Pool Corporation (POOL) — Q2 2018 Earnings Call Transcript

Thank you. Good morning, everyone, and welcome to our second quarter 2018 earnings 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 2018 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 measure 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. Manny?

Thank you, Mark, and good morning to everyone on the call. My prepared remarks this quarter will be more limited than the previous 77 quarterly investor calls as Pete Arvan will provide color on sales and operations, while Mark provides color on expenses and the balance sheet. In terms of the 2018 season, after a slow start in March and April activity reverted to expected levels in May and June, albeit constrained by customer capacity and reduced workdays due to higher rainfalls in selected markets. As a benchmark, we had our first billion-dollar sales quarter, which is noteworthy for our industry. We're expecting ongoing growth in the second half as demand remains strong, and the main constraint to growth is customer capacity. As mentioned in previous calls, we were expecting greater and earlier price increases in 2018 given materials and operating cost pressures. Those increases have now started to be communicated and are starting to be passed on through the channel. While the impact will be felt primarily in 2019 given the late 2018 season timing, there will be some impact on sales and some noise on gross margins in the last four months of 2018. For 2018, the bottom line impact should be fairly muted, but it should add to our sales in 2019 and beyond. As I look at our business, we are stronger and better across the board. Our ongoing investments in people, facilities, product lines, fleet, technology, marketing and customer service continue to separate us in the marketplace. These investments occasionally result in lumpy expense growth, but that's historically been followed by higher operating leverage in subsequent years. To that end, we have largely kept our EPS guidance intact for 2018 by incorporating the $0.04 pickup in the second quarter due to ASU 2016-09 into our range. Beyond 2018, our model for sustained organic growth is intact with 6% to 9% sales growth leading to double-digit operating profit growth and solid mid-teens plus EPS growth. Now I'll turn the call over to Pete for his business commentary.

Thank you, Manny, and good morning to everyone on the call. Thank you all for taking the time to join us today. Let me start by introducing myself to those of you who might not have had the pleasure of meeting. I am Peter Arvan, the Chief Operating Officer of Pool Corp. I joined the company in January of 2017 and have been leading our North American blue and green businesses along with marketing, IT, and operations ever since. As you all saw in our announcement, we had a respectable second quarter with revenue growth of 7% overall and 6% from our base business. This is on top of last year's 7.5% overall and 7% base business growth for the same period. As Manny mentioned, the delayed spring in our seasonal markets led to a slower than normal April, but once the weather broke in May, overall demand for our products ramped up in the seasonal markets and that continued into June. In fact, on a same selling days basis, our base business sales increased 1% in April, followed by 9% growth in May and June. Of our four largest markets, only Arizona saw normal weather patterns while in California we saw unseasonably cool weather for most of the spring which delayed pool activity. Weather conditions in Florida for May and June and a very wet spring in South Texas also impacted construction days further compressing the year. Understand that these are year-round markets so we should make much of this in the second half as again underlying demand is strong. Despite these challenges, the markets collectively saw 7% growth for the quarter, which reflects solid share gains as we estimate the markets grew at roughly 4% collectively. For the same period, our green business grew at 7%, all of which is organic. Switching to gross profit, our base business gross profit grew at 6%, while the total business saw a 7% growth rate. Operating income for both the base business and total company grew at 5% for the quarter. Mark will provide commentary on expense growth in the period and how that affected operating income. The delayed spring pushed back openings of pools in the seasonal markets with the greatest impact falling on pool retailers with weak April demand for chemicals and maintenance products. Despite the slow start, as soon as the weather warmed up in May, pool openings demand spiked with retail sales up 4% overall for the quarter. In the commercial area, strength in share gains continued as we experienced 8% growth in the quarter. From a product view, sales of building materials and associated outdoor living products were strong as we saw revenue increase by 12%. Equipment growth in the quarter was 8%, again reflecting strength in the discretionary market. Now I’d like to provide an update on our POOL360 sales as this has been a focus area for us. Our POOL360 app allows customers to place orders, search for products, and even pay their bills without ever leaving the job site. Sales over this platform are up 21% year-to-date which shows the inherent value to our customers. To facilitate faster service in our sales centers and higher productivity, we have added specialty equipment and priority pick areas to reduce the wait time for our customers, getting them back on their jobs faster, further differentiating our value proposition. Moving on, I would like to comment on two areas that we've been focused on that I think are appropriate to discuss in today's environment, which are inflation pressures on transportation costs and a tight job market as it relates to turnover. On transportation, year-to-date the teams have worked very hard to contain inflationary pressures that exist. In fact, the increase in our net transportation costs, including third-party freight and fuel, are in line with our sales growth. Lastly, I would like to point out that even in today's competitive job market, our attrition rate is down. Our employer of choice focus has allowed us to attract, retain, and develop the best team in the industry; between our suppliers and our exceptional team, we are able to provide unparalleled value to more than 100,000 customers. Thank you for your time today. I will now turn the call over to Mark for his financial commentary.

