2023-05-01 09:30:00 ET
Summary
- POOL released a discouraging Q1 result, which sparked my interest in studying the worst-case scenario.
- In a worst-case scenario, I believe the stock could hit $101.83, representing a further 70% downside from its current level.
- But, even if we compare the "worst-case" scenario against the "better-than-expected" scenario, the risk-to-reward ratio is still approximately 1:1.
- The short-term headwinds shouldn't overshadow POOL's strong fundamentals and promising future.
Pool Corp (POOL) released its FQ1 2023 earnings report on April 20, 2023. Surprisingly, it disappointed the analysts by a wide margin. Facing tough comps, net sales were down 15%, gross profit decreased 17%, operating income plummeted 38%, and earnings per diluted share dropped 41% to $2.58, which missed Wall Street's estimates by $0.73. As CEO Peter D. Arvan reflected , unfavorable weather conditions in the western markets and a weakening economic backdrop slowed down new pool construction activities and sales of maintenance-related products.
Thus, the company updated its annual guidance range to $14.62 to $16.12 per diluted share, which is short of the analysts' consensus of $16.24.
However, I believe POOL will prevail as a long-term winner, although short-term turbulence may undermine the stock's performance. Let's not forget the company has an excellent track record (an incredible return of 35,000% since being listed in 1995) and a continual growth trajectory.
Preparing for the worst
The yield curve inversion hints a recession may hit soon.
It is important to raise our preparedness for an economic recession. In the book Richer, Wiser, Happier, author William Green borrowed the words of Jeffrey Gundlach :
If I assume that I'm wrong on this, what's the consequence going to be? Make your mistakes nonfatal.
In my last article on POOL, I rated the company as a BUY because: "Backlog cases still provide strong demand for new pool construction and refurbishment. And the demand for repair and maintenance products is recurrent and less disturbed by the macroeconomic atmosphere… even if POOL's earnings are cut in half in 2023, the PE ratio will still be lower than the 5-year average at the current price level. Thus, I believe it is a rare opportunity to buy some shares of this excellent company considering the underlying risk and reward."
I remain long-term bullish on POOL. But I am interested in studying the worst-case scenario to see how bad it could be if my previous investment thesis did not play out.
New Pool Construction and Pool Refurbishment
The company estimated in their latest earnings call that there would be:
- A 25% decline in sales of the pool construction segment, and
- A 10% to 15% decline in volumes of products used in the remodeling, renovation and upgrading of swimming pools.
US consumer sentiment remains low and cautious, although headline inflation moderated to 5% in March 2023. Retail sales of building materials, garden equipment and supplies reached a plateau after a rapid gain benefited from the pandemic.
The delinquency rate on credit card loans ticked up for five consecutive quarters from the Q3 2021 low, which shows the financial situation of consumers is deteriorating and may slow down their spending in the near future. Meanwhile, as reported by Reuters , economists expect tighter financial conditions will undercut consumption and push the economy into recession.
Board of Governors of the Federal Reserve System (US)
All of the above points to a potentially weakening discretionary spending on swimming pool products.
A huge decline expected
During the Great Recession, the scale of housing market activities plummeted dramatically. If private housing units under construction and building permits drop to a similar level in 2008 due to recessionary market conditions, implying a 70% drop from the current level, the sales volume of swimming pool products is likely to plummet by a similar range.
Given prices of swimming pool products are likely to rise moderately under an inflationary environment, I assume net sales for the new pool construction segment will decline by 65% from FY2022.
U.S. Census Bureau and U.S. Department of Housing and Urban Development U.S. Census Bureau and U.S. Department of Housing and Urban Development
Although existing home sales are also adversely impacted by economic conditions, it only dropped by about 40% in 2007 and 2008. By the same token, I will assume net sales for products used in remodeling, renovating and upgrading swimming pools will decline by 35% when a recession hits.
Repair and Maintenance
The repair and maintenance segment is vital in POOL's business, representing around 60% of the total sales. During harsh economic conditions, it plays an even more pivotal part as other segments may perform poorly.
The company estimated in their latest earnings call that:
On the maintenance side, that was the volume related versus our expectation on inflation, still remains around 4% for the full year.
