion in our May board meeting and that's been consistent now for a number of years, maintaining that 35% payout ratio. So with earnings going up, you would expect that the dividends would go up in kind.

Yes, that 35% is a non-ASU basis which is a non-cash tax adjustment.

Yes.

Thanks for that clarification, Mark. And then a couple of other small questions and I'll let you go. So as far as the product line extension that you mentioned as far as the packing and green business, can you just remind us as to when this exactly occurred so we should know when the anniversary is?

It would anniversary in December.

And lastly, I assume that the number of billing days in Q4 this year versus last year is the same?

Yes.

I would like to ask about your guidance range. Is it reasonable to assume that in the fourth quarter, considering your gross margin outlook, the primary factor affecting variance is the weather and the duration of the pool season this winter, or are there other factors within the guidance that are influencing the range?

That's it. That's essentially it because everything else is pretty much normal and it's in seasonal markets and when it shuts down.

Got it. And then if you could speak to the gross margin improvement in Q3, just wondering if there's any mix benefits that you saw, and then also was there any benefit from the gross margin from some of the deferrals in Irma that you expect to be a head-winner, reversal in Q4?

Yes, there is certainly a mix benefit. However, prior to discussing that, we had a program in place, with every aspect of execution on both the sales and sourcing sides contributing positively, a factor that has been reflected in our numbers for many years. The counter to this is the growth mix of certain product categories, particularly the lower margin equipment we sell, which has a reduced cost to serve. While the equipment growth rate remains strong for the quarter and year-to-date, it experienced a slight dip compared to recent periods. Consequently, a minor mix benefit is incorporated into the numbers. As Mark mentioned earlier, we essentially give some of that benefit back as the mix of our total business stabilizes in the fourth quarter.

And I wanted to ask about commercial, how did that perform in the quarter and what's the M&A opportunity?

The performance in the quarter was solid. I mentioned earlier that we saw a 10% increase from our base operations in the commercial segment. The Lincoln acquisition we completed in the second quarter has contributed to this, although its growth isn't as strong as our legacy commercial operations. We are working together and leveraging both organizations to enhance our presence, focusing more on 2018 and 2019 rather than just 2017, and progress is being made. Regarding future mergers and acquisitions, our market share is lower than we would like, so we are actively looking for opportunities, while maintaining the disciplined approach we've historically practiced in all our endeavors.

Got it. And then just last housekeeping question, just given the buybacks that occurred in Q3, what's the right share count that you exited the quarter with?

The actual share count would be approximately half during the quarter, so if you compare the year-to-date with the three months, the difference is about 0.5 million. You can determine that the end of the quarter was about 0.5 million shares less.

There was an article today discussing how backyard space in homes is increasing, particularly in new homes. I'm curious how often these projects, including outdoor elements, are associated with pool installations. I have always assumed it would be a yearly one-for-one ratio. Could you also provide some context regarding your outlook on financing and what you expect for 2018 in terms of tighter or looser credit conditions?

First, in terms of existing pool owners, in many cases, but not all cases, in many cases when they remodel their pool, they tend to also look at the perimeter of the pool and the associated decking and refresh or replace that deck. Okay? That doesn't always happen because in many cases that decking is perfectly fine and no need. There are also cases where people redo the decking and not have to do the pool. So there is some connection when they're redoing their backyard, but not necessarily. I'd make the association when people redo the cabinets in their kitchen; in many cases they also redo their appliances, but sometimes they redo appliances, but sometimes they're very much independent events. Okay? In terms of new pools, there is more of a tendency on new pools to not just do the pool, but do the perimeter as well, and that certainly is positive for us, but even more telling for us is across the borders we talked about in a couple of other questions earlier; people are doing it and stepping up, so they're not just doing a plain white plaster shelf; they are doing whether it's stonescapes or JewelScapes or whatever, one of our higher-end and more aesthetically appealing finishes. So that's an example of what's happening there. In the same way when they're doing decks, instead of doing a simple cement deck with perhaps a dye from a color and a stamp process which is very common 15, 20 years ago, now they're using natural stone or papers and both of which have very positive attributes that help sell them through the channel. So those are the things that are happening. And I think it's positive. Again, I don't see the external market being an impediment any time soon, I think more the impediment, if any impediment is there, is going to be labor.

Right. And I guess as it relates to the very good increases in equipment, building material et cetera, how much in collectively has inflation kind of flowed through in 3Q or throughout 3Q and year-to-date numbers, is it 1%, 2% or some more in specific categories?

In the overall business, it's likely very close to 1%. Certain product categories, like chemicals and accessories, haven't experienced any inflation at all, while other categories, such as equipment, have seen inflation running at about 2% to 2.5%. However, the overall weighted average is closer to 1%.

Great. When you say that 2%, is that like-for-like or is that kind of mix creeping in there, just to understand that?

That's a great derivative, that's like-for-like. Many factors have invested in more innovative products, and there has been some top grading that's also been taking place, whether that's in lighting, whether that's in pumps and a number of product categories there's been some gradual top grading from a product mix standpoint which is independent of the like-for-like inflation that I answered about earlier.

Well, thank you very much, and thank you all for listening. Our next call is scheduled for February 15, mark it on your calendars, February 15 when we will discuss our full-year 2017 results. Thank you and have a great day.