Description

Description

Trader Talk – historically good business coming off a cyclical low that can double as the cycle turns, sales improve, and opex and inventory efficiencies roll through the PNL

Introduction

Leslie’s (LESL) is the largest direct-to-consumer pool supplier and distributor in the United State, with smaller businesses targeting pool professionals and spas/hot tubs. LESL mainly targets the aftermarket pool supply market, with ~80% of revenues tied to repair and maintenance. The stock was a hot IPO in fall 2020, with the stock trading as high as 24x forward EBITDA and ~35x forward EPS in spring 2021 on the belief that it was a resilient, category killer with a strong growth outlook. Things have not gone so well since, to put it lightly, but I do not believe the business is permanently broken. Instead, I think LESL was coming off an unsustainable demand high from “stuck at home” COVID demand, and as we cycle forward into a more normalized environment, the stock can appreciate as a good, consistent retailer/distributor.

First, I’ll walk through LESL’s history to explain how we got here, and then I’ll explain why I think it’s an attractive buy here along with some key points to the thesis.

History

Prior to its IPO, LESL had been a “steady eddy” type of business passed between private equity funds. As the chart above shows, LESL had an admirable track record of consistent mid-to-high single-digit growth, largely due to the non-discretionary nature of pool maintenance. In fact, before 2023, LESL had grown for 59 consecutive years. Further, this steady growth came with some of the highest margins in hardline retail, due to LESL’s scale and the complexity of pool care.

Entering 2020, the company was poised for another year of steady growth, when the COVID pandemic, combined with record stimulus, drove a surge in demand for pools. The company IPOed in the fall of 2020, and this demand continued into 2021 and 2022. LESL sales grew from $928MM in 2019 to $1.56B in 2022, a ~70% increase driven by high-teens same-store sales growth each year. However, LESL was previously a tightly managed, PE-controlled business run to pay down debt with a great deal of outdated systems. For instance, LESL was still using Excel spreadsheets for areas of inventory management when most similar-sized retailers had moved to tailored software solutions. To facilitate this rapid sales growth, and arguably to catch up from underinvestment while in PE control, LESL rapidly increased its opex spending – inventory management software, modernizing omnichannel shopping experience (buy online, pick up in store), adding distribution centers, etc. Further, a fire at a chemical plant in 2020 caused a shortage of a key pool chemical, trichlor (10-15% of LESL sales), which along with general supply chain issues in 2021 caused LESL to invest in a large inventory buy during 2022 to ensure strong in-stock rates in 2023, as LESL assumed the POOL market strength would continue.

And then… everything changed.

Entering 2022, management made a classic, and typical, business mistake – they mistook a cyclical peak for regular demand trends. Throughout the year, they were building opex and inventory investments assuming 2023 would be another strong year, until sales began to deteriorate in fall 2022. Despite the slowdown, management did not expect, either through arrogance or an honest mistake, the degree to which pool spending would slow in 2023, and they repeatedly issued too-aggressive guidance, which was promptly followed by large misses and lowered estimates. Further, their erroneous sales assumptions combined with inventory and opex planning that assumed strong growth, which drove gross margins from 43% to 38% and EBITDA margins from 19% to 12% on what should have a manageable 7% overall sales decline. As a result, LESL shares have fallen from $29 in spring 2021 to $5 in fall 2023, and currently trade around $7.

Going forward, I believe the key questions are 1) are numbers at a bottom LESL, and 2) is LESL still a structurally advantaged retailer/distributor that should be able to compound EBITDA at a mid-to-high single-digit rate going forward? I believe the answer to both is yes.

Thesis

My basic thesis is that LESL can grow sales 15-20% in the next 3 years with 45-50% incremental margins, which gets EBITDA towards ~$300MM ($265MM-$315MM). This compares to 2024 guidance of $170-$190MM and 2026 Street consensus of $225MM. While this might seem high, 1) LESL had 2022 EBITDA of $292MM, 2) LESL has consistently delivered gross margins ex-rent in the highs 40s, and 3) I believe LESL has room to optimize opex, holding SG&A relatively flat to LSD growth as they lever their existing investments.

Looking towards the balance sheet, I believe LESL can unlock $100MM in working capital from burning through their excess inventory by taking inventory to sales from ~22% back to 15%, which combined with cash generated from the business can reduce net debt from $726MM at YE2023 to under $500MM by YE2025. Combined with rates falling ~200bps, I reach $25MM in 2026 interest, which along with ~$40MM capex and a 26% tax rate yields FCF/sh. of ~$1.