Thank you, Pete. I’ll start with a quick comment on gross margins. As discussed in some detail at our last Investor Day meeting, our big business results for any given quarter will reflect normal year-over-year changes in product mix, which will drive some variation in year-over-year margins. However, on an annual basis, margins should be relatively flat. Our results this year reflect that, with mix changes driving 10 basis points lower gross margin in the quarter and no change in the year-to-date gross margin as you can see when looking at our base business results schedule. With five acquisitions and seven new locations opened since June of last year, we had a bit more noise in our financials this quarter than most, so let me focus your attention for a minute on that base business addendum included in our press release. Note here that the excluded business results for the quarter included just five acquired businesses but not the seven new locations which were opened in existing markets and for our base business definition are not excluded from base business results. These acquired locations contributed $4.4 million in gross profit and added a like amount on operating expense. So there was no profit contribution from these in the quarter and a $1.2 million operating loss year-to-date. In addition, the seven new locations also had negative contribution results in the quarter and year-to-date. As we've discussed in the past, new locations and most acquisitions take a number of years to grow into our expected return and are normally dilutive in the short term, as has clearly been the case this year. Despite the negative contribution from acquired businesses and new locations, base business operating expenses as a percentage of sales were flat year-over-year for both the quarter and year-to-date. So we did not pick up any operating leverage as we would normally expect, and flat year-to-date operating margins of 12.2% this year and last. So let me fill that back a bit to help you understand where we’re at looking at base business expense growth and our outlook for contribution margin improvement. First, as we mentioned in our press release, the U.S. dollar weakened against major currencies compared to a year ago. This favorably impacted our sales and margins while unfavorably impacting operating and non-operating expenses with no bottom line impact net. The impact on operating expenses was to add $700,000 for the quarter and add $1.8 million year-to-date. The U.S. dollar now sits about where it was a year ago, so I wouldn’t plan on substantial additional impact for the year, although there may be some. A bigger contribution to our expense growth in the quarter relates to changes made to non-executive performance-based compensation, which shifted some of the incentive opportunity for certain employees to the peak of our pool season. This resulted in approximately $1.5 million greater expense in the quarter than Q2 last year. We expect this higher Q2 cost to be more than offset in the remainder of the year, particularly Q4. Backing up the FX and incentive comp timing impact base business expense growth, and the impact of new locations of approximately $500,000, our base business operating expenses would have been closer to 4% growth for the quarter, which is more in line with what we're looking for given our expected sales growth. With the sales contributions we’re expecting as contractors catch up on their backlog over the next few months and the positive impact I just mentioned from expense recognition timing, we expect to see some of the operating leverage we’re looking for in Q3 and even more in Q4. This should get us to our targeted 20 to 40 basis points base business contribution margin growth for the year. I’ll comment now on interest and other non-operating expenses, which were $2 million higher than last year Q2. We’ve already mentioned the currency exchange impact, which added $0.5 million to this line in the quarter, with the remainder of the cost increase related to both higher debt levels and higher interest rates which I cautioned about on our last call. For the quarter, our average debt was $627 million, which was up 20% over Q2 last year, while our average interest rate on debt was 3.23%, up 35 basis points from a year ago. We will continue to see elevated costs in this line for the remainder of the year, adding roughly $2 million in interest cost compared to last year over the back half of the year. As a reminder, we look to keep our leverage, as calculated on a trailing 12-month debt to EBITDA basis, at between 1.5 and 2 times. We ended Q2 at 1.7 leverage, so right in line with our target. Moving down to taxes, you’ll note that we picked up a slight benefit from the ASU 2016-09 accounting, which was similar to the benefit we recorded in Q2 last year. Excluding this benefit, our tax rate in the quarter was 26%, or 50 basis points higher than the 25.5% pre-ASU tax rate I discussed last quarter as our forecast for the year. This 25.5% rate is still a good number to use for the year, and we will get there by making up for a slightly higher Q2 rate with a slightly lower Q3 rate. Turning to the balance sheet, total receivables increased from $370 million last year to $404 million this year, which was a 9% increase that was right in line with our sales growth for the month of June. Inventories grew a bit more at 12% year-over-year reflecting roughly $40 million deliveries made on mid-year purchases discussed by Manny and Pete. As we grew accounts payable at 10% year-over-year, the impact on our cash flow from operations was not significant. As you can see from our cash flow statement, our cash from operations improved by $5 million year-over-year, resulting in a seasonal use of cash for the year of $37 million in 2018. Note that given the vendor pricing dynamics and how that will impact our purchases this year, it is likely that our cash flow from operations will not exceed net income for the year, although that should recover and return to normal in 2019. I should also point out that PP&E expenditures are down $10 million year-over-year at $25 million year-to-date, which is in line with the forecasted $40 million total capital expenditure forecast for the year that I provided on our last call. Next on my list is share repurchases, which for the quarter were $250,000 shares repurchased at an average price of $140 using $35 million in cash. As a reminder, we target $100 million to $150 million in share repurchases for the year to return excess cash to shareholders and to keep our debt levels within our targeted leverage range. I'll finish with the mention of our return on invested capital at the end of the quarter, which is calculated on the basis of trailing 12-month after-tax operating income over net invested assets. This metric reached a new high at 28.6% at the end of June compared to 24.2% last year. Now I’ll turn the call back over to the operator to begin our question-and-answer session.

