2023-10-20 12:46:49 ET
Summary
- Pool Corp's shares fell 3.5% after reporting Q3 earnings impacted by slowing pool construction.
- The company's revenue fell 9.3% from last year, but pool-related activity remains elevated relative to history.
- Pool Corp's majority of revenue comes from maintenance and service work, providing stability and cash flow visibility.
- While this recurring cash justifies a premium multiple, I see a fair value closer to $275 than to current levels.
Shares of Pool Corp ( POOL ) fell by about 3.5% on Thursday after reporting Q3 earnings that showed the impact of slowing pool construction. Frankly, given the slowing housing market and unwind of the post-COVID boom that have weighed on POOL, the shares have actually performed solidly over the past year, in part because POOL’s business is less cyclical than many realize. While Pool Corp is an impressive business, dominating a niche industry, shares screen expensive for a business likely to see muted new construction activity.
In the company’s third quarter , it earned $3.50 in adjusted EPS, which was $0.06 ahead of consensus on in-line revenue of $1.47 billion. EPS was down about 26.5% from 2022 as revenue fell 9.3% from last year. I would note this was still the second-highest third quarter in company history on a revenue basis. So while pool-related activity has come down, it remains elevated relative to history. POOL also saw margin compression, which exacerbated the revenue decline, though some of this was due to accounting.
Last year, POOL made the shrewd decision to pull forward the purchase of supplies and product as it saw inflation coming and wanted to buy products at lower prices, given it had the balance sheet flexibility. We obviously have seen meaningful inflation, and as the company has now sold through this pre-bought inventory during the quarter, it is now selling inventory purchased at today’s market prices. In a sense, margins over the past few quarters were exaggerated, but this decision netted about $7-10 million in one-time income for shareholders. As a result of this and some natural operating de-leveraging from lower sales, operating margin was 13.2% down from 16.3% last year. Gross margins similarly posted a decline of 210bps.
As it has sold through excess inventory, inventories are down $280 million from last year to a more normal level of $1.259 billion. This improvement in working capital has also allowed POOL to pay down $479 million in debt over the past year, leaving it with just $1 billion in long-term debt. POOL has a sturdy balance sheet, as it should give the cyclicality inherent in the pool construction side of the business. While the company has generated $707 million in free cash flow year to date, it is important to normalize this for the reduction in working capital, a one-time benefit, leaving it with $477 million in true free cash flow. Still, POOL should generate $575-600 million in full year free cash flow, a solid outcome.
While POOL has a smattering of irrigation/landscaping offerings and a minor international exposure, it is primarily a North American pool business, as its corporate name suggests. That is where 88% of its revenue comes from. However, within pools, it does two distinct things: it builds pools, and it offers services and products to maintain them. These businesses are obviously intertwined. After building the pool, POOL Corp aims to maintain a relationship with the customer by servicing it in future years. The more pools it can build, the higher the installed base for maintenance work.
At the risk of being simplistic, one can see a parallel to Apple ( AAPL ), which sells iPhones, (the initial product sales), to then collect recurring service, iCloud, and app revenue fees on its ever-growing user base. Of course, phones and pools are quite different, but the underlying model of selling a product to then sell add-on recurring services is a fundamentally good business model. With shares up nearly 500% over the past decade, long-term holders of POOL are certainly pleased.
POOL generates about 17% of its revenue from building new pools. This is the most discretionary (i.e. economically sensitive) aspect of its business. Pools are expensive—costing between $50-$100,000 for most of POOL’s offerings—and with interest rates so elevated, tapping home equity to borrow to add a pool is an expensive proposition. Based on permitting data, new construction has been trending down 30% this year.
Interestingly, POOL is seeing new construction weaker at the entry level pool category, whereas the high-end is holding in better. This is likely as those “stretching” to afford a pool are more prone to be more reliant on financing, which has become expensive, whereas wealthier consumers with assets on hand to fund the pool are less impacted by shifts in interest rates. Management is cautiously optimistic that construction activity is towards its bottom.
