Description

Summary:

Pool Corporation (POOL) is a high-quality distribution business currently experiencing a slowdown in demand following a COVID-induced surge. Investor sentiment is quite negative at the moment as evidenced by short interest at ten-year highs. We believe the short-term disruption to POOL’s business is presenting an attractive entry point into a company with continued strong long-term growth prospects. While @SwissBear accurately predicted earnings disappointments in his January 2023 post, following this reset, we now see a path for 2025 EPS to come in >10% above consensus.

Business description:

POOL is the world’s largest wholesale distributor of swimming pool supplies, equipment, and related products. The company operates ~420 sales centers and ~92% of revenue is generated domestically. POOL procures products from 2,200 suppliers and sells to more than 120,000 customers, offering over 200,000 SKUs. The company defines its revenue profile as 61% maintenance, 22% renovation and remodel, and 17% new pool construction. (Source: POOL Investor Presentation and 10-K)

Industry/company background:

POOL is a secular share gainer within a secularly growing industry – the compounding effects of this growth are often underestimated by the Street. 50 years of data demonstrates that the installed base of pools in the US shows persistent, steady growth (i.e. new pools constructed > pool removals). As the chart below depicts, this low-single-digit CAGR has been fairly consistent, even during recessionary periods. 

Source: Hayward (HAYW) Investor Presentation

Once a pool is in the installed base it must be serviced or the homeowner will risk malfunction (and ultimately, home price degradation). Given that ~60% of POOL’s revenue is driven by maintenance of existing pools, this creates a virtuous cycle of growth.

While the graphic above points to the durable volume growth in POOL’s end market, the company’s historical performance has far outpaced the growth in the industry installed base. As shown below, from 2006 to 2Q23, POOL has grown organic revenue at a ~6.7% CAGR. This compares to US new housing starts decreasing at a 2.7% CAGR, US existing home sales decreasing at a 3.4% CAGR, and US home improvement spend (as reported by the Census Bureau) increasing at a 5.2% CAGR. POOL’s outperformance is clear whether including or excluding the COVID-induced demand increase. 

Sources: POOL Earnings Reports, Census Bureau

What drives the persistent outperformance? Perhaps the most underappreciated driver of POOL’s impressive organic growth is the very nature of the business model itself. Management has indicated that 80% of POOL customers are contractors of some sort. Said another way, the vast majority of POOL’s customers are not the actual end user of its products. Because many of these products are ultimately delivered to end customers with a service/labor component provided by contractors, the pricing of the products is often obfuscated and/or is not the sole decision factor for end customers. This is akin to the Sherwin-Williams investment proposition, whereby the company sells paint to professional painters, who then charge customers for their time and labor (in addition to the cost of the paint). Unlike more commoditized distributors in other verticals (lumber, chemicals, steel service centers, etc.), the nature of POOL’s business allows for pricing to increase annually. In fact, the company has stated that the broader pool category has never experienced price deflation.

POOL has also created its own flywheel of growth. POOL is nearly 4x larger than its closest competitor, privately-held Heritage Pool Supply Group, and the majority of other competitors are regional players. POOL has utilized its scale to procure the widest offering of products at the lowest possible price, thereby enabling new customer wins. The company also utilizes excess cash to continue opening new sales centers to further grow its footprint. POOL has grown its sales center count by ~3% annually over the past decade, and we expect low-single-digit growth to continue. 

Source: POOL filings

As evidence of the company’s dominance, the eight sales centers opened year to date are more than the rest of the industry combined.

Investment thesis:

Following ~22% organic sales growth in 2020, 28% in 2021, and ~11% in 2022, POOL is currently in the midst of a growth slowdown. The company has lowered its 2023 guidance in two consecutive quarters and the stock is currently ~33% below its late 2021 highs. Nonetheless, we believe POOL’s earnings are approaching near-term trough levels, and we expect the earnings recovery to be faster and stronger than consensus currently estimates.

While some of POOL’s revenue slowdown is clearly to be expected following an incredible acceleration of growth, the slowdown has also been exacerbated by declines in the new pool construction market. Industrywide new pool construction declined ~16% in 2022 and is projected to decline another ~30% in 2023 (Source: POOL Q2 2023 Earnings Call). These projected declines would take new pool construction to the lowest level since 2016 and below the longer-term industry average. On the surface, this would seemingly imply that the headwind from the new pool construction market is set to dissipate at a minimum. 