I want to start off Manny, you mentioned some noise on gross margins in the last four months of the year, but you also said that there would be a notable impact on gross margin from some of the supplier price increases. So, can you just clarify that comment? What did you mean by noise?

Given our cost pressures primarily on raw materials, steel being one prime example given the profile that steel has with tariffs and everything else. But just the raw material cost increases that many factors are incurring. As well as what I have mentioned for the last at least two, if not three calls on some of the impact on chemicals, there are price increases taking place and some of them have already been announced. As they are being announced and there is the set data that they are effective, we typically buy into those increases. How much we buy will depend on the extent of the increases at the individual SKU level. Following that, we typically raise prices in the marketplace 30 to 60 days later. The noise happens on how our competitors follow or not follow our lead in terms of passing on those price increases. The vast majority have the business sense to realize that there's a higher cost and therefore just like we do when they pass it on. In some cases, they don't realize that the facility costs money and it costs money if they borrow money. So they don’t have that business sense, and therefore they don't pass those increases on. We have to selectively respond to that. So, the noise there is as those timeframes come to place which are really going to start in September and then move on through the fourth quarter. The noise is that we could have some inventory gains on the margin side from the fact that we bought in on certain SKUs, and that’s how the accounting rates capture it although we price them on replacement cost. In some cases, depending on how some of our competitors react in certain markets, they may hold prices, and therefore, in certain markets, we may not - we may have a price compression or margin compression dynamic. Overall, I don't see any significant impact, but again that's largely premised on the fact that our competitors have the same business sense we have in terms of realizing that there are higher costs of doing business, and those costs are not only products but also facilities and the cost of capital. The last point there Ryan is that for 2019, the expectation is that inflation will be more than the norm, and you've been following the company for a number of years. When we talk about our long-term trajectory, we're typically referring to a 1% to 2% average inflation rate. As you know very well, for the past six, seven, or eight years, that’s been closer to 1%, if that. This year will be one of those blip years where we’ll have a little higher than normal inflation which will transfer itself to logically sales growth.