Sales may fall moderately
Revenue from this segment is recurrent and non-discretionary, but a weak economic outlook will still affect its performance, particularly those related to low-end pools.
According to the data from the U.S. Bureau of Labor Statistics, expenditures on maintenance, repairs and insurance dropped by around 5% from 2008 to 2010. And I believe it will stay more or less the same in the upcoming recession.
U.S. Bureau of Labor Statistics
Horizon
Apart from swimming pool businesses, please don't discard Horizon, which is accountable for 8% of net sales in 2022. The company predicted a 5% to 10% decline in 2023 due to weakening construction activities.
In the worst case, I anticipate sales from Horizon will decline by 30%, in line with the decrease in building materials and garden equipment sales from 2006 to 2010.
Summary
Taking the above assumptions, the revenue will drop by 20.5% from the 2022 level.
Segment | Sales Mix | Revenue Change |
New Pool Construction | ~15% (Assume 14%) | -65% |
Pool Refurbishment | ~20% (Assume 17%) | -35% |
Repair and Maintenance | ~60% (Assume 61%) | -5% |
Horizon | 8% | -30% |
Total | 100% | -20.5% |
Assuming margins return to normal (gross margin at 30% and operating margin at 12%) and other expenses are similar to the 2021 level (e.g. $180M), FY2023 EPS will be $10.37.
Revenue in 2022 () | 6179.7 |
Estimated Revenue in 2023 () | 4912.3 |
Estimated Gross Profit () | 1473.9 |
Estimated Operating Profit () | 589.5 |
Estimated Net Income () | 409.5 |
Shares Outstanding ('M') | 39.5 |
Estimated Earnings per Share ($) | 10.37 |
Still safe to invest in POOL?
So, when there are chances that EPS may drop by almost half in 2023, is POOL still a sound investment in the long run?
The answer is still a big YES in my view.
A Solid Balance Sheet
POOL's long-term excellent performance has provided the company with a solid balance sheet. Although the company raised substantial capital in 2021 to acquire Porpoise Pool & Patio, it is still not heavily indebted. Also, under a high interest rate environment, the company keeps the effective average interest rate at 4.4%, which is a similar level to the US 1 year Treasury Yield.
Below displays the financial health metrics of POOL, which demonstrate its financial strength.
Debt to Asset Ratio | 0.43 |
Debt to Equity Ratio | 1.31 |
Equity to Asset Ratio | 0.33 |
(Source: Author, data from Gurufocus)
Valuation risk
Ben Graham said:
In the short run, the market is a voting machine, but in the long run, it is a weighing machine.
In 2008, when the market sentiment hit rock bottom, POOL recorded a PE ratio of 9.82. This resulted in a huge contrast to the skyrocketed PE ratio during the pandemic hype.
If the EPS of POOL reaches $10.37, while its PE ratio sinks to 9.82, the stock would theoretically trade at $101.83, representing a further 70% downside from the closing price on April 24, 2023.
But what if the market is wrong that there won't be a recession in 2023? Let's assume the EPS of POOL stay flat at $18.89, and the stock returns to its 15-year PE average of 28.68. There will be around a 61% upside.
It seems like a promising investment this time.
It is surprising that when we compare the "worst-case" scenario against the "better than expected" scenario, the risk-to-reward ratio still hangs at approximately 1:1.
Still A Long-term Winner
The short-term headwinds will not overshadow POOL's strong fundamentals and promising future in my opinion.
Analysts from Stephens Research opined that:
20x next year's earnings for a best-in-class, high quality compounder that consistently puts up 25%-30% ROIC, consistent market out-performance and strong FCF is an attractive entry point.
As the world's largest wholesale distributor of swimming pool supplies, equipment and related leisure products, the company is highly competitive in the industry. It also enjoys industry tailwinds like increasing in-ground pools and favourable demographic trends.
Thus, I remain long-term bullish on POOL and maintain my "BUY" rating on the stock at the current valuation.
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For further details see:
Pool Corporation's Discouraging Q1 Result: A Worst-Case Scenario Study