Source: Stifel Initiation Report April 2022

However, we can also sanity-check this assumption by viewing new pool construction in the context of overall new home construction. Although most new pools are installed in existing homes, new pool construction actually has a stronger correlation with new housing starts. The declines forecasted for new pool construction this year, alongside with new home starts observed YTD, would produce a new low in the relationship between these two variables. We see no reason for this historical relationship to deviate significantly from prior norms, and as such, we expect new pools as a percent of new starts to rebound next year. Said another way, should new home construction simply stabilize (let alone reaccelerate), it seems quite safe to assume that POOL will no longer experience a discrete headwind from the new construction market, historically its most volatile vertical, comprising ~17% of sales.

Source: Stifel Initiation Report April 2022

This analysis of the new construction market is just one factor that informs our view that POOL’s organic revenue does not need to revert much further than it already has. Based on the company’s guidance, POOL’s 2023 organic revenue will likely be ~55% above the 2019 pre-COVID level. We can explain much of this growth quite easily. Informed by POOL’s disclosures over multiple earnings calls, we estimate that cumulative pricing over this period represents ~37%. As aforementioned, pricing in the industry has a history of being incredibly sticky and we do not expect price increases to reverse at all. In fact, on the 2Q23 earnings call, POOL disclosed that it expects 2024 price inflation “to be above normal once again.” Additionally, we estimate that the installed base of pools has increased 7-8% since 2019. This is yet another “permanent” source of higher levels of revenue. This leaves just ~10% of cumulative revenue growth to be accounted for. Over the last four years, POOL has increased its sales center count by 15%  (POOL 10-K), more than explaining this remaining delta. Of course, we would be remiss not to mention significant share gains that we believe have occurred over the past several years and an overall home improvement market that is 90% larger than 2019 (Source: Census Bureau). Putting it all together 2023 should represent this cycle’s trough in POOL’s revenue.

Unlike many other “pandemic winners,” POOL has not experienced a massive increase in its gross margin; rather, the sharp increase in EBIT margin has come from leveraging G&A on a much higher sales base. This is not a new trend for POOL, as the company had “leveraged” G&A for twelve consecutive years, even before the COVID-induced demand spike. Though POOL’s gross margin did increase ~250bps from pre-COVID levels, we believe the margin reversion experienced in 2023 presents a new level from which the company can grow. This slightly higher gross margin base can be attributed to accretive acquisitions, pricing, and product mix uplift. 

Source: POOL filings

Net net, we believe 2023 is the trough for POOL’s earnings. This alone may present reason to invest in a high-quality “compounder.” However, we also believe the earnings recovery will be stronger than the Street assumes.

The real beauty in POOL’s earnings model is its ability to leverage its expense base. The continual downward glide path of G&A as a percent of sales shown above is evidence of that. Since 2010, POOL’s G&A has cumulatively increased at just 12% of its revenue growth rate. This provides tremendous margin leverage in an increasing revenue environment.

Modeling mid-to-high single-digit revenue growth over the next two years while increasing G&A at its historical relationship with revenue, should produce a ~10% EBIT CAGR. Assuming POOL utilizes all FCF for share repurchases and simply returns to the low end of its stated 1.5x-2.0x leverage range, this should allow for a high-teens EPS CAGR and 2025 EPS approaching $19.00, well above the Street at $16.89. Of course, more accretive uses of FCF (i.e. acquisitions) would likely take these numbers even higher.

Risks:

-          Competition: While POOL is the clear market leader, the pool industry remains quite competitive. Leslie’s (LESL), historically a consumer-facing company, has recently begun expanding its “PRO” Initiative to service contractors. Though the impact to POOL seems limited thus far, this bears monitoring nonetheless.

-          Interest rates: Although POOL’s revenue growth has historically outgrown almost all housing metrics, the company’s earnings are intrinsically linked to the housing market. Further rises in interest rates which would dampen housing activity (and access to broader consumer financing/HELOCs) would likely be a negative for POOL. However, we note that the company (and consumers) have already faced a historically sharp increase in interest rates over the past two years.

-          Chemicals: Chemicals historically comprise ~13% of POOL’s revenue. Because some of these products become less potent the longer they sit on a shelf, this is the one pool category which can be subject to price deflation, as has been observed this year in a particular subset of chemicals (tri-chlor). We expect POOL (and competitors) to exit the year in a clean inventory position, mitigating the extent of this risk going forward. 

Disclaimer:

The views and opinions stated are the personal views of the author. Do not rely on the information set forth in this write-up as the basis upon which you make an investment decision – please do your own work. The author and funds in which the author manages hold positions in and trade, from time to time, securities issued by POOL and options on such securities.  This write-up does not purport to be complete on the topics addressed, and the author takes no responsibility to update this write-up in the future.  This is not a recommendation to buy or sell any securities.

Catalyst

2024 guidance and/or positive earnings revisions