So, a little worry on price costs as it relates to the fourth quarter might be offset with some inventory profit. But what about into 2019? Would you be worried about price costs in 2019 or with the smaller competitors, would it just be a timing issue and they would eventually pass along the supply price point?

By 2019, those that haven’t passed around will be out of business. So the logic is that that would happen in the normal course. Typically, that transition period is usually - we may go up in 30 to 60 days from the effective date. Some may do it 90 days or 120 days, but at some point in time as they start replenishing their inventories at higher costs, they are already very marginal as it is. So, they will just go on to order very quickly.

Moving on to OpEx growth, it sounds like the fourth quarter is going to have the slowest year-over-year operating expense growth of the year. I am just hoping you can give us a little color on what should be the range of OpEx growth in the third quarter and then also in the fourth quarter just to calibrate our models?

I would say not to be too specific, but the growth rate that we experienced in the second quarter, really the first half of the year, which was similar in the second quarter, will come down, I would say, by a couple basis points or a couple hundred basis points in the third quarter. And then a couple of hundred more in the fourth quarter. So, I’ll just give you a general expectation of where we’re headed there. And that has a lot to do with some of the timing differences on incentives and some other costs.

And just a little clarity there, so is it that the incentive comp dollars are actually going to go down in the third quarter and fourth quarter?

Year-on-year, yes.

Year-on-year yes, okay, good.

Remember last year we had a very good fourth quarter and so that's part of the incentive comp change story.

And just lastly, and I’ll pass it on, it sounds like you're still excited about the end market, things are still strong, you're expecting a solid second half. I'm wondering if you can just comment on July month-to-date. I don't know if you normally do that, but it would just be helpful if you had a little bit of color there?

Yes, I would say Ryan, it’s consistent with what Pete mentioned that we were at nine in May and June and the backlogs are still very strong, and we’re tracking at a similar rate in July.

First off Mark, you mentioned other expenses being $2 million higher in the second half of this year. I assume that’s for the full half-year so it's roughly give or take $1 million in each of the quarters?

Right, and other expenses specifically were interest and other non-operating income, so that's really interest. Looking at higher debt levels and the higher interest rates and of course it depends a bit on share repurchases, timing on execution of that, roughly looking at a $2 million higher expense for this whole second half.

And then on the topic of price increases could you talk about what sales benefit you saw in the second quarter from price specifically? And then Manny, last quarter you said you were expecting 1% to 2% price increases. I think you said closer to two than one in the back half of this year. And it sounds like you are no longer expecting it for 2018, but you’re pushing it out to 2019, am I reading that right?

No, first of all no impact in the second quarter on price increases in terms of the many factor price increases that started to be announced. They started to announce them in the second quarter, but they were effective mainly starting in the third. To date, all starting in the third given what we've been communicated to date. No, the expectation was typically in most years on a long-term basis where we look at inflation being 1% to 2%, but in this year, it will run closer to 2% for the year and it will be greater than 2% certainly in terms of 2019.

So let’s talk about the operating expenses here for a bit. When did the comp plans change? Was that a January 1 change?

No, we decided to change in March and what we essentially did was change about 3,000 employees' bonus programs that were tied to monthly sales and profitability to change those to be focused more on the five biggest months of the year which are April through August. Same metrics, just from 12 months of the year to five months of the year which is when obviously the busiest people are working longer hours and that's when all the stress is.

I see, so second quarter expenses are…

So normally the second quarter would have represented 25% of the bonuses for those 3,000 employees in prior years. This year it represents 60% of the annual bonus.

I see, so the third quarter and fourth quarter of this year will both be lower than they were a year ago, and then even the first quarter of 2019 will be lower than the first quarter of 2018 because that change rolls over is that right?