We can all debate the proper multiple, but if LESL returns to mid-to-high single-digit sales and EBITDA growth with debt back below 2x leverage, I think 10x FCF would be cheap and 15x reasonable, yielding $10-$15, or roughly a 50-100% return in two years.

Having said all this, this is riskier than most of my investments, and I am sized accordingly. For starters, one area I agree with bears is that LESL is quite levered at ~3.6x rent-adjusted debt to EBITDAR at the mid-point of LESL guidance. Should management execute poorly, or a significant recession hit the USA, a restructuring could be needed, though I think it is unlikely. I gain comfort in that LESL has managed to meet their guidance in the last two quarters, implying expense discipline and realism on demand. Further, LESL has historically been defensive in recessions (see the chart at the top of this report) and I believe overall pool conditions are normalizing. For instance, LESL’s hot tub sales are back to 2019 levels, pool installations are below pre-COVID levels, and pool equipment OEMs (PNR, HAYW, Fluidra) claim the channel is clean and are expecting to push their typical 3-5% price increases. LESL still must lap the price actions taken on certain pool chemicals last year, which will negatively impact sales and margins in the first half, but I am cautiously optimistic the overall pool market and LESL’s numbers are at a bottom.

Note: I have gone this far barely mentioning one of the most debated topics between LESL bull/bears – trichlor. Simply put, I do not believe this matters in the long term. During the pool bull market, LESL had access to trichlor when smaller competitors were rationed by suppliers, which certainly fueled some of LESL’s strong comps during the bull market. As the supply restraints reverse, customers are returning to their previous buying habits – i.e. stopping by Joe’s Pools because it’s on the way home rather than driving an extra 10 minutes to go to LESL. This has been a drain on LESL’s SSS and I expect it to continue to be a modest headwind this year, but I do not believe is not a long-term issue. LESL is still the largest buyer of pool chemicals and equipment and will continue to have a significant cost advantage as a result.

Model

Catalysts

·       Hitting estimates and guiding above Street for 2025

·       A strong housing market putting a bottom in on new pool side of the business

·       Delevering and returning to share buybacks

Risks

·       Impact of chemical pricing is stronger than expected, driving a miss in 2024

·       Significant recession

·       Large box players (HD, LOW, AMZN) changing course and significantly targeting the pool supplies market

·       Growth of “at home” testing solutions decreases the demand for specialty pool retailers

Nothing Permanently Broken

Big picture, I believe LESL remains a structurally advantaged distributor and retailer, which will enable it to work through its short-term operating struggles. LESL is by far the largest direct-to-consumer buyer of pool chemicals and equipment, including big box stores, which makes LESL the default low-cost provider. LESL believes its physical distribution network is larger than the sum of the next 20 largest competitors and that its online business is five times larger than the next competitor. Further, LESL provides not just products but also expertise. Bulk chemicals, such as trichlor, are a commodity purchase competing for the lowest price. However, pool chemistry is complex and price discovery between various chemicals is not always clear. For instance, it's Thursday afternoon, the pool is suddenly green and your kid’s birthday party is Saturday. What should you do? Many customers seek advice by bringing in water samples to the store and asking staff for help. To service these customers, LESL invests in significant employee training and maintains a dedicated, knowledgeable staff, which is not something larger box stores are so far offering nor something online players can so far deliver. In addition, LESL staff will make recommendations on products, such as “Leslie’s Power Powder Plus 73% Calcium Hypochlorite Pool Shock,” which is not necessarily comparable to the variety of brands selling similar products online. If you are not sure what to buy and not really sure what you are even buying when you buy it, plus you often need the product on short notice, it is very hard for customers to get away from shopping at specialty pool stores.

Further, while COVID certainly caused a boom in pool and spa sales and LESL’s management certainly misread it, large cycles in the pool category are the exception, not the norm, as the bulk of chemical and equipment sales are tied to existing pools rather than new ones. Once a pool is constructed, it needs to be taken care of every year. Failure to do so can result in an ugly problem – who wants to have a rotting swamp in your yard and filling in a pool with concrete is unsightly. This makes the demand for pool chemicals and equipment largely non-cyclical. COVID was a unique time (understatement!) when pool demand surged and supply issues in pool chemicals created a sales peak for LESL, but I believe this kind of cycle will be rare if it ever occurs again. Once LESL gets to the other side of its current issues, I believe LESL can return to being a recession-resistant, modestly growing business with a reasonable moat.

Catalyst

·       Hitting estimates and guiding above Street for 2025

·       A strong housing market putting a bottom in on new pool side of the business

·       Delevering and returning to share buybacks