Next, POOL generates about 22% of its revenue from remodeling/reconstruction work. This activity is less discretionary than building a new pool but often somewhat discretionary. Now, if there is a leak or if there is an equipment failure, that needs to be dealt with immediately. At the same time, if a customer is considering redoing stone or tile work around a pool because the current fixtures look old, that project can be delayed a summer or two.
In the third quarter, building materials sales were down 13% while equipment was down 9%. That is across both newbuild and renovation activity. While POOL management believes they are gaining share, given that new construction is down 30%, these more modest sales declines speak to the stabilizing nature of the renovation work.
Finally, POOL actually generates about 61% of its revenue from maintenance and service work—that is the majority of the business. Maintenance activity has been steady because it is fairly nondiscretionary; as any pool owner can attest, if you try to skip putting chemicals into the water for a few weeks, problems can quickly crop up. Indeed, chemicals sales were up 5%. As you can see below, its maintenance and service work covers all aspect of owning a pool with no excess dependency on any product, indeed POOL sells over 200,000 products.
Given the softer level of new construction activity, POOL brought down the higher end of its earnings guidance, which had already been discounted by investors I believe, given its share price decline over the past two months. It now expects full-year earnings per share to be $13.15-$13.65 from $13.14-$14.14.
That leaves shares with a 25x earnings multiple. At first, that seems jarring and extremely high for a pool construction company when homebuilders for instance trade below 10x earnings. Similarly, its free cash flow yield of 4.4% is not exactly cheap, though it does support POOL’s 1.3% dividend yield, 1.5% share count reduction over the past year, and a smattering of bolt-on acquisitions.
Now, before getting too bearish, I would emphasize how the majority of POOL’s business is actually not tied to construction; it is less cyclical of a business than it first seems. That is why revenue is down 10% when new construction is down 30%. Its maintenance works provides meaningful safety and cash flow visibility. Additionally, the number of pools continues to rise, up 7% since 2019, and up nearly 40% since 2000 to 5.5 million, according to POOL Corp. This has powered the company's ongoing, long-term growth. As the number of POOL-built pools increases, its services revenue should reset at higher levels, creating a virtuous circle.
Additionally, even within construction, more of POOL’s business is tied to renovating and remodeling existing pools than building new ones. This is clearly not as stable as maintenance work, but it is more stable than new construction. Moreover, once again, as the installed base rises, that will translate to more pools in need of renovations in the future.
If one values the maintenance work at 20x, the renovation business at 15x, and new construction at 10x based on each business’s certainty of cash flows, POOL would have a fair multiple of ~17-17.5x earnings. In other words, its solid business model justifies a premium multiple to pure-play cyclical, construction companies, but I am left finding shares expensive at about 24x earnings.
Now, one might argue with pool construction already down 30%, its construction earnings power is depressed. I do recognize this point, though with rates so elevated, and the personal savings rate down below 4% I struggle to see pool construction accelerating, though it may not fall further. I would note that last yea r, excluding items, POOL earned a record $18.43. Now, if we boost that 1.5% for share count and 1.5% for growth in the installed base increasing maintenance work, POOL’s “record” earnings would be $19 today. At my blended 17x P/E, that would value POOL at $323.
At the run-rate $13.50 in 2024 earnings that I forecast, assuming flat construction activity and modest maintenance growth, a 17x multiple would value POOL at $230. While $230 may be too low given pool construction has fallen so sharply, shares are currently discounting a return to record levels of construction, which feels overly aggressive.
POOL is a good business with a great model, but it faces clear cyclical headwinds on the construction side of its business, and shares are really priced for protection. At this valuation, POOL is a sell. Respecting the fact pool construction profits are cyclically depressed, shares probably will not reach the $230 level, as investors will look through that to some extent. Assuming a normalized activity level halfway between current levels and 2023’s record boom, POOL is more fairly worth ~$275. That is over 15% downside from here, making shares a sell. POOL is a good company, but investors should wait for a better price to buy it.
For further details see:
Pool Corp: A Great Business At An Excessive Valuation