Yes.

And then finally, I'm just trying to understand, I think you explained a little bit, but so the program is still tied to the same behaviors? You’re not trying to drive any new behaviors; it's just that you're more closely aligning with when the sales happen, is that correct?

And when people are working the longest hours.

So just wanted to follow up, Manny you may have said this and I may have missed this. As far as the extent of the midyear vendor price increases, is there a way you can quantify this?

Well, they range from zero to about 10% at SKU level, and this is on the equipment side. On the chemical side, it’s around 4% to 5%.

And as far as your inflation expectations for 2019, you said it would be greater than 2%, but are you it sounds like you may be reluctant to give us a more specific range for 2019?

That’s true, and the reason for that is that typically the vendors in the business, to the extent they have price increases, typically communicate them in the fall. So, we have only seen some of the price increases to date, and it would be pretty premature for me to speculate as to what the total would be for next year.

And if there are additional price increases, is it safe to assume that you would purchase inventory ahead of those price increases?

Yes, depending on the amount of the increase and the stakes available within our facilities.

And as far as the share buyback, so if I heard it correctly, it sounds like you’re still targeting about $100 million to $150 million of share buybacks for the year, right?

Correct.

Right, so I guess you have some catching up to do in the back half. Okay, that's all I had. Thanks and good luck.

I’m just wondering if you can comment on your expectations for base business growth for the rest of this year. I think coming out of the first quarter, you had expected full year base business growth to be closer to the low end of the 6% to 7% range. You’re tracking in line with that in the first half and now you got price increases coming through. So, and you actually had a very strong last several months, so just wondering if you could provide some color on how that should end up tracking for the remainder of the year.

Garik, there is the - first of all, the annual weighted impact from the fourth quarter and the price increases will obviously dilute the overall impact, but I still think that the year we’re still at 6 to 7. I feel much better about where we are on the 6 to 7 range than I did three months ago, given what we’ve seen in May and June and month-to-date July.

I did want to follow up on the recent trends, the acceleration, the 9% growth that you saw in May and June, and the continuation here in July. Anything specific that you can call out that’s driving that pickup?

No, it's across the board. Pool owners obviously have their pools; they maintain their pools, and that’s always been the case. On top of that, they’re renovating. Pete mentioned building materials growth of 12%. I mean, they’re still spending money, and we still continue to grow share, and both of those things fundamental to us are continuing to happen. The constraint, frankly, is customer capacity. In some cases, like Florida, Pete mentioned the fact that they had a lot of rain in May and June; were it not for that, I feel that we probably would have grown faster than 9% in those two months certainly. So, there is a customer constraint as the fundamental limitation and the ability to do how much they can do in a given day.

And then just on the constraint, just a follow-up: is this beyond just the labor constraints for new pool installations? Are you seeing constraints as well on the normal day-to-day maintenance piece?

No, the constraint is primarily weighted on the more labor-intensive portions of the business. For example, since you opened the door with the new pool comment, it could very well be given the late start of the year and just general labor constraints that new pool construction may be flattish this year. It isn’t because of demands; it's because of the window available to actually do the jobs. When you look at a new pool, typically our products, our materials that we provide to that builder of that pool typically represent 20% to 25% of the total cost of the pool. Whereas when you look at other aspects that are proportionately a lot less labor intensive, like for example the replacement of equipment, in those cases there are really no impediments.

Interest expense, Mark, you're talking about clicking up a bit obviously in Q2 but also the back half. Given where rates are doing, can you help us think about perhaps what FY 2019 would look like? Would it be wise to assume just $1 million more than the front half of 2019 given the trends we’re seeing in the back half versus the front half of 2018, and that would kind of put it at a higher rate obviously for the year?

Well yes Ken, certainly 2019 will be up. So it’s a question of both the debt level and interest rates. We are maintaining leverage, so you have to model out what that leverage is going to be. Let's call it middle of our range 1.75 leverage; how much debt would that translate into? So it's got to be more than $1 million, I’m sure, in the first half of the year when you factor in both the rate and the debt level.

And what is your guide, I apologize, but just quickly, you probably have it – how much of your debt kind of tied to the front end of the curve?

Well, debt is both working capital related, and again, we use debt to fund share repurchases. The timing on that depends on when the share repurchases take place, number one.

Okay.

It's definitely front-end loaded on the working capital investment and in mid-spring.

All right, and I’ll agree to that. Now, Manny, obviously there have been more questions on price consistent with your highlighting it. Price increases with manufacturers to you guys out to the market. Are you trying to put this in the context that whilst it’s higher than last year and the year before for certainly for chemicals and some of these other components, but is it really all that different from your experience in general or is there something unique about this versus the last 15 years?

No, this is unique, and what happens here Ken is that typically, price increases are pretty muted in the overall scheme of things. But every so often, there are triggering events. I think the last time something like this happened was I think in either 2009 or 2010 where there was a higher than normal level of inflation that kicked in. So, this is what - that’s why when we talk about this in the long-range expectations we look at one to two and really what happens is there are five years of one and maybe one of four or five right.

Yes.

And that’s what we could be looking at depending on what happens with the rest of the vendors announcing their changes, if any, in the back half of the year.

Then just for the weather comps, I mean it’s amazing just kind of look at de novo mean temperature percent house for the country and see that you’re going to have a weak April and then fine May and June. As it relates to your pools being up and running, etc. that took part of the business I understand that. Is there some different impact as it relates to the commercial and/or landscaping business related to those weather patterns because I assume obviously we are talking chemicals and pumps that, I mean the discretionary component, is that influenced by the weather as much?

Well, there is - okay, there is two parts weather. One is on the seasonal markets when pools are opened that’s part one. Part two is in the year-round markets, and in the seasonal markets, precipitation is the next factor in terms of certain bodies of work. For example, renovating a pool or building a new pool. You need to be reasonably dry to be able to do that, and that affects also irrigation. So, on the irrigation side of our business, yes, if it's too wet, it typically delays that body - that aspect of work. Now for us, we still have a very strong—I mean, as Pete mentioned, we were up 7% in the quarter organically on the irrigation side of our business. We are like 8.5% on a year-to-date basis on that side of the business. So, we’re clipping along well across the board in the four biggest markets. Again, as Pete mentioned, despite some other weather challenges, we were still up 7% in the quarter. So, that speaks volumes about how we’re transacting business. It also speaks well about the fact that demand is there, and as soon as our customers can work, they work.

I wanted to ask real quickly on the POOL360 app, which I believe you said was up around 21% year-to-date. Are there any efficiencies coming into play? I mean, any savings on labor that we should think about going forward with as more people kind of use this tool?

Sure, certainly there is going to be some, but it’s still relatively small, so it’s growing at a 21% rate. In the future, it would have a larger impact, but the percentage of our total rate now would suggest that the overall impact in the short-term is going to be small.

And then, just kind of on the inflation, and I understand that it's getting higher, but this is more so related to new pool construction. I mean, is there a point where you think that when you think about higher labor cost and labor tightness and then more inflation on kind of the products side, where people maybe put off installing a pool? Or is just the demand so great there that, that should not be an issue for the near future?

Yes, if you look at and have a perspective here, new pool construction is still down about 60% compared to what it was 12 years ago. If you look at other discretionary expenditures, they have in fact recovered faster than new pool construction has. I think there are two key reasons for that. One reason is the availability of financing since a new pool view is a home improvement. Home improvement lending is still very depressed. The second factor is labor capacity: when you're manufacturing something in a plant and you’re protected from the environment, you can work pretty much every day. That is not the case when you're building a pool or basically in your outside space. So that's been a constraint in terms of the ability for that to ramp up together with the other discretionary expenditures.

Thank you, Anita, and thank you all for joining us today. Our next call will be on Thursday, October 18, when we’ll discuss our third quarter 2018 results. Thank you and have a great day.